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Where Danger Lurks

Author(s): Olivier Blanchard

Olivier Blanchard explains how the Great Moderation had created a sense of complacency among macro economists ho had started to beleive that non-linearities , ie small schocks that could cause large adverse effects, were a thing of the past. He then goes on to suggest how benchmark models such as the DSGE need to be adjust to provide warnings for when an economy is close to "dark corners" where the economy malfunctions badly .

From the IMF:

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.

The benign view reflected both factors internal to economics and an external economic environment that for years seemed indeed increasingly benign.

Start with internal factors. The techniques we use affect our thinking in deep and not always conscious ways. This was very much the case in macroeconomics in the decades preceding the crisis. The techniques were best suited to a worldview in which economic fluctuations occurred but were regular, and essentially self correcting. The problem is that we came to believe that this was indeed the way the world worked.

To understand how that view emerged, one has to go back to the so-called rational expectations revolution of the 1970s. The core idea—that the behavior of people and firms depends not only on current economic conditions but on what they expect will happen in the future—was not new. What was new was the development of techniques to solve models under the assumption that people and firms did the best they could in assessing the future. (A glimpse into why this was technically hard: current decisions by people and firms depend on their whole expected future. But their whole expected future itself depends in part on current decisions.)

These techniques however made sense only under a vision in which economic fluctuations were regular enough so that, by looking at the past, people and firms (and the econometricians who apply statistics to economics) could understand their nature and form expectations of the future, and simple enough so that small shocks had small effects and a shock twice as big as another had twice the effect on economic activity. The reason for this assumption, called linearity, was technical: models with nonlinearities—those in which a small shock, such as a decrease in housing prices, can sometimes have large effects, or in which the effect of a shock depends on the rest of the economic environment—were difficult, if not impossible, to solve under rational expectations.

Thinking about macroeconomics was largely shaped by those assumptions. We in the field did think of the economy as roughly linear, constantly subject to different shocks, constantly fluctuating, but naturally returning to its steady state over time. Instead of talking about fluctuations, we increasingly used the term “business cycle.” Even when we later developed techniques to deal with nonlinearities, this generally benign view of fluctuations remained dominant.

This state of affairs, however, would not have developed (or at least not lasted for so long) without external factors playing a role. The state of the world, at least the economic world, provided little impetus for macroeconomists to question their worldview.

From the early 1980s on, most advanced economies experienced what has been dubbed the “Great Moderation,” a steady decrease in the variability of output and its major components—such as consumption and investment. There were, and are still, disagreements about what caused this moderation. Central banks would like to take the credit for it, and it is indeed likely that some of the decline was due to better monetary policy, which resulted in lower and less variable inflation. Others have argued that luck, unusually small shocks hitting the economy, explained much of the decrease. Whatever caused the Great Moderation, for a quarter century the benign, linear view of fluctuations looked fine. (This was the mainstream view. Some researchers did not accept that premise. The late Frank Hahn, a well-known economist who taught at Cambridge University, kept reminding me of his detestation of linear models, including mine, which he called “Mickey Mouse” models.)

Dark corners

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.

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