The Blanchard Danger

by Roger Koppl

Oliver Blanchard tells us “Where Danger Lurks”  in the macro-finance world.

The big theme is nonlinearity, which is a profoundly conservative move: DSGE modeling is just fine and we don’t need to rethink it at all. We just need to add in some nonlinearities. Blanchard does not tell how to calibrate a model with extreme sensitivity to initial conditions. But if the system is chaotic, it is also unpredictable, so how can you pretend to merely add nonlinearities to DSGE models?  It seems like a pretty direct contradiction to me. I mean, you can have the model in a trivial sense, of course. But calibration is an empty exercise that will not let you look around corners.

Blanchard’s second main message is alarming: We do need theoretical innovation, however, in measuring systemic risk. In the modern network literature on financial markets and cascades, one key point is risk externality. My portfolio choice makes your portfolio riskier. We need two things to fix this market failure. First, we need Pigou taxes, which cannot be calculated unless everyone tells the regulator his portfolio so that it can measure systemic risk and calculate a separate Pigou tax for each financial institution. Second, we need to reduce systemic risk. (“[S]teps must be taken to reduce risk and increase distance” from the “dark corners” of the macro-finance system.) In the network literature I suspect Blanchard is alluding to, this is to be done (at least in some of the articles) by having the regulator directly control the portfolios of financial institutions. (Names include: Acharya 2009; Beale et al. 2011; Caccioli et al. 2011; Gai, Haldane,and Kapadia 2011; Haldane and May 2011; and Yellen 2009, 2011)

I take a rather different view of both economic theory and the crisis in my recent IEA Hobart paper From Crisis to Confidence: Macroeconomics after the Crash.

Overall, Blanchard’s message is meant to be reassuring: We the smart macro-finance experts have now got the message on nonlinearities. So no further need to worry, we’ve got the situation in hand. To keep the system out of the “dark corners,” however, we will need more discretionary authority. You don’t mind trading off a bit of financial freedom for greater financial safety do you?

5 thoughts on “The Blanchard Danger

  1. One very simple test to distinguish between the effects of animal spirits and policy uncertainty is to observe the pronouncements and forecasts of policymakers at extremes in asset prices and to relate these to those of financial practitioners, academic economists, and entrepreneurs. Policymakers presumably – even under the most hardcore public choice view of the world – generally believe that their policy is the right one for the circumstances.

    If the policy uncertainty view is the more important explanation of things,, it would imply a relative optimism amongst policymakers, perhaps too amongst academics, and a depressed view of things amongst entrepreneurs and financial practitioners.

    Beyond looking at patterns of dispersion in forecasts, one may arrive at a tolerable gauge of the affect of a group by applying machine learning techniques to the set of writings generated by this group.

    If on the other hand, it is affect that is more important during an episode then one should see complacency and optimism amongst all participants at the peak, and despondency and gloom, at the bottom and for some period afterwards.and one would not expect this pattern of dispersion.

    I note that the relative importance of affect versus policy uncertainty need not have direct implications for how activist policy should be. Indeed should it be the case that animal spirits dominate then it constitutes an important reason not to be activist since it means that policy makers suffer from the same perceptual warping experienced by private agents.

    My own view, for what it is worth, is that negative affect drives policy uncertainty. The mass emotional response to a downturn is to make sure it doesn’t happen again and to lash out and punish those perceived to be responsible, or any convenient scapegoat failing that. So affect is primary, but policy uncertainty may prolong the downturn.

    An implication of this view (for which I do not claim originality) is to expect de facto policy rules loosened as a boom progresses, and tightened after a downturn. Ceteris paribus – there are other factors at play.


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