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

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. 


  • Whether it is Keynes or the Son of Keynes or even the median line between neoKeynesians and neoliberals the problem remains the same, namely:

    What is holding us back from solving the current Eurocrisis is not lack of an appropriate theoretical model. It’s the extremely skewed politics of conservative parties sensing a cause of victory over opposing labor forces and going for the kill.

    Such tactics, of course, spawn mighty resistance movements because as we all know from physics for each action there is an equal and opposite reaction. Only in politics the forces are not equal and in the end one prevails by devouring the other.

    My money is with the reactionary forces because we definitely live in the Age of Discontent where citizens everywhere around the globe are deeply dissatisfied with their governments. Reason no longer prevails, because fear and emotion are amplified in daily reality.

    Reasonable discourse, it seems, is out the window and what he have here is an ugly battle for survival with the majority of citizens having nothing to lose in seeking a monumental change(look up 99% vs. 1%). Politics don’t need to be reasonable, only victorious.

  • You point correctly at the central contribution of Keynes. Basically, it is worth reminding that Keynes had extensively read Freud (although he rarely mentioned him explicitly in his texts), hence his perception about psychology, and more specifically mass psychology, underpinning both social and economic behavior. Instead of basing himself on simplifying (and distorting) assumptions he sought a multidisciplinary perspective bringing on elements from social sciences beyond “economics” (this is extremely clear, btw, for what refers to his analysis of financial crises and speculation). And this is why he placed himself in the great tradition of political economists…

  • Today everyone is imprisoned in it’s own science.

    While everything is a part of the same nature ,everybody tries to frame events as if they are static and in a controlled environment at every level of every activity. Scrutinizing everything to the point where it does not belong to and can not be used with everyday human activity.

    Complexity is of our own making. When in a complex frame ,where different people take different things for granted ,try to simplify events their own way ,parameters are lost and forgotten where all parameters can never be used anyway. Every explanation becomes an oversimplification of reality.

    The problem that i see is not oversimplification.
    The problem that i see is lack of unity of spirit and the whole procedure of explaining a creation that can be too dynamic to explain.

    For if the terms used and the systems built were all explained by terms of basic energy flow ,there wouldn’t be a complex frame to oversimplify in the first place.

    There wouldn’t be an absolute frame of any kind. But a fractal “system” of basic energy flow principles ,accepting the infinite ways of communication between parts on one side and on the other side ,aggreeing on absolute basic terms to keep the flow going at the level of everyday human activity.
    A compination of self-identical and indefinite fractals.

    Do not think of squares as being drawn of solid lines. Not any other shape or curve or equation and euclidean or non-euclidean geometry. But think everything as being drawn of dotted lines.

    Today too much framing has occured ,too many different explanations for the framing ,too many different explanations for the flow of energy between the parts and too many ways to direct and manipulate that energy. All at the back of the majority’s ignorance.

    Having said all of the above ,i am no “scientist”.
    I am a being. And i have allowed for too much interference in my life.


  • Yanis,

    Is it possible that the monetary policies of the US Federal Reserve and the European Central Bank have fostered a “bad equilibrium”? Is all this talk of slow recovery (though still provably “jobless” with declining real property values) a reflection of a successful establishment of a new financial regime?

    Just a thought, worth, maybe, two drachma.

  • Great Post Proffesor.

    I have to say i am very dissapointed lately,finding out that what we are taught may be one of the causes for our recent global economic failures.In 3rd sem. macroeconomy we were being introduced to ISLM or MV=PY,as being holly guidestones able to explain inflation,interest rates,unemployment to the fullest.We went further,being forced to believing in myths such as the money multiplier,the way banks give loans,how the CB controls the money supply etc etc and now im in a situation feeling like i have to learn everything again from scratch.

    Here is another very interesting post by proff. Bill Mitchell,which he coincidentally posted 2 days ago,challening Paul Krugman’s take on ISLM:

    PS1.I have to apologize for calling Bill Mitchell hardheaded in another post,for advocating a euro-exit.I had confused him with Rodger Mitchell.

    Ps2. We have never been taught game theory in such a realistic way,in terms of using game examples to explain economic phenomena.In contrast they never tried to combine the course with what we were being taught in other courses..This makes it way more interesting.

  • A really excellent critique.. totally agree

    “…where we devote our intelligences to anticipating what average opinion expects average opinion to be ..” wonderful quote

    Thanks for bringing back into the light Leijonhufvud’s wonderful 1968 critique of Keynesian – something I was raised on as a student many many years ago

  • Αγαπητέ Γιάνη,
    δεν πρέπει να σου κάνει εντύπωση οτι διαστρεβλώνονται οι θεωρίες του Keynes.
    Δυστυχώς ζούμε στους “υπαρκτούς” -ισμούς. Το Σοβιετικό έκτρωμα ήταν ο “υπαρκτός” κομμουνισμός, ο καπιταλισμός που ζούμε είναι και αυτός “υπαρκτός” αφού δεν εφαρμόζονται βασικές αρχές του περί κυκλοφορίας του χρήματος αλλά αυτό σωρεύεται σε “σεντούκια” ολίγων πνίγοντας έτσι την οικονομία. Ακόμη και το θρησκευτικό ιερατείο έχει μετατρέψει τις διδαχές του Χριστού στον “υπαρκτό” χριστιανισμό (όλων των δογμάτων).
    Γιατί λοιπόν να μη ζήσουμε και στον “υπαρκτό” Κεϊνσιανισμό;

  • BTW, for those of you of Germanic origin who:

    a.resist the idea of Germany profiting from the Greek crisis
    b. that Greece has not cost a penny to the German taxpayer
    c. deny German hypocrisy,

    here comes irrefutable evidence from the 1st German state TV channel ARD, which unequivocally states that the German net profit from Greece so far is in the 55 Bil. euro range.

    Watch it for yourself (with the exception of an opening statement in Greek lasting about 20 seconds the rest of the roughly 7 minute video is in German with Greek subtitles. For those English speakers not speaking German please take my word for it and even ask Yani to verify its contents):

    • Why would somehing by German State TV have any glimpse of thruth? There is never any form of critizism what the EU/EURO is concerned. If they did they would lose their job!

      The summary is pretty clear: So far no loss, like a person jumping from a high rise and briefly before hitting the ground saying “I told you that it is safe to jump!”

      The interest rate advantage is normal. Germany had this before the Euro and as the bankers have learnt, the interest rate convergence was a misjudgment. Let´s hope that it will be around 1000 bps again. Then and only then it will be obvious to bankers that investing in Greek or Spanish gov.erbement risk free,

    • The answer is very simple, just compare with market prices (not politically driven EU transfer prices):

      Disadvantage Italy = Advantage Greece = (Market Interest rate- Rate for Greek Loans) * bilateral loan volume

      Italy receives less interest from the Greek loans in interest than it has to pay itself!

      On top of that you can add the debt guarantees.

      Of course itis up to you to judge if market interest rates are higher or lower than the political interest rates…

    • Only 55 b.?

      It seems not a lot to me.
      What they call a “Greek crisis” is connected to the whole world through the markets.

      What i am saying is ,let’s remember the saying “All roads lead to Rome”.
      In this case is “All capital flows lead to Germany”.

      Even if Tanzania buys Zimbabwe debt.

    • Dimitri, the capital needs to flow back at some point in time. In 2000 when the (now failed) Euro was intoduced, capital starting flowing to Greece, Spain, Portugal and Spain.

  • It is a strange science that you guys practice (this from a computer scientist).

    You talk about production, employment, growth, psychology, prices, and yet, somehow,
    the central laws of your science do not mention the duality of money (money as a means
    of exchange through prices, money as storage of wealth). The two functions are orthogonal, but you do not seem to analyze it too much, while I would put it at the center of any economic

    Maybe this is a reflection of really existing civic laws inherited to us from the days of
    real/metal money (capitalist or not, I wouldn’t say) .

    Yet, you are lambasting a change of currency for Greece, calling it suicide (suicide!)
    based on psychological arguments on the average sentiment of a population having euros
    stashed at home (as wealth) and drachmas in the pocket (or on price lists). How do you know? Do you know enough to call it suicide? If you (or anyone) has an analysis, a model
    or a case study, I have yet to hear it.

    What I do know, because it is straight math, regardless of public sentiment, animal spirits or
    any other economic wisdom, is that “internal devaluation” by 20-30% is a certain path to
    bankruptsy for almost every private entity (person or company) in Greece.
    And there is no sane way around it, that I know.

    NB. (for those of you not in Greece, the non-performing private loans are at 20% and some
    projections show them to 30% in 2013)

    There is now talk of a haircut to private loans. I don’t think it is anything more that
    pre-electoral fraud by the politicians. But, even at the theoretical level, it is weird. Will there not be a haircut to deposits? How will contracts be rewritten? Is this really better than leaving
    the EZ?

    Do you Yanni have a solution to the problem of private debt (I mean a viable one), given Greece’s __current__ state, that does not involve the drachma? It will really make me sleep
    better at night to hear it (and btw, neither I, nor my family have any loans, and we are not
    getting any, but most people I know do).

  • I am unfortunate enough to be imprisoned on A PhD level modern economics and just now got a new direction.

  • I’ve fought my way through this very demanding but interesting piece. And was already thinking up a a nice comment and one, two questions. Then the 1st comment I stumbled upon was some absurd and totally context free rambling about Germany. So I said to me fine, forget about the nice comment.

  • BTW, since Merkel’s party is the European closest relative of the US Republicans, let me give you an advanced warning of how this Euro crisis will go down in history.

    59% of Americans feel that the Republicans are still (4 years after the fact) the ones to blame for the financial crisis.

    Well, guess what Europeans are going to say about Merkel and her mishandling of the European crisis. These trends in public opinion are impossible to contain and/or deny. Plus the run across party lines and ideology.

    So here is how this current event will be settled in World History books: This will be known as a crisis started by US Republicans in American soil and then amplified by its closest ideological cousins (Merkel et al) in Europe. I have no doubt that in the end, Merkel’s picture will become synonymous with a worldwide depression. Teachers will be showing Merkel’s picture to K-12 students of future generations around the globe and the automatic response will be something akin to the instigator of a “financial plague”.

    • As long as German tax money is not wasted on ClubMed countries they can write in history books anything they like. We will be all dead by then 🙂

  • Professor Varoufakis

    Why all the dolorous tears on your strong face about the tragic fate of Europe and carrying a ‘long sieve’ (long dissertation on Keynesianism) in your hand trying to separate the true legitimate Keynesians from the bastard ones, while most indices and the latest OECD report show clearly that Europe is pulling itself out of the recession sans the remedies of Keyne’s “animal spirits” as you are interpreting them?

    • I am sorry Sir but you are living in a different universe to the one I inhabit. Europe is pulling itself out of the recession? Precisely the opposite is happening. Indulge in wishful thinking if you will. Hust know that this is what it is: wishful thinking. Europe is sinking fast in the mire of a self-inflicted recession, its animal spirits blunted by economic history’s greatest series of policy blunders.

    • Exactly, we are in a recession, at least a lot of countries. Plotting historic goverment spending over GDP on the x axis and growth on the y axis might help to see the reason.

      Countries with lower government spending ratios have higher growth.

    • With every passing day, more and more data confirm that all of Europe — not only the periphery — is descending into deep and very painful recession. Actually, depression will be the outcome. You have only to look at the appalling mess that the UK is getting itself into, with the wonderful self-inflicted austerity programme that its moronic government is following. Also, you might care to note that they have reduced the top rate of tax while increasing the tax rates for all pensioners; unemployment is rising rapidly; and public discontent will soon boil over into more and more strikes and riots.

      Every country has a different structure, and every country will follow a slightly different trajectory — but there is a common pattern of socio-economic deterioration.

    • So according to No EU Trade,during the 00s,Greece had one of the lowest gvt spending and thus achieved one of the highest cumulative growths in the decade….yea right….

  • “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.”

    Sorry but you’re still doing something like what the pro-Memoranda people are doing
    (having evolved of course from (ommitting 100 steps of other kolotoumpes 🙂 )
    if we return to the Drachma then you’ll become very poor,it would be a catastrophe,
    if we return to the Drachma then you’ll become extremely more poor than now-soon,
    it would be the second coming of our lord):

    they’re comparing

    (the pros of) an imaginary “normal” situation
    with the -real- dangers,risks and cons of a Euroexit+default,

    while you’re comparing (I’m ommiting here your proposal of default within the €Z for simplicity’s sake;it’s close enough to Grexit+default, the latter being a highly probable outcome of the former)

    implicitly (the pros of) your Modest Proposal accepted,applied and succeeded(assuming that’s true,possible,probable)
    with the -real- dangers,risks and cons of a Euroexit+default.

    The proper comparison(assuming there is an agreement on what we are fighting for, on what we want) is

    years of deflation,of internal devaluation
    with a euroexit+default (or (imo) default within the €Z and…)

    while the proper method of deciding is
    Experience,empirical data and not reasoning (supposedly) a priori.

    What are the closest analogous historical-empirical events?
    Argentina,Gold Standard end etc;not perfect fits but still close enough(imo and I think factually enough)…That’s what Krugman is saying…

    By the way -not this time but many-a-times in the past- please stop using the bogeyman of the two circulating currencies in parallel!
    It’s a real risk with real cons(although one might argue possibly short lived ones)
    but just like
    when one(read many) has 0€,no job and mouth(s) to feed and bills to pay,
    one wouldn’t give a frack about possible or probable (hyper)inflation with Drachmas(or whatever),
    one wouldn’t also give a frack (imo) about the possibility of Drachmas and Euros in parallel circulation…

    The proper comparison,if you chose to do so, is in this case
    the pros and cons of 2 circulating currencies in parallel
    with the pros and cons of years and years of internal devaluation,deflation.

    Or if you want to make the decission tree a … tree,
    id est more complex and less manichean,

    then you must assign probabilities of happening, of being chosen of …,of success to all of the above scenarios(and many others),

    having sketched complex if then choices,

    having set-prepared-made-known the proper strategies at each case

    while testing how are things going in reality(failures etc),


    In example :
    if !A(want years of deflation-internal-devaluation) then
    { A1(Modest Proposal) or A2(Default within EU-€Ζ) or A3(Grexit-Default) or…
    if A1 then
    { A1t(try persuading people chosing A1)
    if A1f(A1t fails) then
    { …



    P.S.If you think that having double currency in circulation is worse than endless internal-devaluation-deflation, please explain why so…

    P.P.S.Please try to understand that Treaties when are not backup up by will and power, then they are hardly worth the value of the paper they’ve been written on.
    If sometime in the future they’ll REALLY want us out
    then they can MOST PROBABLY force out despite what the treaties say;
    plain and simple,directly or indirectly…

    • Very well said… I would take it even one level higher. What we seem to have here is a choice between

      (a) the completely fake, pseudo-scientific, a-logical, one-size-fits-all economic modelling (a la ISLM and others)


      (b) the “narrative” approach of social “science”, advocated I believe by Yanis and others, that always says a lot without saying anything, and because like (a) has very little analytic/normative/predictive power, at the
      end comes down to scaremongering “you must do as I say or else …”.

      I think society is at a stage where it is more and more getting fed up with both (a) and (b). It’s high time people started taking public discourse more seriously. From now on, when somebody is constructing a scenario for the future, can we please have the full list of prior (maybe probabilistic) assumptions? Not hidden under the carpet as both (a) and (b) do but laid bare in the open for all to scrutinize. Then we need the full set of logical steps that takes us from your assumptions to your conclusions and predictions. Anything else is just adding noise.

    • [offtopic(perhaps) mode on]

      I more or less agree but please allow me to add one more thing.It’s from one POV trivial but from another (perhaps meta one) very important so imo it has to be spelled out :

      I think that on top of the great dichotomy between
      hard science(s) and social ones
      there is one more crucial difference which I think that in fact runs in parallel, not on top of the above, being the essence of the problem and being a reality that should force us not to go so hard on these social “scientists”
      (not always of course, many-a-times what they say pretty much clashes so obviously with reality that there is simply no excuse for them).
      It’s not only that some in the left or the right (or midlle or up or down…) don’t care about the data and empirical reality
      (a great think per se),
      it’s at least imo the following
      (which at least in part explains why they(or we..;-)) don’t care about the data, irrelevanty of whether this is a rational decision making process or not;let’s not go there,let’s not explore the latter please;it’s way too hard 😉 ):

      I’ve written above :
      “assuming there is an agreement on what we are fighting for, on what we want”;
      I didn’t want to go there at that time but well,
      this is a VERY STRONG assumption.In fact the assumption is FALSE so everything after that breaks down.

      Social sciences try to deal with not only with (effective naturalistic) causation but also with the subjective or teleological(be it real or not,who knows?I’m just accepting it,posing it as an assumption;again, let’s not go there please ;-)) dimension of human affairs;in practical and simple terms, I just think there is simply no agreement on what we want,on what is the hierachy of moral or ideological principles.
      Moreover it’s not only a problem of different prioritising, of different ordering of fundamental principles;it’s also a problem of some things or ideals being considered good for some while the same are though of as bad for others; the(some) hierachies not only or simply don’t go (very) well together,they simply outrightly clash(obviously or being hidden).

      Some want us to be members of EU-€Ζ no matter what;
      some want national interests to go first;
      some think it’s time for a social(-ist) revolution;
      some… some… some…and so on and so forth.

      These ideological principles and assumptions are sometimes expressed,sometimes not, being hidden under multiple layers of arguments, thoughts and real things.

      How this choice or “choice” is going to play out
      while surely in the end will be an outcome judged and forced by reality onto us whether we like it or not,
      is perhaps the crux of the (very complex) problem,
      is itself an object of these sciences,
      is a matter of past evolutionary paths, present struggles and future history… 😉

      [offtopic(perhaps) mode off]

    • @ If no Marhall Plan then Grexit+Default

      And that is exactly why some great minds try to combine and find the common terms of all sciences. Especially using quantum mechanics.

      All sciences are at the end reffering to the same basic phenomena using a different perspective.

      We are the ones “creating” the terms ,so we have to be in agreement when reffering to the broader frame of social ,economic ,political systems.
      The reason we don’t is simply egoistic agendas.

      The problem arising is twisted meanings and arbitrary criticizing.

      Use of terms of which the definition ,does not connect with true events.
      Like the word “neoliberal”. A word with positive psychological carrier.
      Still the events connected with the word are destructive.
      Of course the context into which the word is used is important.

      Still this allowes for manipulation of perception.

      While life is dynamic ,we can perceive powers that ,for our human nature act as absolute. Otherwise it wouldn’t be possible for us to exist.
      So the broader frame of organisation must be defined by terms we agree to use as absolute ,very clear ,eternal themes ,proven through out the ages. Then as we “zoom in” to frames closer to our dynamic activities ,terms become more dynamic to allow for our illusion of freedom ,but always function as part of the broader frame and absolute moral laws.

      This organisation is a self-identical fractal. Squares within squares all connected with eachother. But the smaller squares ,closer to human activity ,are actually dynamic and act as indefinite fractals allowing for the flow of energy and exchange of the infinity of characteristics. Then we zoom-in on the human being ,which at the same time is a part of the structure and the controller of it ,becoming the broader frame ,while having the “rules” of the broader frame in heart.

      We then see that the end is also the beggining of the structure ,and that at the same every frame or every level of actions acts as a part of every level. A primary or a secondary part ,a strong or a weak link etc. Everything connected.

      Only when we understand that subjectivity is a true part of nature can we build such a structure.

      The advantage is that different cultures do not matter ,except if they are cultures that physically destruct. Obvious and simple.

      Hard sciences is a part of soft sciences and soft sciences is a part of hard sciences. It always was like that.
      Everything connected.

      This is the beauty of nature.
      Relative is absolute. Absolute is relative.
      Compex is simple. Simple is complex.

      KISS (Keep It Simple & Stupid or Keep It Strong & Simple)

    • Every sector can function as a fractal and controller of another. Everything can be explained by terms of energy flow. Public services ,public transportation ,physics ,archeology etc. etc..

      My 0,02 cents as stupid as they may be.

    • @Dimitri
      Are you going Sokal on me-us???

      P.S.These (social) phaenomena are complex and (perhaps as I’ve said) subjective enough;no need imo to make things even more difficult by making them even more vague…

      “Every sector can function as a fractal and controller of another. Everything can be explained by terms of energy flow. Public services ,public transportation ,physics ,archeology etc. etc..”

      Idou he Rhodos idou kai to pedema… 😉

    • Hehe

      No i am not going Sokal on you.
      Do not go Sokal on me.

      I certainly am not the right person for this.
      These are things i have picked up over the years ,or so i think ,from scientists of many fields.

      Just opinions. As i said maybe stupid ,maybe not.

      “Idou he Rhodos idou kai to pedema…”

      Do not say it to me. It is to high to jump.
      Say it to those that R&D.

      But i do and always will state my opinion ,even if i catch fire and burn.

      Things become complicated when we decide to have a closed mind and use so called political ideologies as absolute categorizations of human activity and the idea that one fits all. “I am left and this solves all the problems” , “No ,i am right and this solves all the problems”.
      Economy and politics can not always be the broader frame and everything else part of them. Even human life. Situations change.

      When we accept complexity things may become simpler. Instead of trying to control phenomena that are out of our reach (maybe just for today ,maybe always) ,we create mechanisms that allow for the existance of this phenomena and have the ability to act as absorbers of the negative energy flow.
      Mechanisms that act as the broader frame ,using as parts ,signifant (because we made them so – ECB ,EFSF etc.) points of energy manipulation.
      So instead of thinking of all the parameters ,we think of the obvious flows and adjust. But adjust fast. Really fast.

      That is why i like Yanis’ proposal. It is a universal shock absorber. For now.

      “Water changes its form according to the land it flows on.
      Be water.”

      I think i am going to read the “Art of War” again.

  • Let me add something to your account of Keynes.

    Although Keynes acknowledges that wage cuts might have a positive effect on exports by lowering the cost of export producing firms, he stresses that this effect is rather uncertain and surely less certain than the negative effect of wage cuts on domestic demand.
    This as a reply to both those asserting that the General Theory is economics for a closed economy and those believing that wage rigidity is an assumption and not a fact in recessions as you and Keynes would point out.
    Thank you for your excellent piece including your game which is a brilliant metaphor of Keynes’s own metaphor in the “beauty contest” And indeed this is exactly what bastard-Keynesians cannot and do not want to understand

  • Professor Varoufakis

    If I’m indulging in “wishful thinking” then I’m in good company with the likewise wishful thinking of the OECD whose estimate, as reported in The Australian, on March 30, 2012, is that Europe is “pulling out” of the recession. Whereas your down-to-earth unsentimental thinking, seems to me, cannot be accommodated on any known “universe,” other than your personal one, or if you invented and discovered a new one.

    • As they say, time will show. So far I have been cursed with accurate predictions. I hope you and Murdoch’s Aussie paper are proven right. But you will not be. Lastly, the OECD says nothing of what you think it said. You were, I am afraid, misled by an inaccurate report by the aforementioned rag – whose inner workings I know better than you (as I have worked with some of its lead writers – who used to be my students at Sydney University).

  • Dear Yannis,
    you say:
    >the ISLM is devoid of that idea, what is then the point of taking
    >the ISLM from a static to a dynamic setting?

    the Nash equilibrium certainly captures “that idea”
    (i.e. iterated anticipations/observations of optimism levels),

    so the ESS (evolutionary stable strategy )
    of Sigmund, Hofbauer etc. does so as well,
    since it is for all effects and purposes equivalent
    -though not quite mathematically equivalent.

    but the latter amounts just to iterating the game,
    ** giving the winners of previous rounds
    the right to clone (with their strategies)
    more players for successive rounds.

    So it seems that a dynamic setting can be relevant,
    but, only if the “reproduction of strategies” feature is
    incorporated appropriately.
    Then the question is whether the models of
    Krugman et al are implicitly
    using some form of this “reproduction”?
    It could take the form of redistribution of wealth for example,
    which would reset underlying supply/demand etc.


    • The Nash equlibrium fails spectacularly to tell us anything useful about the litle game that I presented in my piece; the one that captures (in my mind) the thinking of Keynes. Why? Consider the Nash equilibria of this game: Every value of X is consistent with a (pure strategy) Nash equlibrium. Which means, that anything goes! In other words, any choice is consistent with some equilibrium. Put differently, the Nash equilibrium is a useless concept in this game – as it explain any possible action as consistent with its logic.

      Turning to ESS (evolutionarily stable strategies), here we have some more light: There are two such evolutionary equlibria. One have everyone choosing 0, the other everyone choosing 1. In macro terms, this translates into two possible equilibria: One has all investors investing to the full, the other investing nothing. So, ESS predicts either recovery or full blown depression. In essence, again there is no determinate prediction.

      This was precisely Keynes’ point: Rationality cannot help us predict what the hell will happen once pessimism begins to rear its ughly head.

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