naked capitalism

By Philip Pilkington, a writer and journalist based in Dublin, Ireland

Recently the mainstream press have done some rather interesting coverage of Modern Monetary Theory (MMT). Particularly good was the Washington Post’s attempt to spell out the key differences between Modern Monetary Theory and standard post-war Keynesianism.

In their piece on MMT, the Post rightly pointed out that after the war there were two distinct brands of Keynesianism. One came down from Keynes himself through his students at Cambridge; the other was essentially invented by the American economist John Hicks and came to dominate academia after the war.

In the coming days we will probably see many commentators expressing confusion over the differences between the two types of Keynesianism. And while there are many threads that one could follow to try to draw what is a very real distinction between the two approaches, we will concern ourselves here with Hick’s old ISLM model and the liquidity trap interpretation of Keynes’ argument.

Hopefully following this thread will tease out some of the differences between the two approaches (differences which Hicks conceded when he rejected his own interpretation of Keynes later in his life). Key among these will be: the post-Keynesian protest in trying to fit Keynes into some engineering diagram straitjacket; the post-Keynesian focus on actual business psychology; the rejection of the so-called ‘loanable funds’ theory; and the post-Keynesian scepticism as to monetary policy.

From the Mists of Time

First, the liquidity trap itself. Keynes deduced it – like he deduced so many other things – but it was only an endnote to a chapter entitled ‘The Psychological and Business Incentives to Liquidity’ in his General Theory of Employment, Money and Interest. The passage in the original – remarkably difficult to find given the muddle surrounding the liquidity trap today – is as follows:

“There is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest. But whilst this limiting case might become practically important in future, I know of no example of it hitherto. Indeed, owing to the unwillingness of most monetary authorities to deal boldly in debts of long term, there has not been much opportunity for a test. Moreover, if such a situation were to arise, it would mean that the public authority itself could borrow through the banking system on an unlimited scale at a nominal rate of interest.

This passage was seized upon by Hicks and other monetary policy enthusiasts as the nodal point of Keynes’ theory of an economy out of whack. While we won’t get too deep into the details, these economists thought that it was under these specific circumstances that active government fiscal policy was necessary. Yes, some of these ‘ISLMic Keynesians’ would probably have broadly supported the use of fiscal policy even when the economy was not mired in the dreaded liquidity trap, but their theoretical underpinnings for such a recommendation were weak, self-contradictory (having to do with so-called ‘rigidities’ which were otherwise ruled out in their models) and, dare I say, born of naked political motivation.

Keynes, on the other hand, clearly advocated fiscal policy measures even though, in his own words “whilst this limiting case [of the liquidity trap] might become practically important in future, I know of no example of it hitherto”. Here was a man who never saw a so-called liquidity trap in his life, yet whose theory led him to advocate fiscal policy in a manner that he understood to be wholly consistent with logic. In Chapter 12 of the General Theory entitled ‘The State of Long-Term Expectations’ he wrote:

For my own part I am now somewhat sceptical of the success of a merely monetary policy directed towards influencing the rate of interest. I expect to see the State, which is in a position to calculate the marginal efficiency of capital-goods on long views and on the basis of the general social advantage, taking an ever greater responsibility for directly organizing investment; since it seems likely that the fluctuations in the market estimation of the marginal efficiency of different types of capital, calculated on the principles I have described above, will be too great to be offset by any practicable changes in the rate of interest.

Clearly Keynes was sceptical of monetary policy despite the fact that he had never seen a so-called liquidity trap. His analysis – which was not Hicks’ ISLM model – led him to conclude that monetary policy was too weak a tool to manage a capitalist economy. He was right of course; as a means to stimulate growth monetary policy is probably, to a large extent, voodoo – a conjuring trick summoned out of dust to tweak the animal spirits of investors in the good times. And the reason it is still appealed to by the ISLMists? Because without it their criss-crossing totem falls apart and they are once again led to think in terms of business psychology and the real world.

Moving back to our little history, Keynes’ liquidity trap argument was not loved by all and sundry. The British economist Arthur Cecil Pigou, who had received something of a clawing in Keynes’ General Theory, was convinced that even if an economy entered a liquidity trap the self-equilibrating forces of The Market would ensure that everything would return to normal eventually. Pigou thought that if competition were allowed to work its magic wages and prices would fall. This fall in prices would mean that already existing money would become worth more in real terms, so consumption would increase and the economy would exit the liquidity trap as GDP grew – this became known as the ‘Pigou effect’.

Pigou’s argument was rather dim. It did not, for example, take into account the distributional impacts of the real money boost provided by the deflation together with the disproportionate propensity to consume among the different income classes. Nor did it consider the fact that when people see a general decline in prices they might hold back purchases in the hope of more declines, thus reinforcing the deflation spiral. And then there was another, rather enormous problem that was pointed out by the great Polish economist Michal Kalecki: put simply, that the real levels of debt would rise as prices and income fell:

The adjustment required would increase catastrophically the real value of debts, and would consequently lead to wholesale bankruptcy and a ‘confidence crisis’.

While the deflation might – we emphasise the word ‘might’ – encourage those who held money to consume, it would cast debtors deep underwater and massively increase bankruptcies. Kalecki’s point had, of course, already been stated in theoretical form a few years before by Irving Fischer in his ‘The Debt Deflation Theory of Great Depressions’ – especially in this now famous passage. But, of course, such theories are not equilibrium theories and so Pigou could never have accepted them.

Pigou was largely ignored by the new Keynesian orthodoxy. This new orthodoxy, who were otherwise ISLMists to the core, also tended to broadly ignore the liquidity trap argument. Partially this was because they had, like Keynes, never seen such a thing; but partially too because fiscal policy was, due to contemporary government policy, the economic fashion of the day – and if economists are good at nothing else they are quite brilliant at following intellectual fashions.

The New ISLMists

Moving on to recent history – one in which the fashion is undoubtedly monetary policy – the most popular advocate of the ‘liquidity trap’ argument today is Paul Krugman. Krugman had long been familiar with what he thinks to be a liquidity trap problem because of his study of Japan, which went through similar problems to those currently being experienced by the US and the UK after their housing and stock bubbles blew up in 1991.

Krugman is, of course, an avid ISLMist. But prior to this he thought that Pigou’s argument had some merit:

If you really want to know, I had initially believed that the ‘Pigou effect’ might play an important role in the discussion, and needed the intertemporal model to convince myself that it did not.

From his initial Pigovian ideas, Krugman has since moved onto the ISLM model. Although Krugman does recognise that government fiscal stimulus should be used aggressively in the current downturn he understands this only in terms of the ISLM. This leads him not only to fundamentally misunderstand the nature of the problem, but also to call for negative real interest rates. He recommends that in lieu of adequate fiscal policy the central bank should try to scare people into thinking that inflation is just around the corner. This is a rehash of the arguments he put forward in relation to Japan:

[M]onetary policy therefore cannot get the economy to full employment unless the central bank can convince the public that the future inflation rate will be sufficiently high to permit that negative real interest rate… [And] an economy which is in a liquidity trap is an economy that as currently constituted needs expected inflation… (My emphasis)

Negative real interest rates – which essentially mean trying to blackmail savers into investing by threatening to inflate away their savings – are a dubious tactic for number of reasons, none of which can be appreciated from within the ISLM model.

I wrote about some of the potential problems of this approach on this site recently. Put simply, because the ISLMists rely on a toy model with intersecting lines to determine investment behaviour, they cannot even begin to try to think in terms of investor psychology – which is precisely the type of thing that Keynes, plugged into the real world as he was, was interested in. The ISLM model implicitly models robot that, lo and behold, act in their investments as if they were reading the results of an ISLM model. (Tautology, much?). This leads the ISLMists to completely ignore the perverse effects that certain policies may have upon the psychology of the investor. Their ISLM robots only move in one direction when pushed – in the real world investors can go in any number of directions.

Related to this is that by scaring the hell out of investors that inflation is around the corner they may seek to hedge against the perceived threat to their money savings and they may do so by hedging in commodities. This can cause any number of economic problems.

The most obvious of such anomalies in the current situation is gold, the market for which is in an obvious bubble. Now the gold bubble will have few effects on the real economy except for leaving a few convinced gold bugs with ashes in their hands when the whole thing burns – but there are other commodities markets that certainly do have effects on the real economy when they inflate. As former International Petroleum Exchange director Chris Cook argued on this site recently, oil and other commodities markets are probably being inflated right now due to investors hedging against feared inflation. Ironically enough, this produces the feared inflation by raising energy and other prices which in turn push up the CPI.

This is not the first time these issues have been raised. Hedge fund manager Mike Masters, MMT economist Randy Wray and Commodity Futures Trading Commission commissioner Bart Chilton have all noted that massive amounts of money looking for a ‘safe haven’ might be inflating bubbles across the commodities markets and raising prices for consumers.

Of course, the model-obsessed ISLMists will truck out their criss-crossing totems once more to ‘prove’ that supply and demand in the oil and other markets cannot be tampered with by hedgers and speculators (presumably they would say the same about the gold market, although it would take quite a twisted mind to explain why the ‘real’ demand for gold has more than doubled since the financial crisis). Harking back to undergraduate level economic models is a weak move and would, I think, be laughed at by real world investors who are nowhere so naïve about commodity markets.

ISLMists would, as usual, be better off reading Keynes himself who in his Treatise on Money spelled out the possibility of what he called ‘commodity inflation’. But alas, they probably will not. After all investors piling out of dollars and into commodities to hedge against inflation in the current environment doesn’t look like how their ISLM robots should be acting during a so-called liquidity trap. And when models are worshiped like totems it is reality that is to be ignored rather than an anomalous reading recognised for what it is.

Death of the Loanable Funds Doctrine

In truth the liquidity trap argument is basically meaningless in how it relates to a modern economy with a modern banking system. This is because, as followers of Keynes and his students have now known for over 30 years, the amount of money in a modern economy is determined by the demand for said money and not its supply. This is a key difference between the standard ISLM Keynesians and the post-Keynesians which should be stressed as much as possible.

The only control that central banks have over the supply of money is through the exogenously determined interest rate which, as everyone knows, is set through open market operations (OMOs). This means that if we whip up a model the supply function of money will be represented by a horizontal line, indicating the infinite elasticity of the supply of money. One of Keynes’ most eminent students, Nicholas Kaldor, put it as such:

The supply of money is infinitely elastic – or rather it cannot be distinguished from the demand for money.

We won’t get into the reasons that this is the case as they are quite complex, but the reader can consult the mounds of theoretical and empirical material that has accumulated over the past few decades in Post-Keynesian circles. Instead let us see what consequences such an argument has for those that adhere to the liquidity trap theory.

Any good ISLMist will tell you that if the supply for money is indeed infinitely elastic then the Holy Model is truly cooked and the liquidity trap theory burns up with it. Why? Because if we plot a horizontal line representing the supply of money (LM) across the ISLM model we will see that the investment-saving function (IS) is then always moving along a horizontal line which, in the standard ISLM model, only occurs when a liquidity trap is hit.

Monetary economist Marc Lavoie sums it up rather well in his book Foundations of Post-Keynesian Economic Analysis:

In a theory of endogenous credit money, the role attributed to liquidity preference by the earlier neoclassical Keynesians loses its significance. The preference of the public for holding money does not play any role, either in the determination of the rate of interest or in that of employment.

This means that the liquidity trap argument is reduced to being a rather bland statement about the fact that interest rates are not leading to increased confidence rather than a fancy modelled theory about how investment is determined. The reason that the ISLM turns up such boring results when confronted with the endogenous theory of money is because the ISLM model itself is reductionist and faulty.

Indeed, those researching and theorising in the tradition of Keynes have come very far from the old liquidity trap arguments and the ISLM doctrines. But the mainstream, with their collective head buried in a model, remain painfully unaware.

Refocusing the Issues

While it would take us rather too far off topic to go into any detail on where economic commentators should be looking for the causes of the current stagnation, a few comments should be made in passing because these subtle theoretical differences have enormous real world consequences.

First of all, the world around us is not as the old models would have it. Where the models might expect mild deflation we have persistent but mild inflation and this even with unemployment at high levels. This inflation, as alluded to above, is in part due to the very policy choices by economists who apply pseudo-Keynesian models to analyse the world around them. Before they are to understand a single thing beyond the ends of their noses, economic analysts have to stop abstracting so violently away from the real world and seriously ask themselves why their models come up lacking when confronted with the facts.

Secondly, and tied to this, models like the ISLM are reductionist in the extreme and should be thrown out immediately. Not only do they fail to integrate many aspects of Keynes’ own analysis (as was later recognised by the creator of the ISLM himself), but they essentially fall apart when confronted with certain important realities of our modern world – especially those realities that have to do with credit and the real processes of credit creation in modern economies.

I will no doubt be chastised for not supplying a replacement for the ISLM. This is a ridiculous criticism to be made of a short essay focused on the liquidity trap. But there are mounds of real Keynesian research and theory out there for the interested reader to explore. As for a replacement for the ISLM… frankly, the model should never have existed and should anything resembling it ever come into existence again it should be immediately thrown out.

Economists need to become more flexible – and flexibility is not built into these models. (Nor are they built into their supposedly more ‘sophisticated’ but equally reductionist DSGE cousins). These models are constructed in a manner that excludes contradiction, especially empirical contradiction, and so they lead to ignorance and prejudice rather than to new discoveries. The models also, as we never tire of pointing out, allow their adherents to avoid thinking about how economic agents might react in psychological terms. This was a key aspect of Keynes’ analysis and one that gave it such power.

The models are like calculators in that they add up the limited variables inputted neatly but allow us a handy excuse to stop thinking – and given sufficient ‘training’ in these models the user will inevitably become something of a calculator himself.

As for the liquidity trap? When it was invented it was nothing but a footnote that its author brushed aside. Today it is a fad theory that explains away the pressing need to take a good hard look at what is going on around us. Confine the bloody thing to the dustbin of history where it belongs!