A digression

Careful readers of The General Theory may have noticed that there is more than one concrete or applied economic model that can be culled from the abstract theory presented in the book.

The primary contribution of the IS/LM model is that it helps explain why, in the short run, it is possible to have a high-unemployment equilib­rium. The central problem is that, as a short-run static-equilibrium model, the IS/LM model does not incorporate four of the most important building blocks of Keynes's economic theory - secular stagnation; endogenous expectations in an environment of fundamental uncertainty; endogenous "confidence" in expectations; and endogenous balance sheets. The first three are constantly stressed in The General Theory. The fourth is discussed in chapters 2, 19, and 22, but not emphasized throughout the book. However, it was of central importance to Keynes's 1930s writings about the causes of the financial collapse and Great Depression.

The IS/LM model therefore cannot adequately represent the full set of dysfunctions in a capitalist economy that Keynes stressed, nor the sources of endogenous dynamics identified by Keynes in the book. This makes the IS/LM model incapable of explaining the extreme volatility of finan­cial markets and investment spending or the collapse of the financial system in the USA in the late 1920s and 1930s. Ironically, the IS/LM model demonstrates that financial markets always help stabilize the economy by lowering interest rates when AD is falling and unemployment is high, and, when embedded in a standard AS/AD model in which the price level is an endogenous variable, it demonstrates that deflation helps restore full employment when AD is depressed. We have shown that Keynes believed both of these propositions were the opposite of the truth, a fact that is rarely if ever mentioned when the IS/LM model is described in under­graduate text books or even in standard advanced treatments of Keynes's economic theory.

The first model in order of presentation in this book was Keynes's model of secular or long-term stagnation. Based on his evaluation of the institutional and behavioral characteristics of the interwar period, Keynes argued that there was a historically contingent tendency of the rate of profit to fall as the capital stock increased, of the mps to be high and there­fore the multiplier to be low (due to the high income and wealth inequality of the period), and of the interest rate to remain too high to stimulate a level of investment adequate to sustain full employment. The defense of this theory is centered in chapters 16 and 17 of The General Theory, but also appears throughout the book. Keynes's most formal defense of the secular stagnation thesis was presented in his Galton Lecture in 1937, discussed in Chapter 14 of this book.

The simple short-run IS/LM model can be used to organize a narrative of sorts that explains the long-term stagnation trends in the era based on the assumption that the mec has a tendency to fall over time - model

1.

The IS/LM framework is most aptly suited to reflect Keynes's model

2, which explains the existence of short-run, static, high-unemployment equilibriums. This is the great strength of the IS/LM translation of The General Theory: it demonstrates quite clearly, using core ideas from the book, why a high-unemployment equilibrium can exist in the short to intermediate run in a capitalist economy.

Keynes presented the third model, the model of endogenously generated instability, in chapter 22 on the business cycle. For chapter 22 to be consistent with Keynes's model 3, the static IS/LM model would have to be made dynamic, incorporating the endogenous sources of movement in the actual rate of profit on capital, in the expected rate of profit (which is influenced by stock prices), and in the interest rate. This would require the IS/LM model: to reflect Keynes's insistence that both expectations and confidence are endogenously determined variables generated through extrapolation from recent trends in the economy; to emphasize that the cyclical pattern of divergence between expectations and realizations is a driving force of cyclical dynamics; and to embed these patterns in a model of endogenous balance sheets to be compatible with Keynes's insistence

A digression 271 in chapter 22 that, in the "crisis" phase of the cycle, "when disillusion falls over an optimistic and over-bought market, it should fall with sudden and even catastrophic force" (CW 7, pp. 315-316). A simple dynamization of the IS/LM model is discussed below.

Model 4 focuses on the destructive disequilibrium processes of wage and price deflation, which we treated in chapter 15, and interest rate dynamics, which are analyzed in chapter 16. Here, I will just remind the reader that chapter 15 stresses endogenous expectations and confi­dence formation and concludes that wage and price deflation are likely to aggravate rather than eliminate the deficiencies in AD that cause high unemployment, especially if the AD deficiency is large and balance sheets are fragile.

The fifth model used by Keynes, if "model" is even an appropriate term, is the very-short-term analysis of moments or points of crises of extreme volatility, in which the expectation-formation process becomes unhinged and unstable and confidence in expectations evaporates, espe­cially but not exclusively in casino financial markets. It is thus a crucial component of his model of extreme business cycles. Since Keynes devoted much of chapters 12, 13, 15, and 22 of The General Theory and much of the defense of that book in the QJE article in 1937 to explaining the outbreak and persistence of instability in the period, it seems reasonable to consider it separately here.

I already discussed (in Chapter 17) Keynes's emphasis on those points he called "abnormal times," when financial investors lose all confidence in the expectation-formation process. This causes financial asset prices to move in erratic patterns. Recall that in 1930 he said he discussed the outbreak of instability and unpredictability in US financial asset prices with "all sorts of people [in America]." He observed a complete and total collapse in investors' confidence in expectation formation. He said he:

found no-one who even thought his opinion was worth two-pence. When the elements of bluff and skilled market-manipulation and mass psychology and pure chance are added to the intrinsic difficulties of forecasting the courses of the credit cycle itself, the case is hopeless.

(CW 20, p. 586)

In chapter 12, Keynes described these points of extreme instability and unpredictability as follows:

A conventional valuation [of security prices] which is established as the outcome of the mass psychology of a large number of ignorant individuals is liable to change violently as the result of sudden fluctuations of opinion due to factors that do not really matter much to the prospective yield; since there will no strong roots to hold it steady. In abnormal times in particular, when the hypothesis of an

indefinite continuance of the existing state of affairs is less plausible than usual even though there are no express grounds to anticipate a definite change, the market will be subject to waves of optimistic and pessimistic sentiment, which are unreasoning and yet in a sense legit­imate where no solid basis exists for a reasonable calculation.

(CW 7, p. 154, emphasis added)

The potential for a breakdown in the continuity and stability of financial markets at the end of a long expansion is a crucial part of the model Keynes used to explain key economic developments of the era, and it should be one possible outcome of any model that claims to adequately represent The General Theory. This model or model component plays no role in any of the standard Mainstream Keynesian models with which I am familiar.¹