Olivier Blanchard, who in August of 2008 describe it as “good,” has modified his views. Concerning the consensus methodology that he praised back then, Blanchard writes,

However, these techniques only made sense 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.

Pointers from Mark Thoma and Greg Mankiw. Read the whole thing. I have to give Blanchard credit for writing this:

The reality of financial regulation is that new rules open new avenues for regulatory arbitrage, as institutions find loopholes in regulations. That in turn forces authorities to institute new regulations in an ongoing cat-and-mouse game (between a very adroit mouse and a less nimble cat). Staying away from dark corners will require continuous effort, not one-shot regulation.

That is the theme of The Chess Game of Financial Regulation.

However, my overall take on Blanchard’s essay will be harsh.*

1. He still wants to believe in equations and technical brilliance. He implies that if we were just better at manipulating nonlinear models, all would be well. Once again, an MIT economist is unable to grasp Hayek’s insight that there is knowledge embedded in the economic order that no individual can possess. No thanks to MIT, and long after I had left it, I wound up on the side of Hayek. In fact, when it comes to macro I would argue that I am more Hayekian than Hayek.

2. Rational expectations helped make the careers of Fischer, Blanchard, and other MIT contemporaries, and refusal to tool up in rational-expectations modeling is what un-made my own academic career. In hindsight, and with an assist from Frydman and Goldberg, I would say that rational expectations was the ultimate anti-Hayek proposition. In effect, Chicago said that everyone knows everything. Eventually, MIT countered with “behavioral economics,” which said that some people are often mistaken while assuming at least implicitly that the technocratic elites know everything.

3. My least favorite paragraph:

Now that we are more aware of nonlinearities and the dangers they pose, we should explore them further theoretically and empirically – and in all sorts of models. This is happening already, and to judge from the flow of working papers since the beginning of the crisis, it is happening on a large scale. Finance and macroeconomics in particular are becoming much better integrated, which is very good news.

I’ll be uncharitable (and sarcastic) and say that he is telling us once again that the state of macro is good, because the same modeling hubris still predominates. The way I see it, the drunks are still looking under the same lamppost.

As for integrating finance and macroeconoimcs, my prediction is that this will accomplish nothing. I believe that mainstream macroeconomists are over-stating the importance of the financial crisis. Instead, I am inclined to treat the financial crisis as a blip, one whose apparent macroeconomic impact was made somewhat worse by the very policies that mainstream economists claim were successful.

This blip took place in the context of key multi-decade trends:

–the transition away from goods-producing sectors and toward the New Commanding Heights of education and health care

–the transition of successful men away from marrying housekeepers and toward marrying successful women

–the integration of workers in other nations, most notably China and India, into the U.S. production system

–the increasing power of computer technology that ise more complementary to some workers than others

These trends are what explain the patterns of employment and relative wages that we observe. The financial crisis, and the government panic in response, pushed the impact of some of these developments forward in time. Overall, however, the focal points of mainstream macroeconomics, including fiscal and monetary measures, are not nearly as significant to the actual economy as they are on paper in the models.

I have always been harsh on Blanchard. You should discount for that.