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Sunday, August 31, 2014

'Where Danger Lurks'

Olivier Blanchard (a much shortened version of his arguments, the entire piece is worth reading):

Where Danger Lurks: Until the 2008 global financial crisis, mainstream U.S. macroeconomics had taken an increasingly benign view of economic fluctuations in output and employment. The crisis has made it clear that this view was wrong and that there is a need for a deep reassessment. ...
That small shocks could sometimes have large effects and, as a result, that things could turn really bad, was not completely ignored by economists. But such an outcome was thought to be a thing of the past that would not happen again, or at least not in advanced economies thanks to their sound economic policies. ... We all knew that there were “dark corners”—situations in which the economy could badly malfunction. But we thought we were far away from those corners, and could for the most part ignore them. ...
The main lesson of the crisis is that we were much closer to those dark corners than we thought—and the corners were even darker than we had thought too. ...
How should we modify our benchmark models—the so-called dynamic stochastic general equilibrium (DSGE) models...? The easy and uncontroversial part of the answer is that the DSGE models should be expanded to better recognize the role of the financial system—and this is happening. But should these models be able to describe how the economy behaves in the dark corners?
Let me offer a pragmatic answer. If macroeconomic policy and financial regulation are set in such a way as to maintain a healthy distance from dark corners, then our models that portray normal times may still be largely appropriate. Another class of economic models, aimed at measuring systemic risk, can be used to give warning signals that we are getting too close to dark corners, and that steps must be taken to reduce risk and increase distance. Trying to create a model that integrates normal times and systemic risks may be beyond the profession’s conceptual and technical reach at this stage.
The crisis has been immensely painful. But one of its silver linings has been to jolt macroeconomics and macroeconomic policy. The main policy lesson is a simple one: Stay away from dark corners.

That may be the best we can do for now (have separate models for normal times and "dark corners"), but an integrated model would be preferable. An integrated model would, for example, be better for conducting "policy and financial regulation ... to maintain a healthy distance from dark corners," and our aspirations ought to include models that can explain both normal and abnormal times. That may mean moving beyond the DSGE class of models, or perhaps the technical reach of DSGE models can be extended to incorporate the kinds of problems that can lead to Great Recessions, but we shouldn't be satisfied with models of normal times that cannot explain and anticipate major economic problems.

    Posted by on Sunday, August 31, 2014 at 08:24 AM in Economics, Macroeconomics, Methodology | Permalink  Comments (8)



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