Dragons in Dark Corners

 
In the early days of cartography (circa 1500) the problem of depicting the unknown on maps was addressed by leaving the space blank, except for the warning “hic sunt dracones” (here be dragons).
 
Olivier Blanchard, the International Monetary Fund’s (IMF) Economic Counsellor and Director of Research, has come up with the contemporary economic equivalent in the IMF’s quarterly publication, with an article entitled “Where Danger Lurks.”
 
The risks are in what he calls the “dark corners”.
 
It’s an important and distinctly scary account of why he believes the global financial crisiscaught most macroeconomists by surprise with its arrival, magnitude and duration.
 
Blanchard argues that the macroeconomists – those operating in the critical areas of monetary and fiscal policy formulation – had developed economic models based on benign but erroneous assumptions about the role of fluctuations in output and employment.
 
The techniques incorporated in these models were best suited to a worldview in which economic fluctuations occurred but were regular and essentially self-correcting. The expression ‘business cycle’ with its implied predictability displaced ‘fluctuations’.
Blanchard writes, “The problem is that we came to believe that this was indeed the way the world worked.
 
“These techniques (incorporated in the models), 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.”

Great Moderation

One reason why this benign attitude towards fluctuations took root as the mainstream view of macroeconomists was the persistence from the mid-eighties of what came to be called the ‘Great Moderation’. This era that ran for around 25 years was characterised by a steady decrease in the variability of output and its major components – consumption and investment.
 
Inflation and unemployment remained subdued.
 
There were some who doubted the claimed relationship between moderation and the role of macroeconomists.
 
Blanchard mentions the late Frank Hahn, a well-known economist who taught at Cambridge “who kept reminding me of his detestation of linear models, including mine, which he called
“Mickey Mouse” models.”
 
Another reason for this misplaced complacency was what Blanchard calls the sometimes “provincial character of mainstream macroeconomics in the US”.
 
“In a number of doctoral programs” he wrote, “a student can specialize in macroeconomics without knowing what an exchange rate is, much less an emerging market economy.”
 
Then there are the ‘dark corners’, “in short, the notion that small shocks could have large adverse effects or could result in long and persistent slumps, was not perceived as a
major issue.”
 
According to Blanchard, “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.”
 
Japan, which was mired in deflation and an extended slump, offered a counter factual lesson. “But, its situation was largely dismissed as being the result of misguided policies rather than
being a harder-to-solve problem.”

Blindsided by the crisis

Blanchard says the main lesson of the crisis is, “we were much closer to those dark corners than we thought – and the corners were even darker than we had thought too.”
 
According to him, the Great Moderation had blind-sided not only macroeconomists. Financial institutions and regulators also underestimated risks. The result was a global financial system that was increasingly exposed to potential shocks.
 
In other words, the global economy operated closer and closer to the dark corners without economists, policymakers, and financial institutions realising it.
 
When the US housing boom turned to bust the complex and opaque system which had flourished in the era of moderation and deregulation, led to high anxiety as to institutional liquidity and solvency.
 
A succession of crises saw central banks adopt unorthodox and large scale operations to liquefy their financial institutions.
 
“So-called diabolical loops developed between public and private debt: weak government weakened banks that held government bonds in their portfolios; weakened banks needed more capital, which often had to come from public funds, weakening governments.”

Where does this take us?

According to Blanchard the crisis has one obvious policy implication, “authorities should make it one of the major objectives of policy – macroeconomic, financial regulatory, or macroprudential – to stay further away from the dark corners.”
 
He says we are still too close to them. “The crisis itself led to large accumulations of debt, both public and private.” Households remain overextended in a number of developed economies.
 
“For the time being the diabolical loops have receded, but it would not take much of an adverse shock for them to reappear.
 
“For a long time to come, one of the priorities of macroeconomic policy will be to slowly but steadily return debt to less dangerous levels, to move away from those dark corners.”
 
We have a long way to go before the global economy can be said to have returned to normal.

A currency war in Australia

Looking briefly at the Australian scene it is obvious that housing debt is rising at an unsustainable pace. Conventional monetary tightening has been rejected by the Reserve Bank because higher interest rates would simply attract more footloose capital and further push up the exchange rate.
 
Australia must be one of the few economies running a clean float of its currency.
 
However, we could well get dragged into what is looking increasingly like a currency war.

QE3 winds up

Another much larger area of potential disruption and crisis is the winding up of the US monetary stimulus program QE3.
 
It can be said that the Federal Reserve ‘succeeded’ in its strategy of driving up the price of financial assets.
 
However, the artificial stimulus that has sent equities to record highs has not yet stirred the animal spirits of ‘Main Street’.
 
A sharp correction in US equity markets could be a particularly nasty corner event.

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Max Walsh

Contributor

Max Walsh was for many years one of Australia’s top economic and political commentators, highly regarded as a journalist, author and broadcaster. Throughout his career, Max was involved in all dimensions of the media industry, which has encompassed positions with two of Australia’s largest publishing companies and television networks.

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