Tending to His Own Garden: Has Krugman Finally Turned on the ISLM?

Blue Velvet Hose

In a recent post Paul Krugman, as part of an ongoing debate with MMT/MMR advocate Cullen Roche, has said that the ISLM is not a good approach to macroeconomics. Hurrah! Right? Well, maybe not.

In fact, New Keynesians do not generally use the ISLM in its original form any more. A good example of this is a paper by David Romer entitled Keynesian Macroeconomics Without the LM Curve. What Romer does in that paper is essentially replace the classic LM curve in the ISLM with a Taylor Rule interest rate target.

From a Post-Keynesian/MMT perspective this is certainly more accurate than the classic ISLM, but it raises considerable problems of it own. As the Post-Keynesian monetary economist Marc Lavoie writes in his paper Money, Credit and Central Banks in Post-Keynesian Economics this is just “old wine in new bottles”.

The problem with the Taylor Rule is that it rests on the implicit idea of a natural rate of interest which was rejected by Keynes in the General Theory when he wrote:

In my Treatise on Money I defined what purported to be a unique rate of interest, which I called the natural rate of interest — namely, the rate of interest which, in the terminology of my Treatise, preserved equality between the rate of saving (as there defined) and the rate of investment. I believed this to be a development and clarification of Wicksell’s “natural rate of interest”, which was, according to him, the rate which would preserve the stability if some, not quite clearly specified, price-level. I had, however, overlooked the fact that in any given society there is, on this definition, a different natural rate of interest for each hypothetical level of employment. And, similarly, for every rate of interest there is a level of employment for which that rate is the “natural” rate, in the sense that the system will be in equilibrium with that rate of interest and that level of employment. Thus it was a mistake to speak of the natural rate of interest or to suggest that the above definition would yield a unique value for the rate of interest irrespective of the level of employment. I had not then understood that, in certain conditions, the system could be in equilibrium with less than full employment.

I have provided a separate criticism of the New Keynesians and the natural rate here that shows that theorists like Krugman are completely incoherent on this point. While this is the direction that this debate should take, I will deal here with another problem in Krugman’s reasoning which shows that he has not moved from the mainstream quantity of money/exogenous money position as some may have hoped from reading the post. In his latest piece Krugman writes:

So why am I bringing IS-LM into the discussion? First of all, I should have been much clearer than I have been that the LM curve I’ve been drawing is for a given monetary base, not a given M1, M2,or whatever. I guess I haven’t said that clearly, although it’s implicit in my old Japan paper (pdf), where I do state clearly the point that in the liquidity trap the central bank, while it can control the monetary base, generally can’t control broader monetary aggregates. (My emphasis)

Krugman’s statement implies that outside of what he calls “liquidity trap” conditions the central bank can indeed control “broader monetary aggregates”. This is simply false. We had experiments to this effect in late 1970s and early 1980s when the “mad monetarists” rose to power in central banks across the world and it was a complete failure. In Britain, for example, where the mad monetarists — sanctioned by that lunatic Thatcher — had more power to experiment with their quantity theory than perhaps anywhere else, the monetarists completely failed to exert any control over the broad monetary aggregates.

Below is a graph taken from the excellent paper by the late Wynne Godley and Ken Coutts entitled The British Economy Under Mrs. Thatcher which shows clearly how the monetary aggregates behaved during the reign of the mad monetarists.

M3 Britain

To give that some context, the monetarist experiment is usually dated as having taken place between 1979 and 1983. During this period the mad monetarists at the Bank of England pulled out all the stops in trying to control the broad monetary aggregates and, as we can see, failed completely. During the period 1979-1983 the M3 in Britain grew at a far faster pace than it did in the period 1976-1979 before the experiment took place. It also grew at a rate that was not far off the rate of growth during the first major inflationary burst of 1970-1973.

All this indicates that contrary to what Krugman seems to be implying, the central bank never controls the broad monetary aggregates — they merely set interest rates. This is exactly what the MMT/Post-Keynesian endogenous money argument tells us. As Godley famously wrote:

Governments can no more “control” stocks of either bank money or cash than a gardener can control the direction of a hosepipe by grabbing at the water jet.

Indeed. It is time the mainstream got this through their heads so that a real debate over whether there exists a natural rate of interest or not can take place. Provided, of course, the mainstream is confident that their theory stands up to scrutiny; because, frankly, I don’t think that it does.


About pilkingtonphil

Philip Pilkington is a macroeconomist and investment professional. Writing about all things macro and investment. Views my own.You can follow him on Twitter at @philippilk.
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5 Responses to Tending to His Own Garden: Has Krugman Finally Turned on the ISLM?

  1. ivansml says:

    Taylor rule doesn’t require existence of natural interest rate, as it merely link the policy variable (interest rate) to some other variables. And the quotation from Keynes is exactly what the IS curve is about, i.e. that many combinations of interest rate and output are compatible with short-run equilibrium in goods market. Now, Romer closes his model by assuming that natural level of output, at which inflation stays constant, exists (and thus implicitly defines the natural rate), but one could imagine that the model is closed in some other way.

    Moreover, claiming that mainstream position is one of “quantity of money/exogenous money” is just typical heterodox nonsense. Apparently you missed this part of Krugman’s post:

    But in this more complex world, where even the definition of the money supply becomes highly dubious, why even talk about an LM curve? Well, before 2008 most macroeconomists didn’t! They talked instead about interest rate targets, Taylor rules, and all that. Mike Woodford, who is probably our leading macroeconomist’s macroeconomist, has even made one of his signature modeling tricks the building of models in which there is (almost) no outside money. Sensible macroeconomists have known for a long time that quantity-theory type models, if they were ever useful, aren’t much use in the modern economy.

    If heterodox economists want to have a dialogue, that’s great. Discussing actual economics ideas instead of writing angry diatribes obsessing over Paul Kurgman’s blogposts would be a good start.

    • (1) I’m not getting into the Taylor Rule thing. There’s a paper by Philip Arestis in the book cited above containing the Marc Lavoie paper if you are interested in why the Taylor Rule implies a natural rate.

      (2) You’re wrong on the Keynes point. For Keynes the interest rate is not an effective variable to move investment and output. It is the investment and output that “sets” the equilibrium interest rate, not vice versa. In the ISLM it is the interest rate that sets the equilibrium output and investment. The causality is backwards.

      (3) Regarding Krugman, you have not substantially shown that I am wrong in my interpretation. You’ve just tried to distract attention from the quote I provided. It seems quite clear that he implies that in normal times (i.e. non-liquidity trap times) the central bank controls the money supply. He is wrong. And if you agree with him then you are wrong.

      • ivansml says:

        (1) I’ve read the paper. It deals with properties of a basic New-Keynesian model, not Taylor rule per se. You could specify a rule that doesn’t explicitly depend on natural rate and hand it down to people in the central bank. Such a rule could be suboptimal, but otherwise everything would work, regardless of whether the natural rate is a valid concept. Anyway, that’s a minor point.

        (2) Outcome in the ISLM model is determined by a system of equations, i.e. all endogenous variables are determined simultaneously. Thinking in terms of simple unidirectional causality is a sign of confusion.

        (3) No, it’s not clear. Just by pure logic, saying “under circumstances X, proposition A doesn’t hold” doesn’t imply “if not X, A holds”. It’s true that in his 1998 paper, Krugman extends his model in a way that money multiplier is constant in normal times and breaks down in liquidity trap. But it’s a long way to conclude that he thinks this is literally true, certainly without any further explicit statements on his part. Any model involves unrealistic and simplifying assumption that the author doesn’t believe to be true. And the quote I cited shows that most economists don’t think that constant multiplier is really true.

        And by the way, Krugman is not really a monetary macroeconomist (and these days, he’s generally more journalist than economist anyway), so it’s not clear to me why his opinions are taken as representative of the whole field. One could almost get the impression that heterodox bloggers are interested more in silly attention-grabbing blogfights than in seriously engaging with mainstream literature.

      • (2) Don’t be evasive and silly. In the ISLM if the interest rate falls investment and output increase. Keynes didn’t believe in this. Neither do I.

        (3a) I cannot read Krugman’s mind. Only what he writes. And what he writes implies a quantity theory conception of the economy outside what he calls a liquidity trap. This is incorrect. If Krugman agrees he can stop writing about it. Until then, he is open to criticism by all those of us who cannot read minds.

        (3b) Most of my blog is not taken up with such fights. But you only weigh in on the rare post that is. I think this says something about you rather than something about me. Maybe you should reflect on that for a moment or two.

    • P.S. I don’t see any “anger” in the above blogpost. The “anger” seems to be on your part here in the comments section. I’m beginning to care less and less what Krugman is saying as it strikes me as being increasingly incoherent and irrelevant. I wrote the above for Cullen Roche in case he cares to respond to Krugman.

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