By Philip Pilkington

Back in 2013 Paul Krugman, as part of an ongoing debate with MMT/MMR advocate Cullen Roche, said that the ISLM is not a good approach to macroeconomics. Hurrah! Right? Well, maybe not.

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

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

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

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

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

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

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

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

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

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

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

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

Caption graphic is a clip from "an example for the IS-LM scene", Wikipedia reproduced here under a Creative Commons Attribution-Share Alike 3.0 Unported license.