Keynesian Legacies neither Europe nor Keynes deserved: A critique of New and ISLM Keynesians in the context of Europe’s Crisis

28/03/2012 by

In a previous article, entitled On the Political Economy of Eurozone Bailouts – The curious case of Greece’s neoliberals, I took great pleasure in lambasting the internal inconsistency of Europe’s (and in particular Greece’s) neoliberals. In today’s article I cast a critical gaze at the ‘other camp’; that which consists of self declared Keynesians. The article comprises four sections. After a brief introduction, Section 2 sums up (what I think was) Keynes’ central insight. Section 2 then looks at the so-called New Keynesians and their desperate attempt to ingratiate the anti-Keynesian powers-that-be within the economic profession while still retaining something of what Keynes was saying alive. Section 3 is dedicated to the school of thought best represented by Paul Krugman, Brad de Long, and other economists who have played an important role in returning some sanity to the debate initiated by the Crash of 2008. As the reader will discover, my respect for them does not suffice to desist from considering some of their underlying economics not only flawed but also profoundly inconsistent with Keynes. Lastly, Section 4 relates the above discussion to the European Crisis, making the point that the internal inconsistencies of the best and brightest Keynesians have, unwittingly, hampered the search for a rational solution.

Section 1

Few of the great thinkers deserve their disciples. What would Adam Smith really think of the Adam Smith Institute, Karl Marx of Pol Pot, Michel Foucault of assorted postmodernists? I shudder to think! Curiously, the figure that, in recent times, has been let down the most by the vast majority of his disciples (though not all) is the thinker whose fortunes were revived the strongest following the Crash of 2008: John Maynard Keynes.

 That Keynes was horribly distorted by people who claimed to speak in his name is not new. Axel Leijonhufvud published the definitive treatise on the matter in 1968, under the telling title On Keynesian Economics and the Economics of Keynes: A Study in Monetary Theory (New York: Oxford University Press). In its pages Professor Leijonhufvud painstakingly accounted for the many ways in which what passed for Keynesian economics in the era of the Global Plan (also known as Bretton Woods) was but a caricature of Keynes’ own thinking; a theoretical schema that confirmed Keynes’ perspective more in the breach than in the observance.

One of the reasons that Keynes became almost a forgotten figure amongst ‘very serious economists’ during the era of the Global Minotaur (1973 to 2008), boils down to the fact that all that was left to remember him by was the version of his thought that was propagated with copious success by economists like Paul Samuelson. Since I have written extensively about that sorry bastardisation of Keynes, I shall not repeat myself here. Suffice to claim that the version of Keynesianism that was repudiated in the 1970s would have also been repudiated by Keynes himself!

This means that, today, and since Keynes’ name and ideas have been bathed in the limelight after the Crash of 2008, it is important to state clearly what each one of us thinks Keynes’s point really was. Section 2 presents my understanding of his central insight.

Section 2 Keynes’ momentous insight

In the earlier article referred to above, I introduced Keynes’ point of embarkation thus:

“In the aftermath of the Crash of 1929, Keynes famously criticised the conventional wisdom of his time (the so-called Treasury View) which held that, given sufficient time, the economy would adjust to any recession by letting wages and interest rates fall until the entrepreneurs’ animal spirits’ are stirred sufficiently to stimulate both the additional employment and investment necessary to end the recession. Keynes’ objection was that, following a massive financial crisis that manages to infect the ‘real’ economy, it is highly likely that the large diminution in output, investment and income will lead to a ‘bad’ equilibrium. To a situation where unemployment is sustainably high (and unresponsive to wage reductions that cause labour to become dirt cheap), investment is rarer than snow in the desert (even after interest rates have crashed to zero; the so-called liquidity trap) and, generally, to an economy stuck in a new underemployment equilibrium from which it will not escape even if prices are free to adjust to their heart’s content. Under those circumstances, thought Keynes, to target government budget deficits, by means of government spending cuts, is precisely wrong. His proposition was that, once an economy finds itself locked into an underemployment equilibrium, any attempt to try to “cut itself out of the slump” is tantamount to cutting one’s nose to spite one’s face. No, for Keynes the trick was to “grow out of the depression”.”

To recap, the problem with economic recessions, thought Keynes, is that they are not always redemptive, cathartic. Some times, especially after a massive banking failure (like that of 1929 and, more recently, of 2008), a recession can spawn a low activity equilibrium; a state of depression out of which the economy will not bounce back and which will deepen the more government tries to reduce its deficit, through cuts, and to stimulate employment, through wage reductions. And why is that so? The best way I can explain Keynes’ insight is by means of the following game (which I have employed in this blog previously):

Suppose that 100 strangers (who have no way of communicating with one another) are playing the following game. Each must email me a number between 0 and 1 (including 0 and 1). Once I collect all their emails, I compute their payments (which may turn out negative – i.e. losses) as follows: Assuming that player i emailed me number Xi, she or he will receive a number of dollars equal to di = 1000x(1-3m+2Xi), where m is the maximum value of X chosen by someone in this group of 100 people. What number X would you choose if you were one of the participants?.

The best outcome for everyone, the happy scenario, is that each emails me the number 0 and wins $1000. [Nb. when everyone sets their X equal to 0, then m, the maximum number emailed, is also 0 and di = 1000.] Do they have any incentive to email me a number greater than 0 if they predict that all 99 of their co-players will set their X equal to 0? No, they do not. [Nb. For if they did something of the sort, then their choice of X, Xi,  would become the maximum emailed number, m, and their own reward would diminish.] Does this mean that the best strategy is to email me the number 0? Not necessarily. It depends on everyone’s expectations in a situation when no one, however rational, can predict what these expectations will be.

The truth of the matter is that one’s best strategy here depends on one’s estimation of the degree of optimism among the group of co-players. Optimism here means that everyone expects m to approximate 0. If this is what one thinks is going on, one will have a cast iron reason to email me the number 0, or very close to it (recall the argument in the previous paragraph). And if everyone does this, he or she will receive $1000 each. But then again, what if they predict that someone in the group will email me, say, number 0.9. It is easy to show that their best response to this expectation is that they also choose 0.9!  But, you may well ask: Why would anyone choose 0.9? Well, because if someone predicts that someone else may fear that there is one person in this group who will choose 0.9, then that ‘someone’ will have a dominant strategy: Choose 0.9! And if everyone is anticipating this, then each player will be emailing me the number 0.9; the tragic conclusion being that, instead of a $1000 credit in their bank account, all they will get is a measly $100.

This conclusion resonates powerfully with the experience of a complex, dynamic capitalism where, at the first scent of an impending recession, capitalists go on an investment strike and the recession occurs, confirming their gloomy forecasts. It echoes nicely John Maynard Keynes’ famous description of investment decisions as a realm “…where we devote our intelligences to anticipating what average opinion expects average opinion to be.” Or as he wrote in his General Theory,

“Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits – a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.” (Chapter 12, General Theory; the emphasis is ours)


In the reading of Keynes proposed here, economic agents are smart and as well informed as possible. They act sensibly in the pursuit of their objectives and in accordance with their forecasts of a future rendered unknowable due to its dependence on the average opinion. That their estimates can be systematically wrong is not due to their stupidity or misinformation but, rather, to the fact that, however intelligent they may be, it is impossible to see into the future consistently when that future is co-determined by everyone’s forecasts. Thus, the future’s inevitable opacity causes deep insecurity in the mind of investors but also of consumers, workers etc. When something untoward happens, this rational insecurity may feed on itself: people begin to form pessimistic expectations which are then confirmed simply because of the reductions in both consumption and investment that they motivate. Like Laius was killed by his son, Oedipus, just because he believed the prophesy that this would happen, so do capitalists may bring about a crisis if they simply believe that a crisis is looming.

Keynes’ recommendation was that we stop thinking of capitalism as we do of Robinson Crusoe’s economy and that we distinguish what is good for the whole from what is good for the one. In the case of Crusoe, it is of course a tautology that thrift is always good for his little economy’s growth and for the building up of stockpiles for a rainy day. Similarly for the shopkeeper who must reduce costs instantly the moment sales dip. But these examples of micromanagement are, according to Keynes, disastrous if they are to be used as a parable for clever macroeconomic policy during lean years. He referred to this as the Fallacy of Composition: mistaken conclusions about how a complex system works drawn from observations of the workings of its constituent parts. E.g. the conclusion that because thrift is always good for Crusoe it must also be always good for the United States or the Chinese government. When a complex capitalist economy enters a downward spiral, thrift (or, in today’s parlance, austerity) makes things far, far worse.

Section 2: Surrendered Keynesians, also known as New Keynesians

By the 1970s, and the end of the first postwar phase, a form of bastardised Keynesianism was in retreat. At the theoretical level, the challenge took the form of the so-called Rational Expectations Hypothesis (REH) which helped restore the Treasury View (more recently known as Monetarism) to the prominence that Keynes so rudely interrupted. The main point of the REH was this: “We cannot rationally expect a policy to succeed if its success depends on people failing to understand its logic.” Who would disagree with this? It is like saying that, while you can fool some of the people all of the time, and all of the people some of the time, you cannot fool all of the people all of the time. Why should Keynesianism be stumped by this hypothesis?

The answer is: Because ‘Keynesianism’ had, after Keynes had met his ‘long run’, accepted the preposterous proposition that one can think of the macroeconomy as if it comprised of millions of clones of a single person; a genetically reproduced Robinson Crusoe whose clones think the same thoughts (plus or minus some random error). (Recall the disastrous Samuelsonian interpretation of Keynes.) And why did they make this concession? In order to put Keynes’ thought into a closed mathematical model or, at the textbook level, to capture his ‘thought’ in terms of some appealing, easy to explain geometry. To see that this concession destroyed whatever analytical value Keynes had to offer, consider again the little game I presented (in blue) in Section 2. Suppose that the players are clones and they think identical thoughts, plus or minus a random error. Suddenly, the game loses all its interest: The outcome becomes predicable (each will choose 0 and everyone will gain $1000) and the game’s subtle point (that it is impossible even for the smartest player to know what to do; the result depending on the average degree of optimism) vanishes. Similarly, the moment Keynes’ thought was imprisoned in these mathematical models, populated by telepathic clones of some Robinson Crusoe, Keynes was doomed to oblivion.

Later on, perhaps for the purposes of ‘product differentiation’, some of those economists wanted to bring back into economics a whiff of ‘Keynesianism’. But how could they, when their models required these clones in order to be solved mathematically (so that they could get them published in the top journals of the profession in order to get their tenured position in the top departments)?

At that point they latched on to something Keynes had said, misinterpreted it, and used it to concoct versions of their models that simulated some of Keynes’ ideas. That ‘something’ that Keynes had said was the famous ‘inflexibility’ of wages. Keynes, it is true, had observed that the price of labour (wages) and some other commodities do not fall during a recession as quickly as economists had expected. One reason was that workers resist wage cuts because their reference point is the wages of their peers and not prices. Based on this observation, New Keynesians introduced into their mathematical models so-called wage rigidities: when some external shock reduced economic activity in the model (external, of course, because these silly models could not explain internally why such a reduction might occur), their Robinson Crusoe clones, for some unexplained by the model reason, would not work for wages below a certain point. Ergo, the New Keynesians concluded with shrieks of pleasure, this explains unemployment during a crisis: wages will not fall sufficiently to restore demand for labour. So, what should happen then? Perhaps, they answered meekly, government must stimulate the economy.

These are the depths of idiocy that the New Keynesians descended to in order simultaneously to stay on the good books of the new barbarism that took over Economics Departments and pretend that they have something mildly Keynesian to say. Alas, there was nothing whatsoever Keynesian in their analysis: Keynes may have observed, and discussed, nominal wage rigidity but he never, never suggested that, during a recession, if wages were to, somehow, become flexible, the demand for labour would rise. His point was exactly the opposite: If wage flexibility is restored, and wages fall ‘freely’, demand will be further undermined and unemployment will rise.

In summary, New Keynesians are best described as Surrendered Keynesians. As economists who, in a different world, might have wanted to be associated with Keynes but who, given the dominance of neoclassical-monetarist-REH barbarism in the departments that they coveted, did not have the bottle to argue Keynes’ case. In its stead, they placed idiotic models that true-blue monetarists accepted condescendingly and genuine Keynesians treated with the contempt that they deserved. Tragically, these Surrendered Keynesians were to play a treacherous role once the European Crisis was underway. For it is not hard to see how their crass little models fitted perfectly into the austerian mindset which proposed policies for overcoming Europe’s structural Crisis that attacked… ‘wage inflexibility’.

Section 3: ISLM Keynesians

Models are useful as a check on the capacity of our analytical power to reach determinate conclusions. In a few short paragraphs, logical fallacies can be exposed and our mind can be trained to avoid the errors that stem from them. However, when Keynesians of note, like Paul Krugman and Brad de Long, state their belief that some determinate, closed model contains the essence of the truth of how an economy behaves when in recession, then we are in trouble.  

Lest I am misunderstood, I just mentioned two economists whose contribution I value tremendously – especially since the Crash of 2008, when these two men rose up and did a sterling job at instilling some much needed sanity into the economic debates that ensued. However, I am dumbfounded by their commitment to a piece of geometry that does Keynes, and the economists who have made it their task to further his thinking, no good whatsoever. Let me explain this claim, and my (painful) decision to criticise worthy economists like Paul Krugman.

In a recent post Krugman states: “the right way to do economics is usually to start with the simplest model that can get at the essential features of whatever you are trying to understand.» Who could disagree with that? “In macro, or at least macro that tries to get at monetary and fiscal issues,” continues Krugman, “what you need, at minimum, is to understand an economy in which there are three goods: money, bonds, and economic output”. Fair enough. Let’s, however, see which this model ought to be. Here is Krugman’s answer: “A full-employment version of IS-LM. Add in some form of price stickiness and what you have is Hicks/Keynes. There’s nothing arbitrary about it.”

This is the point I part, quite sharply, company with one of my favourite economists. My objection is that this type of model misses out, by definition, the essence of Keynes’ thinking. While it is perfectly true that the ISLM model can be written down, complete with attractive looking curves, in a manner that produces macroeconomic outcomes consistent with those Keynes described (e.g. a contractionary fiscal policy can be shown, when employment is below its maximum level, to yield lower taxes, greater deficits and even lower employment), this is not the point. Why not? For two reasons.

The first reason is that an opponent of Keynes (and Krugman) can demolish any argument coming out of this ISLM geometry by re-drawing one of its curves (e.g. the aggregate supply curve, which if drawn perpendicular to the output axis, all room for fiscal policy disappears). And since Krugman’s positioning of these curves is just as arbitrary as his opponent’s, the debate will reach a stalemate.

The second reason that an ISLM-like model misses out, almost as much as the Surrendered Keynesians’ models do (see previous section), the essence of Keynes’ thinking; the idea that, in a recession, the driving force of the economy is average opinion amongst investors and business people. In a static model containing, as Krugman describes it, the three variables “money, bonds, and economic output”, the main insight that we derived from the game of Section 2 is well and truly lost. And with it, Keynes’ main point disappears, leaving behind some contestable diagrams and several empty-shell equations.

Of course Krugman is too sophisticated not to understand that the ISLM leaves much to be desired, courtesy of its static, one-sector, nature. Indeed, in the same post he writes: “To be sure, IS-LM is an attempt to squeeze a dynamic economy into a static model, which is why people like me usually cross-check our conclusions with something intertemporal.” This is the point where I panic. The problem with the ISLM is that it fails to capture the essence of Keynes’ central point even at the static, timeless level. Taking the ISLM from its timeless to a dynamic setting is no help whatsoever. If (A) the idea that average investor optimism is indeterminate in static situations (like the one I presented in Section 2) is the key to understanding the way recessions turn into depressions, and (B) the ISLM is devoid of that idea, what is then the point of taking the ISLM from a static to a dynamic setting? What will we gain except large doses of mindless complication? The answer is: nothing at all.

In summary, ISLM Keynesians may be wonderful economists quite independently of their commitment to the ISLM geometry. Paul Krugman is more often than not extremely erudite and helpful in his commentary on the Crisis. He seems to believe that he owes much of his analysis to the ISLM framework. Perhaps he does. I too have benefitted in the past from imagining what the ISLM curves would look like if, say, the government were to boost taxes or the Central Bank to alter interest rates. However, no truth resides in these models (unlike the physicists’ models which are perfectly capable of containing nuggets of truth about Nature – for more on this see my interview with Naked Capitalism, Parts A and B). To suggest that the problem with Keynes’ opponents is that they do not take the ISLM framework seriously is to underestimate both Keynes and his opponents. Yes, simple models can capture well complex ideas. I am afraid, however, that the ISLM is incapable of capturing Keynes’ central insight. The simple game of Section 2 does a much better job.

Section 4: How the failures of Keynesians have helped fan the European Crisis

The New Keynesians have a great deal to answer for, at least here in Europe. By misunderstanding spectacularly Keynes’ point about the inflexibility of certain prices and wages, they have aided and abetted misanthropic, austerian policies that would make Keynes cringe. Since the only way they could squeeze some unemployment out of their models, as part of their equilibria, was to introduce wage rigidities, the obvious conclusion is that, if we want to get rid of the unemployment, we better liquidate these rigidities. Is this not what the troika is doing now in Greece, in Ireland, in Portugal? Is this not the pound of flesh that the ECB demands of Spain and Italy? The fact that some of the leading supporters, and indeed executors, of the current bailout-fiscal-adjustment programs that are eating away at the foundations of Europe today are New Keynesians, is not a coincidence. Their models were ripe for the picking by the powers-that-be in Frankfurt, in Berlin, in Brussels.

Turning now to the ISLM-Keynesians, the bone I have to pick with them is different. While they are definitely not guilty of supporting, or even tolerating, austerian idiocies (and, in fact, have been amongst the most eloquent critics of the austerian ‘logic’), their commitment to models bereft of the deep uncertainty caused by the struggle of investors to estimate their average degree of optimism (i.e. the multiple equilibria of the little game in Section 2) has rendered ISLM-Keynesians impervious to crucial aspects of the eurozone crisis. To offer an example, when economists like Paul Krugman surmise that a country like Greece is better off exiting the euro, he is setting aside crucial factors that, admittedly, are absent in an ISLM world. And they are not absent just because the ISLM is static but because it fails analytically to capture the fragility of business sentiment (Keynes’ animal spirits) when such an exit is touted. This is not just a matter of changing the numeraire. The uncertainty about average optimism becomes even more crushing than ever when additional tiers of uncertainty are added: uncertainty about how a plethora of contracts denominated in euros will be denominated post-exit; uncertainty about the rate of the new drachma’s devaluation rate under the weight of a very large percentage of domestic savings kept either in cash form or in foreign banks.

Concluding remark

Keynes was dropped from the curricula in the 1970s because, during the 1960s, he was never taught or read. Instead, a bastardised form of Keynes was pushed into the mind of each aspiring economist. When the Global Plan perished in the 1970s, the political agenda changed. Suddenly, the powers-that-be, in the United States primarily, faced the task of purposefully disintegrating regulations and impediments that prevented capital from flowing into Wall Street. One victim of this new era of deregulation was the bastardised Keynesian model, which was dutifully slaughtered by even more ridiculous models (I grant Paul Krugman that, the ISLM, in comparison to the REH, looks like rocket science). It was a little like re-writing Shakespeare’s Hamlet using no more than one hundred words and then taking the bard to task for the play’s paucity.

Today Keynes, after a brief re-appearance that was sine qua non in view of the Great Recession that followed the Crash of 2008, is facing the same fate. On the one hand, the New Keynesians, who have surrendered even the most basic of principles for which Keynes stood staunchly, are invoking the name of the great man in vain; while all along giving a hand to the New Depression’s handmaidens. Meanwhile, on the other hand, some of the brightest minds, well meaning economists of note and erudition, are imprisoned in the confines of ISLM like geometries. As a result, while their narratives on the United States and other places (lacking Europe’s deep architectural flaws) are pertinent and apt, their commentary on Europe damages the struggle against the type of continental implosion that Keynes was worried about since he was a young man.

In the end, perhaps it is inevitable that the greatest of thinkers will see their legacy damaged the most by those who claim to speak in their name. Be that as it may, today there is more than a great theorist’s legacy at stake. There is a Crisis to deal with, especially in Europe. It would be good if the better, potentially useful, ideas of great thinkers from the past were not diluted or, worse, polluted by their own disciples. 

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