Krugman Uses ISLM to Proclaim Looming Fiscal Crisis, Denounces Those Who Don’t Use ISLM

doomsday

Some people often ask why I complain about Krugman. “Hey Phil, Krugman is a good guy. He likes government spending. You like government spending. Therefore you must like Krugman,” says our budding young Socrates. Well, I’ll tell you why: because Krugman is a pretty awful economist who pushes completely outdated views and tricks people into thinking that they’re cutting edge. Anything that is of interest he poaches from elsewhere, typically engages in dubious accreditation and ultimately gets it wrong.

The reason for this? Because Krugman loves models and hates books. He loves little simplifications of the world and hates complexity. That is why he has been wrong on most substantive issues over most of his career. What are the roots of this hatred? From his public writings it appears to have something to do with the influence of JK Galbraith and American institutional economics (which, in Krugman’s mind, is tied up with all heterodox economics).

In the mid-1990s Krugman used to write awful reviews of Galbraith’s books. The motivation appears to have been to consign the true economic progressivism and eclecticism that Galbraith represented to the bin and promote a new type of thick-skinned liberal of the type that Krugman saw himself to be. In his review he wrote,

The truth is that constructing and maintaining a good society has turned out to be far more difficult than anyone imagined a generation ago. To be a serious liberal, one must confront that difficulty, make hard choices, and persuade others to do the same. It is therefore a cause for sadness that America’s most famous liberal economist has produced a manifesto that simply assumes most of the difficulties away.

This was the 1990s, of course; in the middle of the era of Clinton and all that. While heterodox economists were warning about income inequality and the dangers of running a fiscal surplus and a trade deficit at the same type (by identity this means rising private sector debt), Krugman was proclaiming that the welfare state in Europe was causing the unemployment there and that, well, Pete Peterson might have a point about cutting social security. That is what being a ‘serious liberal’ meant to Krugman in the 1990s and attacking heterodox economics — which he associated with institutional economics — was his way of promoting his creed.

Yesterday, Krugman discussed the always excellent Lars Syll’s criticisms of the ISLM and the old demons bubbled up once more to the surface. He claims that Syll is promoting some sort of model-free institutional economics. He gives a tired (and incorrect) little history of American economics that basically says that while the institutionalists were fumbling in the Great Depression, Paul Samuelson delivered the country from evil with his neo-Keynesian doctrine.

Actually, the real history is much more complicated and involves a textbook by Lorie Tarshis that was rejected due to a right-wing conspiracy launched by William F. Buckley and a massive war that allowed for budget deficits. Samuelson had very little to do with any of this history. But he was the one who succeeded in popularising neo-Keynesian economics to students in the 1960s (while losing debates against the real Keynesians at Cambrige, UK…).

Anyway, back to ISLM. Krugman’s main contention is that while us silly heterodox types are fumbling with our clumsy ‘institutionalism’ Paul Krugman and his ‘serious liberal’ friends are taking a hard-headed view of the world and calling for fiscal stimulus. What’s more, he’s utilising the ISLM framework and, according to him, the ISLM framework makes True predictions about the world. He writes,

You see that a lot among people who reject IS-LM as too simple and unsubtle: what they have ended up doing in practice, for the most part, is predicting soaring inflation and interest rates, because whether they know it or not they have effectively reverted to crude quantity-theory and loanable-funds models.

Meanwhile, those of us working with IS-LM, and arguing that we had entered a liquidity trap, predicted little effect from the Fed’s balance sheet expansion, certainly not an explosion of inflation; low interest rates despite government borrowing; severe adverse effects from austerity. And we were right – because in reality, using a “silly” little model is a lot more sophisticated than talking grandly about complexity, and then trying to make diagnoses with no explicit model at all.

Okay, apparently the two alternatives are (i) worship ISLM or (ii) predict soaring inflation and interest rates. I don’t know who Krugman is writing for these days but only the most ignorant idiot with no interest in economics and no access to the internet could believe such preposterous tripe. But given that Krugman thinks that his little ISLM is such a great predictor let’s see how it fared when he applied it in what he would call a non-liquidity trap environment.

Back in 2003 Krugman saw George W. Bush run up large fiscal deficits to fund the war. While most heterodox economists were reluctantly saying that this bout of Military Keynesianism would buttress a US economy greatly weakened by the dot-com crash a few years before, what was Krugman and his little toy models telling his readers? Well, in an article entitled A Fiscal Train Wreck he was telling them that interest rates would soar and there would be a fiscal crisis.

With war looming, it’s time to be prepared. So last week I switched to a fixed-rate mortgage. It means higher monthly payments, but I’m terrified about what will happen to interest rates once financial markets wake up to the implications of skyrocketing budget deficits.

From a fiscal point of view the impending war is a lose-lose proposition. If it goes badly, the resulting mess will be a disaster for the budget. If it goes well, administration officials have made it clear that they will use any bump in the polls to ram through more big tax cuts, which will also be a disaster for the budget. Either way, the tide of red ink will keep on rising.

Whoops! In March 2003 Krugman was calling for mortgage rates to rise… just at the beginning of what would turn out to be the biggest housing bubble in US history. What actually happened? Mortgage rates basically flat-lined for the next 5 years.

mortgage rates 2003

Of course, rising interest rates were precisely what his little ISLM model told him would happen. He figured that since the economy was not in what he calls a ‘liquidity trap’ then a rise in the budget deficit would lead to a rise in interest rates across the board.

But the heterodox types were more focused on the fall-off in demand that had occurred three years earlier and the rising private sector debt that was starting to fill in the gap. This, together with the Iraq War, were what was going to drive the economy forward in the next few years. They were not concerned with interest rates rising because they knew that the Fed ultimately sets interest rates and that money is endogenous.

In his book The Predator State ‘non-serious liberal’ JK Galbraith’s equally ‘non-serious liberal’ son laid out what actually happened in this era (note that interest rates are not even mentioned because to heterodox economists the idea that fiscal deficits cause a rise in the interest rate is manifestly absurd),

From 1997 to the peak in 2000, business nonresidential fixed investment rose by around $300bn 1996 dollars, a gain of about 2 percent in relation to GDP, or from 12.2 to 14.4 percent. Most of the gain was technology investment. In the two years after the peak, the falloff was on the order of $150bn. The entire falloff in business investment was then replaced by the increase in the military budget put in place by the Bush administration following the terrorist attacks on September 11, 2001, and the invasion of Iraq in 2003. As a result the US economy returned to nearly full-strength by mid-2006, and once again the stock market recovered. (p100)

So, what is the lesson here? Simple. The ISLM is a crappy tool for understanding the economy. Krugman is not a very good forecaster and is more often wrong than right (a broken clock and all that…). And what Krugman thinks to be ‘institutionalism’ (i.e. heterodox economics) is a far better paradigm if you want a realistic view of macroeconomics. If you want to learn outdated and oversimplified rot while playing at being a ‘serious’ and ‘hard-nosed’ liberal read Krugman; if you want to gain interesting perspectives on economics and fight for true progressivism read Syll and Galbraith.

 

 

About pilkingtonphil

Philip Pilkington is a London-based economist and member of the Political Economy Research Group (PERG) at Kingston University. You can follow him on Twitter at @pilkingtonphil.
This entry was posted in Economic History, Economic Policy, Economic Theory. Bookmark the permalink.

26 Responses to Krugman Uses ISLM to Proclaim Looming Fiscal Crisis, Denounces Those Who Don’t Use ISLM

  1. You forgot to mention Krugman’s attachment issues! 😉

    Actually, I gave up on Krugman years ago. He’s become (or perhaps always was) a cover for the phony Democrats who are the other half of our one-party system.

  2. ciaran says:

    Could we have that article on “The Predator State” you promised us? Pretty please!

  3. NeilW says:

    I do wonder whether Krugman is essentially the RIght’s court jester – there to allow those who believe things should be different to feel as though their views are being listened to.

    Essentially though he’s an appeaser who fundamentally believes the same stuff as those currently in charge.

    Very much a Chamberlain rather than a Churchill.

  4. philippe101 says:

    Phil,

    “They were not concerned with interest rates rising because they knew that the Fed ultimately sets interest rates and that money is endogenous”.

    Say inflation were to rise significantly for some reason, do you think longer term interest rates could rise very steeply even if the Fed decided to keep the overnight rate low by increasing the monetary base? Just interested on your view, cheers.

    • Not really. I think that long-term rates track the short-term rate. Any correlation you see between inflation and the long-term rate is due to the Fed raising the short-term rate in line with rises in inflation. See here:

      As the reader can see, the long-term interest rate is not actually a very good predictor of future trends at all. The correlation between the inflation rate and the short-term interest rate is very tight which is not surprising because the central bank is tracking the inflation rate and adjusting the short-term rate accordingly. The long-term interest rate, on the other hand, seems to follow the lead of the other two.

      • philippe101 says:

        If you were a lender, wouldn’t you demand a higher rate to lend if inflation was high and expected to be high in future? Why would you choose to lend at a rate which caused you to lose money in real terms?

      • Asymptosis says:

        In uncertain and more pessimistic times, wealthy people/entities worry more about return of capital than return on capital. Steve Randy Waldman explains beautifully why this is so, using a Titanic metaphor:

        http://www.interfluidity.com/v2/3487.html

        “Wealth is about insurance much more than it is about consumption.”

        There’s a reason why China owns all those US treasuries.

      • Because of the lack of available alternatives. You could ask the same question as to why Japanese savers have for nearly a decade been accepting negative returns on government bonds.

        When its the only game in town people tend to adjust.

        Not to say that inflation won’t affect rates at all. But it seems to me that they tend to follow the short-term interest rate.

        Take an unlikely scenario: say inflation was running at 30% a year and the overnight rate was 1%, would mortgages really have to be more than 30% a year for lenders to make money? I don’t see why. They can borrow at 1% and then charge a spread over the 1%. So, they can lend at maybe 5% or so. No?

      • philippe101 says:

        Good point. Thanks.

        I suppose its difficult to know what might happen given that central banks usually raise short term rates when there is high inflation.

        Do you know of any cases in which a central bank has kept short term rates low despite there being high inflation? It would be useful to see what actually happened.

      • philippe101 says:

        This is relevant, and might interest you:

        http://slackwire.blogspot.co.uk/2014/03/liquidity-preference-and-solidity.html

        “As you can see from this graph, none of the major inflations or deflations between 1850 and 1960 had any effect on nominal interest rates. The idea that there is a fundamentals-determined “real” interest rate while the nominal rate adjusts in response to changes in the price level, clearly has no relevance outside the past 50 years. (Whether it describes the experience of the past 50 years either is a question for another time.)”

  5. Claud Alexander says:

    Phil, excellent. Only point I’d add is the degree to which K. doesn’t even bother to pretend that he’s actually read what he is attacking. He’s a busy man and can’t be expected to read entire blog posts.
    If you can ignore for a minute the arrant rubbish about Post-K or MMT people predicting hyperinflation, look at how that passage’s constructed: “I read Syll’s paean to Minsky, and I have no idea how he would answer any of these questions. What I suspect, however, is that he would talk about. . and then propose. . .without any model at all – which would in fact mean engaging in implicit theorizing, and probably fairly crude implicit theorizing at that. You see that a lot among people who . . . : what they have ended up doing . . . for the most part is. . .because whether they know it or not they have effectively reverted. . .”
    I understand a little better now how he was able to convince himself, in an earlier debate, that Steve Keen had said New Keynesian and Real Business Cycle models were identical, on the basis of something he thought Nick Rowe wrote in another blog. Perhaps he just assumes that his critics are as cavalier and inattentive as he appears to be himself.
    This is all rather a shame, and quite ugly.

  6. Pingback: Philip Pilkington: How Krugman's Addiction to the Discredited ISLM Model Has Led to Repeated Bad Forecasts | naked capitalism

  7. Pingback: Philip Pilkington: How Krugman's Addiction to the ISLM Model Has Led to Repeated Bad Forecasts | naked capitalism

  8. circuit says:

    Yeah, that review of Good Society by Krugman is pretty bad. One wonders if he would change his mind about that one, as he did about the Bush deficits.

  9. googleheim says:

    Krugman has also never picked up again on the concept of US Treasury hoarding by China, UK, Japan, OPEC, and others. The hoarding is the same as not spending. When the USD is dropped into any sales venue around the world it hits our currency zone in a stimulating manner. They say that if they “sell” it then the USD will tank. But not spending it makes EVERYTHING tank and drop. In fact, if they spend the USD they will find that the economy will surge and they can move to other baskets and or find that the USD is still the same if not stronger !

    Hoarding USD is like balancing the government budget – it is a drag on the economy and taxes everyone because the more they hoard the more they are taxed directly and indirectly !

  10. Troy says:

    Slipping into Ferguson territory mate

  11. Asymptosis says:

    PK: “To be a serious liberal, one must confront that difficulty, make hard choices, and persuade others to do the same.”

    IOW, one must be a Very Serious Person.

    Even as he denounces them, he can’t resist their “gravity.”

  12. Asymptosis says:

    Yikes: everything we thought we knew are wrong. Josh Mason rocks it again:

    http://slackwire.blogspot.com/2013/04/borrowing-debt.html

  13. Pingback: Krugman’s vindication of the IS-LM gadget — brilliantly silly | LARS P. SYLL

  14. Pingback: Welfare Cap, Labour are crap | alittleecon

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