No More Economic Theories !

Currently, there does not seem to be any way to control the world economy. Regardless of the will of individuals, economic indices are volatile and the prediction hardly predicts any expected outcome. Economic theories seem to be excellent at explaining the nature of how various economic activities whilst they seem to be poor at predicting the outcomes caused by these activities. Individual agents in this world have become so interconnected with each other that small margin of errors and frictions is no longer insignificant to ignore. Any spontaneously matters of this world are now influencing economy simultaneously. In another word, predicting economic outcomes is like predicting any seismologic matters. Predicting and controlling when another recession strikes is like doing for when the next earth quake occurs.

I have never regretted having studied economics even in a postgraduate degree level. The subject economics helps to systematically understand the nature of how any trades, decision making processes, and power relationship are maintained in daily life, business, and politics. However, I have simply found out that professional economists are just adding up footnotes onto the already invented economic theories, and any brand new invention, surprising the mass in this world, seems to be unable to come up.

Adam Smith, the father of economics, has already summed up the fundamental principle of economics. Various classical economic theorists added up some unavoidable footnotes onto Adam Smith's work. Then, John Maynard Keynes introduced countermeasures against chaos causing economy deviating from the ordinary movement of what Adam Smith explained. All these economists admired Adam Smith and kept his idea as the fundamental criterion of their own theories. Market economy itself does not seem to fade out as long as trades are carried out in our daily life and the notion of private properties, which seems to be one of innate human natures, prevails to exist. Then, the free market principle explained by Adam Smith keeps prevailing, and only some minor reforms are adapted to it.

Karl Marx attempted to offer an alternative principle but his principle sounds suspicious. Marxian theory is that it claims for a very abstruct factor such as determining the value of labour which is often substantially undervalued in the market economy. The problem of this claim is that the scaling method of this value is utterly subjective and this is inconceivable as same as the quality of a faithful spirit. Despite materialist focus and atheist perspective, Marxian theory sounds more like a religious theology expecting for an absolute being and a universal morality judging human qualities. Furthermore, Marx's theoretical backgrounds are actually not so original. His basis economic principle highly relies on David Ricardo's theory. His philosophical foundation is based on his teacher Friedrich Hegel's dialectic philosophy. Marxist economics thus prevails as one form of culture meanwhile it seems to be difficult to categorise as a newly invented academic theory analysing economy.

Adam Smith said "Only fair is laissez-faire (Let it do)". This implies that there is no way economy can be manipulated and there is no universal principle of how economy should be operated. Economy nowadays is prone to be influenced and even messed up by any chaotic friction. In addition, reactions to any change and any economic policy in economy vary across different psychological mindsets of individuals and their culture codes. The mainstream modern economic theories excessively standardise market structures and the mindsets of individual agents. Only the solution seems to be just let the market move alone and let each individual agent to handle it with their own way.

The major financial institutions can be guilty for having messed up the world economy with their pseudo science called financial engineering. Even John Maynard Keynes had already warned that financial market is more psychological than natural-scientific so there is no legitimate answer and equation precisely tracking the market movement. Despite Keynes's warning, these financial elites and government aiding them ignores as though Keynes's original theories of investment had never existed. They have injected extraordinarily massive supply of cash and financial assets into the market against the natural level of the demand.

The extraordinary market stimulus propped up by the excess supply of cash and financial assets are causing the severe negative bounce back effects. Understanding of their financial engineering does not exist to solve problems of economy; It actually causes unnecessary problems caused by those using this engineering technique only for their own short term gain by sacrificing the majority others. As a matter of fact, those gaining the short term gain from this pseudo-science eventually lose out due to the negative impact of the bounce back caused by their reckless manipulation. It comes back to the point of the quote by Adam Smith "Only fair is laissez-faire".

It is the right point that the subject economics was originally introduced as one of philosophical theories by Adam Smith. Although economics nowadays tend to be considered as more physical scientific, Smith was more concerned about metaphysical matters like how the world is formed and how logic derives answers and is evaluated by its principle. Perhaps, there is no absolute answer in economics as same as metaphysics and other philosophical realms. Many economic theorists seem to pretend to be natural scientists claiming there shall be a solid answer for something they are pursuing and demonstrating some pseudo-natural scientific something.

In particular, nowadays, the world is dynamically changing and any already existed social scientific theories hardly prevail to solve the newly emerging problems and promote the newly emerging opportunities. It has already come to the point where it is necessary to start thinking in terms of metaphysical ways of thinking about the world functions including economy. Economy is a life style so it should be more free to think about economy and there should be various unique ways of conceiving it such as doing philosophy.

The IS-LM Model is wrong!

This was originally posted on Wednesday, October 22, 2014

* Preface *

Many students of economics may have studied about the IS-LM model, and then tackled with various homework assignments requiring to solve the excessively complex formulas and understand the theoretical reasoning behind them. These macroeconomic teachers always expect students to consume their precious time and energy to solve a ton of equations and memorise the theory to explain what these algebras denote. The mathematical formulas applied to this model are mostly linear and straightforwardly simple but all equations are interconnected to all the others. As long as they are familiar with economics in general, it should not be a big problem to understand the theoretical bases. But, these teachers require these students to interlink all the necessary theories which textbooks show to all equations. In addition, when the interpretation of these students differ from what the textbooks and the teachers expect, their mark tends to be lowered. Therefore, studying the IS-LM model is very exhausting.

Nevertheless, despite their efforts and well-understanding, there is a big scepticism about the IS-LM model. There are still many debates about whether or not this model successfully explain the real world economy. Of course, there is always a residual gap between what the prediction model estimates and what the real world phenomenon is in real. This is why the IS-LM model is a problem because of its complex tangle of a bunch of the equations. Especially in social science, when many mathematical equations are used and interlinked together, the total sum of the residuals tends to be significantly magnified, and the bias and the inconsistency of the model also tend to take place much often. Furthermore, these estimate mathematical models are not statistically tested as their formulas are merely based on the literature of economic theories. Therefore, it is really a natural fact that the IS-LM model often fails to fit into what really happens in real.

Even in the pure literature based economic theories and the logical economic theories also counter to the IS-LM model. This report introduces some significant counter-arguments against the IS-LM model as follows.


1. The Ricardian Equivalence


This theory implies that providing economic agents with extra income by the stimulus package does not successfully induce them to spend enough to stimulate their economy. When they prefer consuming/invest less and saving more at the present time to the extra consumption&investment, the extra income available by the tax cut and/or the government expenditure rather causes the negative impact on economy than the positive impact. The cost incurred by the tax cut and/or the government expenditure at the present time period has to be paid back in the future. As the economic stimulus becomes unsuccessful due to their preference of spending less than expected, the tax revenue in the future time period is lowered meanwhile the cost remains.

Those who disagree with the Ricardian Equilibrium argue that there are many economic agents with the low income insufficient to satisfy their needs and wants during the recessionary period so that they happily spend their extra income provided by the stimulus package to stimulate economy.

However, their extra income spent for consumption/investment is eventually transferred to owners of the means of production who produce the consumptions and own the assets invested. These owners will rather want to shift their income earnt from their capital investment to their assets in this downward market to either saving in their bank account or investing more active foreign markets.

When an economy become at the point that even these owners of the means of production become deprived enough to cling to the extra income provided by the stimulus package, the national government is less likely to be able to issue their bonds to incur the debt as the bond credibility is substantially lowered.


2. Liquidity Trap


The stimulus package by the monetary policy channel still does not work due to the liquidity trap. As mentioned in the Ricardian Equivalence, economic agents tend to be reluctant to spend their extra income available during the recession. Even the monetary policy is less likely to incur the cost like the previously mentioned fiscal policy channel, the result is identical to the previously mentioned scenario.

This phenomenon is explained as the liquidity trap. As shown in the graph above, although the extra money supply becomes available to transform to the extra income available for economic agents to spend, the effect is substantially low or even nothing under a very low liquidity level i.e. the investment motive is very low. The little effect on the interest rate reveals little impact of the money supply increase on economy. This means that the factors determining the interest rate such as the price indices, the business activity rate, and the value of this money currency in the foreign currency exchange market hardly changed by this monetary policy.

On the other hand, this interest rate shown in this LM graph merely implies the central bank interest rate, and this only partially affect on the banks' interest rate setting for their borrowers. The rest of this report explains the effect on these interest rates. The IS-LM model neglects explaining the following factors because the IS-LM model assumes all these factors are positively correlated to what it indicates in the model. Nonetheless, the more real economy is obviously different from this false assumption.


3. Under the Banking Monopoly in case of Risk Neutral


The supporters of the IS-LM model assume that their margin rate tends to be always positively correlated to the central bank interest rate so that the final interest rate for both investment and saving is always controlled by the central bank interest rate affected by the fiscal and monetary policy.

The IS-LM model is based on the assumption that all or majority of private banks and the other financial institutes are under the perfectly competitive market. By contrast, the real world economic situation is even not close to this assumption and actually far away from it. They are in the less competitive market due to the nature of the financial industry and market.

The interest rate is the price of money rent and borrowed. So, the private banks and the other financial institutes need to add the extra rate on the central bank interest rate after borrowing from the central bank to rend their money to their customers in order to compensate for the renders' service cost and reward.

Also, in a market economy, the characteristics and the quality of the financial service is heterogeneous to each other, and the demand is severely affected by their geographical situations e.g. access to customers and clients (both quantitative and qualitative), cultural attitudes toward finance, and the infrastructure for obtaining information and technology available there.

On the top of the service quality issue, the service users are difficult to change their service providers often as much as the mainstream economists assume due to the contract binding them together and the transaction cost to close and open their bank accounts. So, these service users are more likely to be bound to their already contracted financial services.

All in all, the market nature is far more monopolistic owing to these aspects. Then, the interest rates are set at the quantity of money invested where the marginal revenue becomes equal to the cost which is the interest payment for savers for this case. So, the quantity invested is lower than the quantity at the investment and saving intersection, and the interest rate charge for borrowing is always significantly way higher than the interest rate payment for savers.

The interest rate payment for savers may be affected by rise of the central bank interest rate increase but not often by fall of the central bank interest rate unless the market is very competitive. These financial service providers take advantage of this situation so that the interest rate payment for savers often tend to be notably lower than the interest rate charge to borrowers.

The following charts explain the different situations to set the final interest rates.

3.1. When the Central Bank Interest Rate is high


When the central bank interest rate is high, then the interest rate paid to savers is adjusted to be equal to the central bank interest rate.

The quantity of money invested is adjusted to the point where the marginal revenue from the return from investment intersects with the central bank interest rate, and then the interest rate charged for investment becomes higher as the central bank interest rate becomes higher.


3.2. When the Central Bank Interest Rate is low


When the central bank interest rate is low enough to be able to split from the investors' profit margin, then no change of both interest rates tends to take place as shown in the graph above.

This aspect completely contradicts what the IS-LM model assumes. As the market is less competitive, the monopoly power is stronger enough to maintain their high interest charge for investment payment unchanged.


3.3. The extreme case: The Central Bank Interest Rate is either zero or minus



In this extreme case which seems to occur frequently under the world economic crisis period nowadays, many central banks of this world have set their interest rate notably close to zero. Even some claim that they should set the rate zero.

Nonetheless, as shown in the previously mentioned mechanisms, the previously mentioned interest rate setting under the low liquidity, the money supply offered by the central bank with a sizably low interest rate hardly stimulates economy.

The interest payment for savers cannot be set below zero because they will no longer save in these banks or any other financial institutes setting such a negative interest rate.


4. Risk Taking Patterns

On the top of the gap between the interest rates, the IS-LM model over-simplifies the investment pattern influenced by the psychological characteristics of banks, investors, and other financial administrators.

What should be concerned is that the interest rate setting based on the investment volume is not always counter-cyclical to the business cycle, and not all economic agents are risk neutral as many mainstream macro-economists tend to assume.

The following examples are based on the situation of the fiscal and monetary policy is tightened to repress the economic boom or the recession repressing the aggregate income level.

The Y_t denotes the aggregate income invested to economy by these investors, and X_t denotes the investment safety (A higher value indicates the lower investment risk).


4.1 Risk Neutral: The IS-LM Curve assumes all agents are as such


This is the way which the risk neutral agents regularly react to the business cycle downturn causing the aggregate income shrinking.

They simply reduce the investment volume, and passively react to the investment risk change.

The IS-LM model may work as long as all the economic agents act as such.


4.2. Risk Averse


The risk averse economic agents put priority on their investment safety to their nominal income gain from their investment volume.

When their investment opportunity becomes more limited, they tend to take this situation warning of losing their business opportunity and potential collapse of their investing clients.

Even in the case where the fiscal and monetary policy represses the booming economy, they imagine about the negative side effect of the over-expansion which the policy alerts, and then they prefer preparing for the worst case scenario.

In particular during the recession, more agents tend to become the risk averse because their perspective tends to be more pessimistic about the future.

All in all, the income downturn exaggerates the investment discouragement furthermore.


4.3. Risk Lover


What the mainstream macro-economists supporting the IS-LM model ignores is this psychological characteristics of economic agents the risk loving attitude toward investment.

When the macroeconomic level of the aggregate income goes down during either the policy tightening or the recession, these risk loving investors start investing more in order to compensate for their loss by the downturn. Even though their action notably increases, they tend to be willing to invest a lot for increase the nominal investment return furthermore.

Their prior objective is to maximise the gross income growth despite the high risk reducing the average expected investment return. So, they will either maintain the current investment volume or even increase the volume in spite both the investment risk, the high central bank interest rate, and the high tax and/or the less government expenditure.

In particular during the economic bubble, an euphoria severely affects people's mind enough to lose their rationality. So, they often tend to become the risk lovers while the economic bubble.



5. Risk Premium in case of the Perfect Competition

Even in the Perfect Competition Model fails in the real investment mechanism because it ignores the interest rate influenced by the risk premium of investment. When renders invest, they add the extra interest rate charge on the top of the risk free interest rate which the mainstream economists supporting the IS-LM model use in the macroeconomic model.

The graph indicates the interest rate setting of a bank under the monopoly:

Under the monopoly or a less competitive market, these firms simply takes the cost incurred by the investment risk by spiriting the expense from their profit.

By contrast, in the perfect competition, it is very complicated to explain with only the saving=investment curves so that the graph will be a overly complicated mess if it attempts to explain the risk premium rate setting under the perfect competition.

So, this analysis introduces the cost denoted as C, which indicates the cost of attracting savers, the interest payment to the central bank, and then the risk premium all together.

The graph below sets the saving motive and the central bank interest rate as rigid so that takes account of only the investment motive and the risk premium.


In this case, the interest rate is not guaranteed to be counter-cyclical to the business cycle, and it can be acyclical or even possibly pro-cyclical to the business cycle.

Some economists argue that the risk premium factor may affect the investment cost more than the other factors such as the central bank interest rate, the saving ratio, and the aggregate income/productivity level.

So, the final interest rate influencing the investment volume may rather rise during the recession because the risk premium rises meanwhile the rate may fall due to the lower risk premium during the stable or booming period.

Minimum wage is necessary to maintain free market economy (Monopsony)

When someone claims for imposing minimum wage, many may still tend to call this person a socialist. However, imposing minimum wage seems to be less socialistic than allowing politicised trade unions (labour unions) to hold their wage bargaining power. In order to preserve capitalist model based on free market market economy requires the reasonable level of regulation in order to sustain the fair rule of market competition, stable risk management of investment (attracting investment), symmetric information (mitigating information bias), and motivation of both employers and employees participating economy without being feared of mismatch (Rationally forming their contact with each other). Minimum wage can be considered as a form of regulation, and it provides a reason to say there is no need for a trade union intervening for avoiding exploitation of labourers.

Nowadays, involuntary unemployment and stagnating aggregate demand are still the significant socioeconomic problem. The root cause of the current economic structure seems to be the shrinking market competition due to growing power of major corporations. Unlike the earlier stage of capitalism, the current capitalistic model is more centralised and specialised in the hand of minority elite corporate executives and public bureaucrats working for the favour of these corporate elites. The market has become less competitive and less free due to this phenomenon, and the market is becoming less liquid than it used to be. Under this circumstance, it reduces the liberal wage/income bargaining of majority individuals owing to this asymmetric power balance.

In the free competitive market, the demand and the supply are more likely to meet at the equilibrium point, and the error from this equilibrium point is corrected by converging the price and the quantity to the equilibrium point. By contrast, due to the asymmetric balance of power mentioned in the aforementioned paragraphs, it is now diverging from the equilibrium point as the market becomes less competitive and the freedom of entering market is suppressed.




This graph shows how monopsony (Buyer holds power over seller). The labour market of the current capitalist economy is in this situation where the labourers (Selling their labour in the market) hold less power over their wage bargaining power whilst the employers (Buying the labour resource in the market) hold excess power.

The demand for labour can be also described as the average revenue from employing labour, and the average labour supply can be the average cost for employers for employing labour. The equilibrium point (Demand meets supply) is where the average revenue becomes equal to the average cost in the labour market. Then, the wage is set at both employers and employees (labourers) agree at the market competitive level, and the labour is employed where involuntary unemployment is reduced.

On the other hand, the most desirable point for the employer is not the equilibrium point because it does not maximise their profit for their business. Their desiring point is the level of the labour employed where the marginal revenue of hiring labour meets the marginal cost of hiring labour. At this point, employers use their influential power over the market to set the wage (their cost) lower than the equilibrium point so that they can maximise their profit. Only the labourers who are still willing to participate by using their labour in the market can be employed.

This situation pretty much explains why some labourers work way too long hours with unsatisfactory wage whereas there are many citizens unhappy to be employed. These unemployed citizens tend to be blamed for not willing to keep applying for a job. But, this is fault of not only them but also the market situation not able to afford the wage motivating them to work. In addition, already employed citizens suffer from the income shortage for propping up their cultural standard of living and for compensating their exhaustion from working.

The depreciated wage level caused by monopsony in the labour market induces the stagnation of the aggregate demand which represses the market multiplier, and this leads to the economic downturn. The aggregate supply level also eventually falls because the revenue from providing the supply declines due to the falling demand. Therefore, this monopsony has to be discouraged not only for majority citizens being employed in the labour market but also the capitalist citizens employing labourers. Some of these capitalist citizens will also start suffering from declining their activities.




Imposing minimum wage may overcome this situation of monopsony by raising the wage standard to the market equilibrium point. This will reduce the involuntary unemployment as well as stimulate the market multiplier. Reduced involuntary unemployment reduces the cost for public spending. It also increases the income of already employed citizens and reduces their frustration, and then this reduces the risk of suffering from mental disease so this also reduces the public spending cost. It will increase the aggregate demand induced by increasing the income level of majority citizens.

The typical counter-argument against minimum wage is that it sets the wage higher than the equilibrium point so it decreases the labour demand. However, the fundamental problem of the current situation is that wage is set at the considerably low enough to increase unemployment and repress the market multiplier.

At the same time, employers cannot be blamed for this situation because of the following reason. The current market economy is based on the specialisation in the global level and it requires the huge economic scale of production, and the model based on the competition among traditional small-medium sized enterprises is already an old fashioned way not able to survive in this current economic model. Therefore, it is inevitable that more selected numbers of corporations with stable fiscal situation and abundant experience, productivity, and net working survive to thrive whereas traditional small-medium sized firms suffer from their staggering business performance.

Instead of cracking down against these major corporations to revive the good old competitive market based on traditional small-medium sized firms, simply imposing the minimum wage is easier and more productive. The government intervention of reducing the power of major corporations will be costly, and will slow down the economy by sacrificing all the wisdom and virtues of major corporations. Therefore, it would be better to allow the current capitalist economic model to grow while reforming it for some optimisation.

This policy will improve the corporate structure of already existing firms. Successful corporations with good managements have enough revenue to cover the cost for minimum wage as long as it is set at the market equilibrium balancing the happiness of employers and labourers. This is also an effective tool to expel ethically misbehaving corporations which usually suffer from bad management with unstable fiscal situation. Then, unnecessary exploitation will be prevented.

This policy will also encourage work sharing among citizens. In the current economy, there are citizens working for excessively long hours. When this policy is implemented, works will be shared among more individuals, and their work and life balance will be optimised. Furthermore, it will encourage to replace some tasks relying on cheap labour with newly invented technologies such as automation by artificial intelligence (AI). There are still many firms hesitate to introduce the new technology optimising their business performances because clinging to relying on their cheap labour is still economical in the short run. All in all, this will be an opportunity to accelerate the innovation.


Having considered about monopsony in labour market, imposing reasonably high minimum wage bring aforementioned benefits. It is still questionable whether it can be ideally adjusted to the equilibrium point or it exceeds more than the equilibrium point. Nevertheless, this policy still seems to be worth off to try to implement in order to tackle with reducing involuntary unemployment and stimulating the market multiplier with relatively lower cost than the other government intervention.