Tag: Olivier Blanchard

There Is an Old Joke About Economists, Keys, and Lampposts That Comes to Mind Here…

Posted on by Brad DeLong
Cursor and Lamppost 2 jpg

This is an interesting, if an Aesopian, article by Olivier Blanchard…

He says that we need five kinds of macroeconomic models. He then gives examples of the five kinds. The examples of four of the kinds track—foundational, policy, toy, and forecasting—and we do indeed need those four kinds.

Then we come to the fifth kind, which Blanchard introduces by saying that we need:

DSGE models. The purpose of these models is to explore the macro implications of distortions or set of distortions. To allow for a productive discussion, they must be built around a largely agreed upon common core, with each model then exploring additional distortions…

But two paragraphs down he writes, of all existing DSGE models:

The current core, roughly an RBC (real business cycle) structure with one main distortion, nominal rigidities, seems too much at odds with reality… the Euler equation for consumers and the pricing equation for price-setters…

What is he saying? That all existing DSGE models are worthless. We should throw them away, and start over with respect to building this fifth kind of model. We can call it “DSGE”, but it will not be what has—hitherto at least—been “DSGE”. In his view, it will have to have “nominal rigidities, bounded rationality and limited horizons, incomplete markets and the role of debt”—i.e., real rather than fake microfoundations.

The problem, of course, is that we cannot (yet) set out such a model in a sufficiently tractable form. Thus I think that one inescapable conclusion that we need to draw from Blanchard is that, for now, we need to keep using our four useful kinds of models—foundational, policy, toy, and forecasting. And I think a second inescapable conclusion we need to draw is that we should stop doing DSGE models which involve looking under the lamppost for the key where it is not. We need, rather, to disassemble the lamppost. And then some of us can use its pieces to try to build another lamppost, but this time locate it in a less silly and useless place.

Olivier Blanchard: On the Need for (At Least) Five Classes of Macro Models https://piie.com/blogs/realtime-economic-issues-watch/need-least-five-classes-macro-models: “We need different… five types…

…[of] general equilibrium models….

  1. Foundational models… the consumption-loan model of Paul Samuelson, the overlapping generations model of Peter Diamond…

  2. DSGE models… to explore the macro implications of distortions or set of distortions… built around a largely agreed upon common core, with each model then exploring additional distortions…. The current core, roughly an RBC… seems too much at odds with reality to be the best starting point…. How close [should] these models… be to reality[?]… They should obviously aim to be close, but not through ad-hoc additions and repairs, such as arbitrary and undocumented higher-order costs introduced only to deliver more realistic lag structures…

  3. Policy models. (Simon Wren-Lewis prefers to call them structural econometric models.)… For this class of models, the rules of the game must be different than for DSGEs. Does the model fit well, for example, in the sense of being consistent with the dynamics of a VAR characterization? Does it capture well the effects of past policies? Does it allow one to think about alternative policies?

  4. Toy models… IS-LM… Mundell-Fleming… RBC… New Keynesian model…. [To] allow for a quick first pass at some question, or present the essence of the answer from a more complicated model or class of models….

  5. Forecasting models. The purpose of these models is straightforward: Give the best forecasts…

All models should be built on solid partial equilibrium foundations and empirical evidence.

Monday DeLong Smackdown: Olivier Blanchard on How the Eurozone Can Be Strengthened After Brexit

Posted on by Brad DeLong

A high-quality DeLong smackdown! Keep ’em coming, please…

Olivier Blanchard: How the Eurozone Can Be Strengthened After Brexit: “Brexit raises fundamental questions…. Meanwhile, Europe must continue to function…

…In this context that a large number of prominent economists from different European countries, ranging from those who desire more political integration to those who are more skeptical, have written what they see as the essential next steps to reinforce the architecture of the eurozone…. The purpose of the project, which started long before Brexit, was twofold. First, assess the nature of the challenges and the progress to date…. Second, assess the degree of agreement among ‘experts’ about the remaining challenges and solutions. If you look at the diversity of people on the list, the answer to the second question is that, in contrast to the often strident disagreements in the press, there is, indeed, surprisingly large agreement among experts….

The basic architecture is largely in place. Some strengthening is needed but does not require dramatic political steps. The most important set of measures to take is a strengthening of the European Stability Mechanism (ESM)…. The banking union is largely in place, and with it better tools to monitor and reduce financial risks…. More progress can be made without requiring much more political integration…. [In] public finances… fiscal rules have become too many, too messy, with too many loopholes…. In many countries, the issue is not so much deficits than the high level of expenditure, which in turn makes it difficult to balance budgets without resorting to excessive taxation…. Even under the best fiscal rules, current levels of debt together with low growth imply that sovereign debt default is not impossible. Defining responsibilities and the process for sovereign default is essential. This should and can be the role of the ESM…. States have to be willing to give up some control. Otherwise the ESM will not be able to do its job…. We have learned… that liquidity runs can… be very destructive. The European Central Bank (ECB) now has the tools to provide liquidity to banks…. It would be good if it could do the same to states….

Many would like to see more ambitious steps taken, from a common fiscal policy, to euro bonds, to euro-level deposit insurance, etc. And indeed, the line taken by some US commentators today (e.g., Bradford DeLong and Paul Krugman is that this is what our manifesto should have asked for…. Our goal was less ambitious and more realistic. It was to see if the eurozone could function and handle shocks without further political integration if political realities made it impossible for the time being. Our answer is a qualified yes, but it is surely not an endorsement of a do-nothing strategy.

Must-Read: Olivier Blanchard: How to Teach Intermediate Macroeconomics after the Crisis?

Posted on by Brad DeLong

Must-Read: Am I allowed to say that nearly all of this is in Paul Krugman’s 1998 The Return of Depression Economics?

Olivier Blanchard: How to Teach Intermediate Macroeconomics after the Crisis?: “The IS relation remains the key to understanding short-run movements in output…

…In the short run, the demand for goods determines the level of output. A desire by people to save more leads to a decrease in demand and, in turn, a decrease in output. Except in exceptional circumstances, the same is true of fiscal consolidation. I was struck by how many times during the crisis I had to explain the ‘paradox of saving’ and fight the Hoover-German line, ‘Reduce your budget deficit, keep your house in order, and don’t worry, the economy will be in good shape.’ Anybody who argues along these lines must explain how it is consistent with the IS relation. The demand for goods, in turn, depends on the rate at which people and firms can borrow (not the policy rate set by the central bank, more on this below) and on expectations… animal spirits… largely self-fulfilling. Worries about future prospects feed back to decisions today….

The LM relation… is the relic of a time when central banks focused on the money supply…. The LM equation must be replaced, quite simply, by the choice of the policy rate by the central bank, subject to the zero lower bound. How the central bank achieves it… can stay in the background…. Traditionally, the financial system was given short shrift in undergraduate macro texts. The same interest rate appeared in the IS and LM equations…. This is not the case and that things go very wrong. The teaching solution, in my view, is to… discuss how the financial system determines the spread between the two….

Turning to the supply side, the contraption known as the aggregate demand–aggregate supply model should be eliminated…. One simply uses a Phillips Curve…. Output above potential, or unemployment below the natural rate, puts upward pressure on inflation. The nature of the pressure depends on the formation of expectations…. If people expect inflation to be the same as in the recent past, pressure takes the form of an increase in the inflation rate. If people expect inflation to be roughly constant… pressure takes the form of higher—rather than increasing—inflation. What happens to the economy, whether it returns to its historical trend, then depends on how the central bank adjusts the policy rate in response to this inflation pressure…. This… is already standard in more advanced presentations and the new Keynesian model (although the Calvo specification used in that model, as elegant as it is, is arbitrarily constraining and does not do justice to the facts). It is time to integrate it into the undergraduate model…. These modified IS, LM, and PC relations can do a good job….

I consider two extensions… expectations… openness. Here, also, there are important lessons from the crisis…. The long interest rate… as the average of future expected short rates, with a fixed term premium. Quantitative easing… can affect this premium…. Deriv[ing]… exchange rates from the uncovered interest rate parity condition… assumes infinitely elastic capital flows. The crisis has shown… capital flows have finite elasticity and are subject to large shocks beyond movements in domestic and foreign interest rates. Periods of ‘risk on-risk off’ and large movements in capital flows have been an essential characteristic of the crisis and its aftermath…

Must-Read: Olivier Blanchard: Rethinking Macro Policy: Progress or Confusion?: Fiscal Policy

Posted on by Brad DeLong

Must-Read: On this one–views of fiscal policy–put me down not for progress but for “confusion for $2000”, Alex, for on this one I think the very sharp Olivier Blanchard has got it wrong.

Graph 10 Year Treasury Constant Maturity Rate FRED St Louis Fed

The world cannot simultaneously be short of safe assets and yet there also be a correct “large consensus that [government debt] is too large today.” That just does not compute. You can say that the IMF and the exorbitant privilege-possessing reserve-currency issuers are not properly backstopping other governments (quite possibly because other governments are unwilling to allow the conditionality that would make such backstopping prudent). You can say that some countries have too much debt and other countries have too little. But you cannot say that government debt in general is too high when markets are screaming as loud as they can that the liabilities of exorbitant privilege-possessing reserve-currency issuers are the scarcest and most valuable things in the world:

Olivier Blanchard: Rethinking Macro Policy: Progress or Confusion?: Fiscal Policy: “Let me move to a brief discussion of the third pillar, fiscal policy…

…We have learned many things. Fiscal stimulus can help. Public debt can increase very quickly when the economy tanks, but even more so when contingent—explicit or implicit—liabilities become actual liabilities. The effects of fiscal consolidation have led to a flurry of research on multipliers, on whether and when the direct effects of fiscal consolidation can be partly offset by confidence effects, through decreasing worries about debt sustainability. (There has been surprisingly little work or action where I was hoping to see it, namely, on a better design of automatic stabilizers.)… Navigation by sight may be fine for the time being. The issue of what debt ratio to aim for in the long run is not of the essence when there is a large consensus that it is too large today and the adjustment will be slow in any case—although even here, Brad DeLong has provocatively argued that current debt ratios are perhaps too low….

There is no magic debt-to-GDP number. Depending on the distribution of future growth rates and interest rates, on the extent of implicit and explicit contingent liabilities, one country’s high debt may well be sustainable, while another’s low debt may not. Conceptually and analytically, the right tool is a stochastic debt sustainability analysis (something we already use at the IMF when designing programs). The task of translating this into simple, understandable goals remains to be done…

Must-read: Olivier Blanchard: “Rethinking Macro Policy”

Posted on by Brad DeLong

Must-Read: It is now six years since Olivier Blanchard called for “outlining the contours of a new macroeconomic policy framework”. Yet what is that framework? Where is it? Who outlines it? And what processes will give it political traction?

Olivier Blanchard et al. (2010): Rethinking Macro Policy: “The global crisis forced economic policymakers…

…to react in ways not anticipated by the pre-crisis consensus…. Here the IMF’s chief economist and colleagues (i) review the main elements of the pre-crisis consensus, (ii) identify the elements which turned out to be wrong, and (iii) take a tentative first pass at outlining the contours of a new macroeconomic policy framework.

Must-read: Olivier Blanchard: The US Phillips Curve: Back to the 60s?

Posted on by Brad DeLong

Must-Read: Olivier Blanchard says that he and Paul Krugman differ not at all on the analytics but, rather, substantially on “tone”…

It looks as though the center of the Federal Reserve is working today as if the slope of the Phillips-Curve relationship is still what it was in the years around 1980, and that the gearing of expected inflation to recent-past inflation is still what it was in the years around 1980.

Why this is so is a mystery.

Olivier Blanchard: The US Phillips Curve: Back to the 60s?: “The US Phillips curve is alive…

…(I wish I could say “alive and well,” but it would be an overstatement: the relation has never been very tight.) Inflation expectations, however, have become steadily more anchored, leading to a relation between the unemployment rate and the level… rather than the change in in inflation… [that] resembles more the Phillips curve of the 1960s than the accelerationist Phillips curve of the later period. The slope of the Phillips curve… has substantially declined…. The standard error of the residual… is large…. Each of the last three conclusions presents challenges for the conduct of monetary policy…

Www piie com publications pb pb16 1 pdf Www piie com publications pb pb16 1 pdf Www piie com publications pb pb16 1 pdf

Must-read: Olivier Blanchard et al.: “Reality Check for the Global Economy”

Posted on by Brad DeLong

Olivier Blanchard et al.: Reality Check for the Global Economy: “After five years of disappointing recovery throughout the major economies…

…almost everyone is ready to believe the worst. The widespread large declines in global asset prices indicate a significant divergence between what financial markets fear and what most mainstream macroeconomic forecasts are showing for the world economy. Having some clarity to distinguish between the more solid underlying economic outlook and the shadows thrown by financial puppetry is critical to avoid an unnecessary recession.

In this Briefing, a group of PIIE scholars came together to provide a reality check for the global economy. They set out what is known, both about macroeconomic dynamics and policy capabilities, in a context where distrust of both mainstream economic analysis and policymakers’ credibility has become excessive. Global economic fundamentals today are not so grim, though there is room for improvement in key areas including China, the United States, European banks, Brazil and Latin America, oil markets, global trade, and monetary policy options.

In particular, we argue: The relative forecasting ability of financial markets for the real economy has probably gone down postcrisis (Adam S. Posen). The US economy remains at a relatively low, though slightly elevated, risk of recession (David Stockton). The positive effects of the decline in the price of oil on the US economy have taken longer to materialize than was expected, but they will strengthen looking forward (Olivier Blanchard and Julien Acalin). Chinese economic growth is, at a minimum, well above current fear-driven estimates, and that growth is predominantly service sector–based and therefore sustainable (Nicholas Lardy). The slowdown in growth of global trade reflects weak global investment and a medium-term adjustment to the past creation of global supply chains and is not a harbinger of further contraction (Caroline Freund). The European banking system is in transition to a stronger state, and the problems evident in Italy are not enough to throw Europe’s economy off course (Nicolas Véron). Brazil’s economy while dysfunctional is far more likely to experience years of higher inflation than any overt fiscal or balance of payments crisis (Monica de Bolle). Latin America more generally has run into problems of slow productivity growth but is not doomed by the commodity cycle (José De Gregorio). Monetary policy remains potent, with multiple possible avenues for additional stimulus if needed, starting with effective quantitative easing on private assets (Joseph Gagnon).

Must-read: Olivier Blanchard and Joseph E. Gagnon: “Are US Stocks Overvalued?”

Posted on by Brad DeLong

Must-Read: I think that this is completely right: expected returns on U.S. stocks right now are lower than average, but the gap between expected returns on stocks and on other assets is significantly higher than average:

Olivier Blanchard and Joseph E. Gagnon: Are US Stocks Overvalued?: “Are stocks obviously overvalued?…

…The answer is no, and the reason is straightforward…. What matters for the valuation of stocks is the relation between future growth and future interest rates. Put another way, the equity premium… has if anything increased relative to where it was before the crisis…. The Shiller P/E ratio reached 26 late last year and is currently around 24, compared with a 60-year average of 20. This elevated Shiller P/E measure is commonly cited as an indicator that stocks may be overpriced, including by Shiller himself….

The deviations of the P/E from its historical average are in fact quite modest. But suppose that we see them as significant, that we believe they indicate the expected return on stocks is unusually low relative to history. Is it low with respect to the expected return on other assets?… [But] in all six cases, the equity premium is higher in 2015 than in 2005. Put another way, stock prices were more undervalued in 2015 than they were in 2005….

If you accept current forecasts, and you accept the notion that stocks were not overvalued in the mid-2000s, then you have to conclude that stocks are not overvalued today. If anything, the evidence from 150 years of data is that the equity premium tends to be high after a financial crisis, and then to slowly decline over the following decades, presumably as memories of the crisis gradually dissipate. If this is the case, then stocks look quite attractive for the long run…

Must-read: Olivier Blanchard et al.: “Inflation and Activity–Two Explorations and their Monetary Policy Implications”

Posted on by Brad DeLong

Must-Read: Olivier Blanchard, Eugenio Cerutti, and Lawrence Summers: Inflation and Activity–Two Explorations and their Monetary Policy Implications: “Since the mid-1970s, short-run inflation expectations have become more stable…

…(λ has increased), and… the slope of the Phillips curve (θ) has flattened over time, with nearly all of the decline taking place from the mid-1970s to the early 1990s…. For most countries, the coefficient θ today is not only small, but also statistically insignificant…

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