Krugman/Keen Round 2 – IS/LM, Disequilbrium and Non-Performing Loans

A second round has opened up in the Keen/Krugman debate.  Complicated by that this time Krugman is less obviously wrong and Keen made an error in assuming that Krugman had assumed a disequilibrium interpretation of  IS/LM whereas Krugman has now qualified that his interpretation is of an equilibrium interpretation but with less than full employment, and Keen acknowledges this mistake but still argues that a disequilibrium interpretation is necessary.

This is helpful as Krugman despite being the main IS/LM cheerleader together with Brad De Long has never given a clear explanation of its operation and furthermore how the labour market reaches this position.

This represents an open goal for Keen and it is puzzling then he does not pursue this line further.

Of course the weakness of ‘vanilla’ keynsianism is that whilst it gives a good explanation of the state of markets following an economic crash and indeed how to recover from this it gives no real explanation of why the economy got there.  As such this fatal weakness provided the opportunity for the lucasian critique that now dominates economics that markets must be always and forever in equilibrium and economic crises are caused by too many people going on holiday at once.  I only half jest.

Taking up then Keen’s challenge, implicit in Hicks own later self critique – what would a disequilibrium explanation of IS/LM look like?

I turn to a little known paper from Gary Smith in 1977  well ahead of its time as it presents a multisectoral dynamic model, with no assumption of prior equilibrium and a central role for debt.  Pretty similar to Steves models.

As Smith says

In a multiagent environment one has to decide not only whether [any] disequilibrium is absorbed by demanders or suppliers but also which particular demanders and suppliers absorb the disequilibrium.  If for example banks do not meet all loan demands, then each loan may be prorated or the rejections may fall disproportionately on such categories as car loans, education loans, vacation loans, poor families, middle-income families, wealthy families, small businesses, or large corporations.        The importance of this distinction is due to the presence of spillover demands from a disequilibrium market into other markets.  If an agent cannot purchase as much of some commodity as it wishes, then it will have excess funds which must be spent elsewhere or held as cash.   Similarly if an agent cannot sell as much as it wishes then it will have to reduce its spending elsewhere…

One  implication  of  spillover  demands  is  that  in  the analysis  of a  particular  market  one  must  be  alert  for  influences  from disequilibrium markets.     The demand  for housing may be critically dependent  upon rationing  in the mortgage  market.   T’he corporate bond market may be influenced by  disequilibria  in  labor,  commodity,  and  loan markets.

Consider the case the classic Minsky case where property speculation has been driven by Ponzi loans and after the peak of a bubble there is a rash of non-performing loans.

Because of these non-performing loans banks have a reduced budget constraint and so must ration their loans and/or must raise interest rates.

Applying Keen’s own walras/schumpeter law on both sides of the excess supply/demand equation we now have a reduction in the rate increase in credit which must result – a reduction in the actual supply of money to banks from loans must create an excess supply of those goods on which that money would have been bought – such as housing.  If banks then firstly ration loans – then ponzi lenders go bust – or raise interest rates – then some speculative lenders go into the red, loans non-perform and there is a downward spiral – in the manner classically described by Homer Hoyt – of banks now having a further budget constraint and increased housing on the market pushing down prices and reducing profits on speculative loans.

Now the equations for this (bar Keens innovation re credit growth) were set out by Smith over 40 years ago.

Corporations on the other hand are able to realize their effective demand for labor but unable to find buyers for their effective supply of commodities…Now with actual sales…  less than notional sales there will be insufficient revenue to pay notional wages and dividends…[one alternative] is to reduce employment in order to produce only as many commodities as are demanded

Though he admits this only works in micro terms because

wages and prices (often as a simple mark-up over normal costs) are established for extended periods and variations in aggregate demand do cause variations in employment and output rather than wages and prices

In this ‘short side wins’ world there are differential exercises in ‘short side’ power – to use Bowles and Ginti’s phrase between holders of different factors of production, and the losers in a downward economic spiral are workers – whether employees or entrpreprenuers seeking credit.

So Keens own anyalytic system, if applied methodologically to a disequilbrium solution of effective supply/demand after the peak of a boom can fully explain why less than full employment results.

In many ways Keen and Krugman mirror the debates between and Hawtry and Keynes.  Hawtry/Keen stressing how we got into the mess, and Keynes/Krugman explaining how to get out of it.  Keynes/Krugman stressing identities, Hawtry/Keen stressing causalities, and now a Keenesque approach explaining the process of disequilibrium following the popping of an asset price bubble and Krugman stressing the stagnation of markets resulting at the ZLB and with equilibrium at less than full employment.