I am sad that the IS-LM debate devolved into IS-LM vs. close substitutes, because I meant to raise a broader set of objections to one particular kind of technocratic curve-shifting as the foundation for macroeconomic thought. Let me list a few alternative starting points for macroeconomics:
1. Public choice economics (still the most underrated, in today’s profession)
2. Growth theory (as distinct from the view that all business cycles are simply fluctuations in the rate of growth)
3. The New Institutional Economics of property rights and incentives
4. Financial asset pricing theory (as distinct from the view that financial markets are always efficient)
To see what this all means, let’s consider the euro crisis. I start with #4, financial asset pricing theory, and consider whether, if “euros in Greek banks” and “euros in German banks” are fundamentally different assets, perhaps they should have different prices. If prices cannot adjust, quantities will.
An IS-LM approach will focus on flows and be distracted — incorrectly — by claims that Ireland, Spain, etc. were not in bad fiscal positions before the crisis hit. That’s wrong, they were writing intolerable naked puts all along.
A macro approach should then move to public choice theory and interpret the governance of the EU and ECB and the coalitions in the various European governments. It wasn’t (for the most part) deliberately set up so that politicians could play short-run fiscal games, but that is in fact why a lot of politicians supported the eurozone. Cheap borrowing brought a big party, but it was a ticking time bomb from the beginning, as recognized by Milton Friedman and others. Based on Buchanan and Tullock (Calculus of Consent), the analysis can move forward with some understanding of why its governance is unworkable in a crisis, and with an understanding of why the Germans originally insisted on such a governance scheme at all. I also wouldn’t mind a citation to Hayek and his critique of French rationalist constructivism, you won’t find that in the IS-LM model either.
We can put all that together, combined with a theory of bank runs, and then we see there will be strong and perhaps intolerable deflationary pressures. Maybe one could use IS-LM for this part of the modeling, but I’ll stick with the kind of ideas you find in Irving Fisher or Scott Sumner. They are simpler and retain the core point that deflationary pressure can be very bad. As Scott notes, the sort of interest rate issues raised by IS-LM are more of a distraction than anything, at this point for this problem. And no, the eurozone for the most part has not been in a liquidity trap. Nonetheless aggregate demand really does matter in this setting.
One often reads that Italy is the linchpin of the euro crisis. To understand Italy we should look to growth theory, the new Institutional Economics, the theory of corruption, theories of political gridlock, and related ideas. Toss in Edward Banfield. Italy’s growth problems predate the immediate mess in the eurozone and they are not plausibly pinned on deflationary forces; the country hasn’t grown much in a decade. IS-LM is absolutely silent here, but if Italy were growing at two percent a year probably the whole mess would be manageable. Demographics matter too, and if this is a messier version of economics sign me up.
The idea that Ireland is seeing a partial recovery, piled on top of some deep structural problems in its domestic sectors, flows more naturally from institutions-based approaches than from IS-LM.
The all-important interplay between monetary and fiscal policy, critical for understanding this crisis, is forced out of the box by IS-LM.
For the final denouement, if indeed it arrives, there is Minsky and the theory of speculative attacks. Keynes in his chapter 12 of the GT had a good understanding of how expectations can switch so suddenly, a key factor at several stages of the euro crisis.
There is more, but you get the point. IS-LM should not be foundational for an analysis of this problem, IS-LM is not necessary, and arguably it is better not to invoke the model at all. And if I had to give undergraduates only one point on one part of the blackboard, I would use the comparison between Greek and German banks.
IS-LM leads one to the mistaken attitude that macro is fundamentally simple, and that all would be well if only people and politicians understood the need to “get tough” with expansionary policy rather than austerity. It’s a lot more complicated than that, yet we can understand these complications by building up from some fairly simple and intuitive models. It’s a better approach to use public choice incentives to understand why the current situation is unworkable, rather than preaching about why the flows should be different than they are. When I hear so much preaching, I tend to think the preacher is using a model with a missing variable or two.
Here is a good post from Philip Levy on why macro is hard, and how that relates to the recent Nobel Prizes.
Soon I’ll turn my attention to whether IS-LM Keynesianism has been making uniquely good predictions during this crisis.