The IS-LM Economic Model

August 30, 2011, 5:48 PM

Who You Gonna Bet On, Yet Again (Somewhat Wonkish)

by Paul Krugman

Today’s FT has a piece on famous financial managers having a bad year; among them are John Paulson and Bill Gross. Regular readers may recall that back in 2010 Business Week ran an article contrasting my views with Paulson’s, with the tone of the article clearly conveying the message that we should trust the billionaire, not the silly academic. You might also recall that I was highly critical of Pimco’s assertions that the end of quantitative easing would lead to a spike in interest rates.

Now, the point of this post isn’t to gloat — OK, it’s not mainly to gloat. Instead, what I want to point out is that there has been a simple principle to getting things mostly right in the Lesser Depression — namely, remember your Hicks.

The basic IS-LM model, with its possibility of a liquidity trap, has been a very good guide in these troubled times. And there’s a reason for that: as I wrote long ago, in a piece from the 1990s, IS-LM is basic economics applied to a world in which in addition to production of goods there is both money and a bond market. Aside from the assumption of sticky prices — which is overwhelmingly obvious and supported by strong evidence — it’s your basic, minimal, compelling model. It should come as no surprise that it gets at a lot of what’s going on.

Yet people don’t know this model — which is to say, they don’t have any simple framework for thinking about how money, interest rates, and the real economy interact.

Which people am I talking about? Money managers, obviously; they may know a lot about individual markets and companies, they may have lots of experience, but now that we’re talking about macro issues of a kind not seen since the 1930s, those talents are a lot less relevant than usual. Pimco used to have Paul McCulley, who was very good on the macro, but with him gone, they seem to be making up theories on the fly. And whatever model Paulson is using, it’s not IS-LM.

But economists also don’t know this stuff. We’re living in a dark age of macroeconomics, in which much of the profession has turned its back on past knowledge. There’s also a contingent of economists who have read Hicks, or at least claim to have read him, but seem to have come out of the experience with nothing more than misleading catchphrases and the strange conviction that they have transcended something they actually don’t understand. (Brad DeLong takes on some of this stuff).

I should add that when I talk about the liquidity trap, I mean the zero-lower-bound problem that arises in IS-LM. End of story. And clearly we are in a liquidity trap by that standard. You can go off and invent some other definition, and then deny that we’re in a liquidity trap by you definition, but who cares? By the original meaning, as defined by a model that is working very well, that’s where we are.

The point, again, is that getting this crisis right isn’t mostly about being super-smart or insightful — it’s about knowing and being willing to apply basic analysis that everyone making pronouncements on macro should have learned in freshman year. It’s sad, and disturbing, how few people are able or willing to do that.