Home > Uncategorized > Paul Krugman — finally — admits he was wrong!

Paul Krugman — finally — admits he was wrong!

from Lars Syll

economist-krugmanIn a recent essay titled “What Economists (Including Me) Got Wrong About Globalization,” adapted from a forthcoming book on inequality, Krugman writes that he and other mainstream economists “missed a crucial part of the story” in failing to realize that globalization would lead to “hyperglobalization” and huge economic and social upheaval, particularly of the industrial middle class in America. And many of these working-class communities have been hit hard by Chinese competition, which economists made a “major mistake” in underestimating, Krugman says.

It was quite a “whoops” moment, considering all the ruined American communities and displaced millions of workers we’ve seen in the interim. And a newly humbled Krugman must consider an even more disturbing idea: Did he and other mainstream economists help put a protectionist populist, Donald Trump, in the White House with a lot of bad advice about free markets?

Michael Hirsh

Yours truly has for years been complaining about Krugman on this issue, so of course, it’s great that he finally admits he was wrong!

Another issue on which I’m having a beef with Krugman is his view that his hobbyhorse IS-LM interpretation of Keynes is fruitful and relevant for understanding monetary economies. It is time for Krugman to come out on this also and admit he has been wrong.

My own view is that IS-LM is not fruitful and relevant and that it does not adequately reflect the width and depth of Keynes’s insights on the workings of monetary economies:

 Almost nothing in the post-General Theory writings of Keynes suggests he considered Hicks’s IS-LM anywhere near a faithful rendering of his thought. In Keynes’s canonical statement of the essence of his theory — in the famous 1937 Quarterly Journal of Economics article — there is nothing to even suggest that Keynes would have thought the existence of a Keynes-Hicks-IS-LM-theory anything but pure nonsense. John Hicks, the man who invented IS-LM in his 1937 Econometrica review of Keynes’ General Theory — “Mr. Keynes and the ‘Classics’. A Suggested Interpretation” — returned to it in an article in 1980 — “IS-LM: an explanation” — in Journal of Post Keynesian Economics. Self-critically he wrote that ”the only way in which IS-LM analysis usefully survives — as anything more than a classroom gadget, to be superseded, later on, by something better — is in application to a particular kind of causal analysis, where the use of equilibrium methods, even a drastic use of equilibrium methods, is not inappropriate.” What Hicks acknowledges in 1980 is basically that his original IS-LM model ignored significant parts of Keynes’ theory. IS-LM is inherently a temporary general equilibrium model. However — much of the discussions we have in macroeconomics are about timing and the speed of relative adjustments of quantities, commodity prices and wages — on which IS-LM doesn’t have much to say.

 IS-LM forces to a large extent the analysis into a static comparative equilibrium setting that doesn’t in any substantial way reflect the processual nature of what takes place in historical time. To me, Keynes’s analysis is in fact inherently dynamic — at least in the sense that it was based on real historical time and not the logical-ergodic-non-entropic time concept used in most neoclassical model building. And as Niels Bohr used to say — thinking is not the same as just being logical …

 IS-LM reduces interaction between real and nominal entities to a rather constrained interest mechanism which is far too simplistic for analyzing complex financialised modern market economies.

 IS-LM gives no place for real money but rather trivializes the role that money and finance play in modern market economies. As Hicks, commenting on his IS-LM construct, had it in 1980 — “one did not have to bother about the market for loanable funds.” From the perspective of modern monetary theory, it’s obvious that IS-LM to a large extent ignores the fact that money in modern market economies is created in the process of financing — and not as IS-LM depicts it, something that central banks determine.

 IS-LM is typically set in a current values numéraire framework that definitely downgrades the importance of expectations and uncertainty — and a fortiori gives too large a role for interests as ruling the roost when it comes to investments and liquidity preferences. In this regard, it is actually as bad as all the modern microfounded Neo-Walrasian-New-Keynesian models where Keynesian genuine uncertainty and expectations aren’t really modelled. Especially the two-dimensionality of Keynesian uncertainty — both a question of probability and “confidence” — has been impossible to incorporate into this framework, which basically presupposes people following the dictates of expected utility theory (high probability may mean nothing if the agent has low “confidence” in it). Reducing uncertainty to risk — implicit in most analyses building on IS-LM models — is nothing but hand waving. According to Keynes, we live in a world permeated by unmeasurable uncertainty — not quantifiable stochastic risk — which often forces us to make decisions based on anything but “rational expectations.” Keynes rather thinks that we base our expectations on the “confidence” or “weight” we put on different events and alternatives. To Keynes, expectations are a question of weighing probabilities by “degrees of belief,” beliefs that often have preciously little to do with the kind of stochastic probabilistic calculations made by the rational agents as modelled by “modern” social sciences. And often we “simply do not know.”

6  IS-LM not only ignores genuine uncertainty, but also the essentially complex and cyclical character of economies and investment activities, speculation, endogenous money, labour market conditions, and the importance of income distribution. And as Axel Leijonhufvud so eloquently notes on IS-LM economics — “one doesn’t find many inklings of the adaptive dynamics behind the explicit statics.” Most of the insights on dynamic coordination problems that made Keynes write General Theory are lost in the translation into the IS-LM framework.

The IS-LM approach is not fruitful or relevant for understanding modern monetary economies. And it does not capture Keynes’ approach to the economy other than in name. If macroeconomic models — no matter of what ilk — make assumptions, and we know that real people and markets cannot be expected to obey these assumptions, the warrants for supposing that conclusions or hypotheses of causally relevant mechanisms or regularities can be bridged, are obviously non-justifiable. A gadget is just a gadget — and brilliantly silly simple models — IS-LM included — do not help us work with the fundamental issues of modern economies any more than brilliantly silly complicated models — calibrated DSGE and RBC models included.

  1. yoshinorishiozawa
    March 31, 2023 at 12:23 am

    Criticism on IS-LM is an old tune. We had heard on it many times. Why doesn’t Lars try to elucidate why Krugman went wrong in his major field of research, that is the theory of international trade?

    • Meta Capitalism
      April 2, 2023 at 3:15 pm

      I have to write repeatedly the same or similar thing…. [I]f this state of RWER blog does not change, it is hopeless that economics changes. We have to produce a new culture. (Yoshinori Shiozawa, RWER, Leaps of Illogic & Non Sequiturs, Catastrophizing Mole Hills & Parroting Old Tunes, Whilst Spreading more Hypocritical Rubbish, 1/13/2020)

      A case of the pot calling the kettle black. At least Lars is consistent. Lars is not obligated to produce a new theory let alone a “new culture” (whatever that means).

  2. April 13, 2023 at 7:33 pm

    Keynes wrote: “The ideas which are here expressed so laboriously are
    extremely simple and should be obvious. The difficulty lies, not in the new ideas, but in escaping from the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds.”

    I find these words to be prescient when Keynes is viewed as an attempt to economic analysis logically consistent as explained in:

    Click to access Mr-Keynes-and-the-Neoclassics-A-Reinterpretation.pdf

    Any comments on this explanation would be deeply appreciated.

    • April 13, 2023 at 9:07 pm

      viewed as an attempt to MAKE economic analysis logically consistent

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