Blanchard's call for policymakers to set policy in such a way that linear models will still work should be seen for what it is–the desperate cry of an aging economist who discovers that the foundations upon which he has built his career are made of sand. He is far from alone…"It's not that bad", says Brad. And he goes on to use the analogy of heart attacks and the common cold to explain why linear models are ok really, mostly:
A more charitable reading of Olivier is that he wants to make this point:Well yes, true. So, when the economy catches a cold, by all means treat it with a hot toddy (plenty of whisky, please!). And if we all keep warm and dry, eat well and get plenty of sleep, we might not get so many colds anyway. This is indeed within the remit of policymakers: avoid obviously stupid or high-risk policies and try to keep the economy on a steady path. If policymakers do this, then clearly linear models will generally be adequate.
- Heart attacks have little in common with the common cold.
- You treat heart attacks with by shocking the heart to restart it.
- Heart attacks and the common cold are both diseases that debilitate.
- Nevertheless, to get out the defibrillator pads when the patient shows up with the sniffles will probably not end well.
The trouble is that in 2008 the economy did not catch a cold. No, it had a stroke. (Brad Delong's heart attack analogy is good, but I like the stroke better.) A stroke is sudden interruption of blood flow to part of the brain, causing tissue death and brain damage. If damage is not too extensive, the brain can rewire itself, creating new connections and activating new regions to take over functions previously done by the damaged areas. But such redirection of activity can take a long time, and during that time the patient may be unable to care for herself unaided, let alone work at previous output levels.
The authorities did not recognise the stroke for what it was. They thought it was simply a particularly nasty cold, so they put extra whisky in the hot toddies. When the patient developed pneumonia, they gave powerful antibiotics (TARP, TALF, QE....). And they carried on giving some of them long after the pneumonia had cleared up, because the patient was still obviously ill. But they failed to see the underlying problem.
Just as the patient was beginning to show signs of improvement, it experienced a second stroke. This one was not as catastrophic as the first, but it seriously set back the patient's recovery. Once again, the stroke was misdiagnosed, this time as a hospital-acquired infection. More antibiotics were given, and the hospital was placed in special measures. The staff had to deep clean the entire place, which redirected many of them away from patient care, leaving the patients to look after themselves. Unsurprisingly, several of the patients got worse, though so far none has died.
Now, seven years after the first stroke and three years after the second, the patient is still partly paralysed down the left side and has a speech impediment, which makes working difficult. As can be seen from this chart (h/t John Van Reenen), UK output is well below its previous level and shows no sign of returning to previous trend growth:
Nor is the UK the only economy to show such a pattern. Indeed it is now one of the better-performing Western economies: output in the Eurozone, for example, is much worse. So economists are scratching their heads and wondering why the patient is still in such a state. After all, the patient recovered well from previous nasty colds (1975, 1981, 1992) and there was no significant change in output trend growth. Surely the patient should be back to normal by now?
And herein lies my beef with Blanchard. Hot toddies and antibiotics are not the right treatment for strokes. Nor is deep cleaning of hospitals, important though this is. But the economics profession's toolkit seems to be limited to hot toddies, antibiotics and cleaning ladies. It can only treat nasty colds and hospital-acquired infections. It didn't even recognise the 2008 and 2012 strokes, let alone know how to treat them. And it justifies its limited diagnostic skills and inadequate toolkit by arguing that if only we keep warm and dry and eat well, we won't catch colds or suffer strokes anyway. But economists do not know why economies catch colds and have strokes. The argument that if we get policy settings right we will never be ill is an old wives' tale - or rather, an old economists' tale.
To be fair, the economics profession seems to be waking up to the idea that 2008 and its aftermath was no ordinary recession. Central banks and supranational institutions seem to be leading the way on recognising the monetary nature of the modern economy and the critical importance of accurate modelling of the financial system: Haldane at the Bank of England, Borio at the BIS and various researchers at the IMF have all explored non-linear modelling for the financial economy. Borio has called for financial cycles, which are longer than business cycles and seem to be increasing in amplitude, to be incorporated into economists' models. But the financial system is known to be in disequilibrium much of the time. I confess I find it difficult to see how a system that is normally far from equilibrium can be adequately represented by a general equilibrium model, but then I am not a mathematician. I am encouraged therefore to see that Borio seems to share my concerns (my emphasis):
Modelling the financial cycle raises major analytical challenges for prevailing paradigms. It calls for booms that do not just precede but generate subsequent busts, for the explicit treatment of disequilibrium debt and capital stock overhangs during the busts, and for a clear distinction between non-inflationary and sustainable output, ie, a richer notion of potential output – all features outside the mainstream. Moving in this direction requires capturing better the coordination failures that drive financial and business fluctuations. This suggests moving away from model-consistent expectations, thereby allowing for endemic uncertainty and disagreement over the workings of the economy. It suggests incorporating perceptions of risk and attitudes towards risk that vary systematically over the cycle, interacting tightly with the waxing and waning of financing constraints. Above all, it suggests capturing more deeply the monetary nature of our economies, ie, working with economies in which financial intermediaries do not just allocate real resources but generate purchasing power ex nihilo and in which these processes interact with loosely anchored perceptions of value, thereby generating instability. In turn, this in all probability means moving away from equilibrium settings and tackling disequilibrium explicitly.So, sorry Brad, but I do not think I am wrong to say that the economics profession's love affair with linear models must be ended. Multiple equilibria, disequilibrium and non-linearities are the new flame.
Having said that, Brad's last comment is spot on:
The key questions of macroeconomic political economy then are not the questions of the construction of nonlinear multiple-equilibrium models that Frances Coppola wants us to study. They are, instead, the questions of why ideological and rent-seeking capture were so complete that North Atlantic governments have not deployed their fiscal and credit policy tools properly since 2008.Indeed, if policymakers want to deny stroke patients essential treatment and force them back to work before they are properly recovered, there is not a great deal economists can do to stop them. Such is democracy.
I must say, I do like being described as femina spectabilis. And despite my criticisms, Olivier Blanchard deserves credit for acknowledging the hubris of the 1980-2008 economic paradigm, and for attempting to change it within his own organisation. Some of the IMF's economic research in recent years under his leadership has been outstanding. He is indeed a vir illustris.
When the Nile floods fail