Where Danger Lurks: The Dark Recesses of the Orthodox Mind

By L. Randall Wray

Ah, the Eternal Sunshine of the Recessed Mind!

Here’s an unintentionally–but riotously–hilarious mea culpa by Olivier Blanchard.

Here’s the CliffsNotes version: Yes, we didn’t see nothing coming. But that isn’t our fault. The Global Financial Crisis—the biggest calamity since 1929—was invisible to us because it had been lurking in the dark corners of the financial system.

However, we had been creating highly sophisticated economic models in which there were no financial institutions—at least nothing like those in the real world. Ours were transparent. They were well-capitalized. Their risks were perfectly hedged. There was no uncertainty. There was no chance of financial instability because the market forces always—inevitably—drove toward equilibrium. We had very nicely behaved DSGE models—models with no default risk. Where everyone was civilized and played nice. No one ever missed a payment. All debts were always paid. On time.

In our world, even Lake Woebegone would have been impossibly unruly.

In the world that Blanchard and other mainstreamers modeled, “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.”

Blanchard goes on: Our 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.”

In other words, like the drunks who look for their keys under the street lights, Blanchard preferred to model impossible worlds because the math was easier. The world—obviously—is not linear, but the math skills of economists were not sufficient to model real, nonlinear worlds.

Blanchard admits he was warned: “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.”

Yep, the mainstream used Mickey Mouse models to reach the conclusion that we’d entered the Era of the Great Moderation—where nothing can possibly go wrong because we’ve got Uncle Ben at the Fed and the Invisible Hand of the Market to protect us.

The dark cornered cobwebs of their minds made it impossible for the mainstream to see the instability building—on trend since 1966! They failed to notice the crises of the early 1970s (commercial paper, Franklin National), the crises of the early 1980s (Developing country debt, commercial real estate), the crises of the mid 1980s (S&Ls, REITs, LBOs) or the late 1980s (all of the biggest US banks) or the 1990s (developing countries—again, LTCM, Dot-com). They missed the residential real estate bubble that was obvious by 2000. And they never understood that the set-up of the EMU guaranteed a Euro area crisis.

Nope, those dark recesses of their minds made it impossible to see anything coming.

Yet, according to Blanchard, they’ve learned from their mistakes. We should listen to them now.

Me thinks not. The one concrete proposal Blanchard lists in his piece is by none-other than the completely clueless Ken Rogoff. Yes, that Ken Rogoff! The guy who cannot even define a Credit Default Swap after it slapped him across the face. Who cannot tell the difference between sovereign government debt and private sector debt. Who fudges the data to claim there are magical debt thresholds that cannot be breached—even if you are a sovereign with the magic porridge pot.

Oh, if we had only had higher interest rates before the crisis, the Fed could have lowered them more in the crisis and then we would have stimulated sufficient growth to achieve lift-off. Or, if we could only get rates below zero—but that is hard if people can hold currency that pays zero. So how-o-how can we get rates below zero? Well, one way is to cause inflation—which central banks the world over have been trying to do without success.

Is there an alternative? Here’s Rogoff’s proposal, cited by Blanchard:

“Harvard Professor Kenneth S. Rogoff, former head of the IMF’s Research Department, has suggested solutions other than higher inflation, such as the replacement of cash with electronic money, which could pay negative nominal interest. That would remove the zero bound constraint.”

Uhhm. Can someone please slap Rogoff and explain to him that lowering interest rates is not a solution to a problem of low rates and deflationary pressures? Rates are already so low on treasuries that low net interest paid by government to savers is depressing demand. What, he wants to push that below zero so that American savers have to pay government? And that is supposed to stimulate the economy?

Clueless as usual.

Electronic money? Really? What world does he live in? Like George Bush, Sr, has he never been to a grocery store? Is he yet to discover zebra codes and credit cards?

Money is 99.9% electronic already. And much of it already has negative returns. Called fees.

No one other than a drug dealer holds green paper note cash. You find a way to tax Federal Reserve Notes with negative interest, and you drive the drug dealers into 500 euro notes. Maybe that is a good policy but it won’t stimulate recovery. And it won’t prevent the next crisis.

Here’s a better idea. Ignore those who never saw that last crisis coming. You can be sure that they’ll miss the next one, too. Nothing will penetrate the dark corners of those minds.

14 responses to “Where Danger Lurks: The Dark Recesses of the Orthodox Mind

  1. Yikes, this is representation of economic thought from IMF on what to do about post 2008 Great Depression. Yes, clueless in the past and still clueless. God! help the Global economy. EU is planning to use “negative nominal interest’ to fight its current deflation.

  2. Great read, appreciate the accessible analysis.

  3. And I say Amen to that!

  4. StevenPenfield

    Yes, interesting. At the end Blanchard suggests the most ‘pragmatic’ approach is precisely the old linear approach, even after spending much space outlining how it fell short. I find that pretty remarkable.

    Even simple Ordinary Differential Equation models are capable of non-linear behaviour. Pretty much any maths graduate from any of the world’s top 500 Universities could construct and conduct some meaningful analysis of such models. How can this be beyond the IMF? Even if economists lack the necessary skills there are plenty of maths departments looking for interesting collaborations.

    Is there a paper describing an empirical approach to modelling a macroeconomy MMT style?

  5. “Uncle Ben and the Invisible Hand” is not funny! The Trillion$ lost by consumers in not only savings, but future income was clearly the intended result of criminal Hedging.
    Consumers were led down the Primrose path of freedom, by governments designed to allow the Snake Oil Salesmen, to Hedge corruption.
    The fact is, the consumer backstops ALL corruption, always has and always will, and only Magical Thinking could believe otherwise!
    We are free, free to be lied to, free to be stolen from, and free to be manipulated, by leaders who only care about themselves and the .01%.

    It is impossible to model corruption, so no one even tries!

  6. James P Savage III

    The problem of having bankers solve economic problems is the same as arming a carpenter with only a hammer–to the carpenter with a hammer every problem looks like a nail!
    The economic problems we face are not actually monetary problems although the problems do have a monetary dimension.
    Our problems arise from a lack of effective aggregate demand. Problem solvers need to use macro-economic analysis to arrive at a solution.
    If the problem solvers have not read and understood Keynes (yes, John Maynard Keynes–you could look it up!), the work of Simon Kuznets and associates (admittedly not perfect) in providing us with the quantitative data for the aggregate economy (GNP, etc.), and the work of my professor (at Cornell University in the early 1960’s) and friend, Morris Copeland, who created the flow of funds analysis of the GNP aggregates, then no good can come of it.
    I personally have benefitted from having had Donald Kemmerer as a professor at the University of Illinois, in the late 1950’s. Kemmerer, who became a life long friend, gave me a powerful foundation in the economic history of the U.S. as a senior, when at the suggestion of the department head, Dr. Bell, I signed up for one of the most memorable intellectual journeys of my life. Finally, Professor Ta Chung Liu, at Cornell, under whom I majored in econometrics for several semesters, provided me with the insights I used to understand the serious shortcomings of the multi-equation predicative models being promoted by naïve and poorly trained engineers, physicists, and mathematicians who aspired to be economists.
    I left Wall Street in 1973 partly because the Chairman of the firm that was making me an excellent offer of employment would not accept the fact that the forecasts being offered to clients by the firm’s economics department for which I was being recruited, were bogus.
    I am in the process of writing a book, (So what’s new! I’m an economist!) which I hope will present a picture of a liberal, Keynesian disciple, who, having been raised in genteel poverty as a result of the impact of the Great Depression of the 1930’s upon the extended family of farmers and professionals in western Iowa, eastern Nebraska and south eastern South Dakota, from which he came, tried to understand and prevent just what we have been through.
    The financial and social misery inflicted upon me and my wife as a result of the conscious depredation–I do not think that this was an accident but rather part of a continuing plot by the “0.001%” to impoverish and enslave at least the bottom 60% of the society— of the criminals in high places in the corporations of the U.S. acting on behalf of their owners and masters.

  7. SBA loans are the primary instruments of the federal government’s welfare program for the nation’s Main Street Republican “job creators”. For one’s business to qualify, for one of these government guaranteed loans, besides having a respectable upper middle class personal credit record, the business has to have a sound record of growth and profitability. Thus, by the federal government’s own standards it is market demand for goods and services and not interest rate levels that that drive loan volume. Banks and non-bank lenders of course apply stiffer standards on non SBA loans. For these loans the market value assets is often the key factor. Here again, in an economic downturn, demand rather than discount rates tends to be the deciding factor. None of this financial market behavior has anything to do with new age financial engineering: the same factors were at play in Thornton’s time. The math, however, may, as you point out, be too complex these modelers to handle.

  8. It’s very sad that the biggest proponents of E-money (Rogoff, Kimball) all support it because they believe it will resuscitate the dying corpse of monetarism and solve the problem of Fed impotence by increasing, rather than reducing, technocratic control over macroeconomic policy.

    In my opinion (and I believe you’ve said so elsewhere) there are other reasons to push some sort of E-money, but they are mainly related to payments system innovation and the benefits of having a public option for banking in terms of financial inclusion and reducing predatory fees, etc. associated with regular transaction accounts/credit cards.

  9. Sorry, I meant to say “some sort of E-money policy reform”. Obviously, as you say, most money is digital now, so this would be more of a framing device. Much like “QE for the people”, the biggest change would be to allow individuals to have access to retail Fed accounts (that could be managed by franchised postal banks) rather than rely on intermediation through the deposit system.

  10. Mark Thoma disagrees. [http://economistsview.typepad.com/economistsview/2014/08/where-danger-lurks.html] (I don’t.)


    What, he wants to push that below zero so that American savers have to pay government? And that is supposed to stimulate the economy?

    No, actually it’s supposed to pry from the middle class’ hands whatever few dollars they have left that they had managed to save.

  11. They’re daft alright. But I think they’re daft in a slightly different way. In the version of the “electronic money” story that I have seen, the Fed would stop issuing Reserve Notes altogether and phase them out. Everyone would thus be forced to hold their dollars as commercial bank deposits. Next, these accounts would be subjected to a flat, recurring “deposit tax,” which would have the effect of imposing an economy-wide negative interest rate. Rather than watch their purchasing power wither away, people would rush to the mall and spend like crazed, meth-smoking sailors on their last liberty before a deployment. They’d especially want to buy anything and everything with any chance of retaining its value. (Assault rifles, gold ingots, vintage comic books, etc., etc.)

    That last point, however, the orthodox forget to remember. In their version, all of the cautious, prudent, pent-up demand that now exists – for beach blankets, kitchen equipment, lawn tractors and such – comes surging forth. After an orgy of Fed-induced consumer spending has at last cured unemployment, the tax can be moderated or eliminated. A whole new world of policy space will have been created using financial engineering alone. Huzzah. Ken Rogoff for President.

    Would they also ban forex trading? People looking for a reliable, untaxed store of value are doing so for a reason. But I guess that’s not the kind of homespun rationality Chicago likes to drone on about.

    Lemme see… Nine millimeter ammo, freeze-dried mashed potatoes, investment-grade baseball cards, heavy-guage copper wire, authentic oriental rugs, incandescent light bulbs, pennies minted before 1982… Yeah, go start up the car.


  12. Randy, This is one of my absolute favorites from you. I hardly stopped laughing, even recited it to my wife, who has previously heard about the great chess champion Ken Rogoff. Ever the epitome of commonsense wisdom, she remarked: “That doesn’t make him right about this!” Nor does the fact that he’s “Harvard Professor Kenneth S. Rogoff, former head of the IMF’s Research Department . . .”

    What I always say about arguments like that is: Look it’s irrelevant, because if his argument is right that it will be able to stand up to criticism, and if it can’t do that, then it doesn’t matter a damn who the hell he is? And btw, if it did matter, then his argument would be right anyway, wouldn’t it?

  13. I think negative interest rates was meant to simulate the Stamp money of Irving and Gesell.

  14. The idea is to increase the velocity without adding money to the system.