Oct 9, 2017

Olivier Blanchard on the State of Macroeconomics

DSGE modeling is the dominant paradigm within present day macroeconomics, but there is plenty of room to improve upon it.
David Beckworth Senior Research Fellow , Olivier Blanchard

Hosted by David Beckworth of the Mercatus Center, Macro Musings is a new podcast which pulls back the curtain on the important macroeconomic issues of the past, present, and future.

Olivier Blanchard is the C. Fred Bergsten Senior Fellow at the Peterson Institute for International Economics and the former Director of Research at the International Monetary Fund. Olivier joins Macro Musings to discuss working at the IMF in the midst of the 2008 financial crisis and Great Recession, and he also shares his thoughts on the limitations of current-day macroeconomic models as well as some suggestions to improve them.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to macromusings@mercatus.gmu.edu.

David Beckworth: Olivier, welcome to the show.

Olivier Blanchard: Happy to be here.

Beckworth: Oh, it's a real treat and honor to have you on the program. One thing I like to do to ask my guest before we get into the actual subject of macro is to tell us a little bit about your journey into macro, how did you become a macro economist?

Blanchard: There are two steps, right? There is how did I become an economist in the first place, and why did I choose macro after that? So I became an economist partly as a result of May '68 in France, in which we decided we wanted to change the world, and I thought that maybe this was one discipline which would help. So this is what, before that I had been an indifferent student, but once I decided "Well, maybe these are important issues and interesting ones." So I decided to be an economist then.

Blanchard: Then I came to MIT, and at MIT I come to do development. But at the time, as opposed to now, development was more or less a dead field, was not exciting. But there was a number of just great macroeconomists at the time at MIT. Stan Fischer was my teacher and then advisor, Rudi Dornbusch who came later was my friend and advisor. Rob Solow was my mentor, it was just too exciting. And I think exposed, that was the right choice. I think I have the kind of traits which are good in macro, would be less good elsewhere. Has been fun.

Beckworth: There's been a lot of individuals like yourself that have come out of MIT who then, great academic work but also gone into the policy world. So what was it about MIT that produced all these policy individuals?

Blanchard: I think it's very much the signal sent by Rob Solow, Stan Fischer, Franco Modigliani, Rudi Dornbusch, I mean these are very good macro theorists, all of them, but they cared about the real world, they were involved in stopping hyperinflation in Israel or trying to work on the mess in Latin America, and I think we all got the signal that, I mean we could do theory and we should do theory, but it was in the service of actual issues and we were all interested and involved in more applied stuff. And I don't know, in addition I think the number of us who ended up in positions of policymaking is surprising.

Beckworth: Yeah, it was very interesting. And one of the common denominators, MIT, is also Stan Fischer was a part of everyone's experience too-

Blanchard: Yes, Stan was central.

Beckworth: ... and now he's got incredible experience, service in his life. I mean, he's been at the Bank of Israel, the IMF, the Fed. So it's amazing to follow the trajectories of many individuals from MIT. Speaking of the policy world, you were the head of the research department at the IMF, so tell us a little bit about that. What is it like to be at the research department there?

Working at the IMF

Blanchard: So first, I actually had two jobs, and-

Beckworth: Okay.

Blanchard: ... you have two jobs when you're wearing that position. You're director of research, and you're economy counselor, which is a very 19th century-sounding title.

Beckworth: Sounds nice.

Blanchard: That's how it's called. And I think depending on who you are and when you go, you tend to do more of the first or more of the second. I had gone, I had accepted the position in early 2008 and I thought I would go over and try to mostly direct research. And the IMF is a marvelous place, you basically have hundreds of people with PhDs and you can just mobilize them, and I thought that was very exciting and things could be done.

Blanchard: And when I arrived, it was two weeks before Lehman. And so I ended up spending also quite a bit of time with the other hat, thinking about what we were doing, what we should do, and trying to interact with management and with countries. And from the point of view of the world, this was tough times. But from an intellectual point of view and from an operational point of view, it was incredible.

Blanchard: I think I was very lucky. If I had gone there five years earlier, say, I would probably have changed research a bit, but people would have said "We know how to do things, leave us alone." That's something that couldn't say, they couldn't say "Well, we've always done that and it works," because the world was a complete mess. The policymakers were lost, many of them. Not so much the central bankers, but the ministers of finance, and also if you actually had something to say, there was an audience which was eager to hear what could be done. So it was a very special time. I mean, I was there from 2008 to 2015, and from an intellectual point of view, it was incredibly exciting.

Beckworth: Yeah, you were there during the height of the crisis, you were there during the recovery, the Eurozone, which, crisis was going on for many years.

Blanchard: No, I got them all.

Beckworth: You cut your teeth on a lot of interesting…

Blanchard: I chose my timing just right.

Beckworth: ... You did, did it very fortunately.

Blanchard: Yes.

Beckworth: Now along those lines, people have asked "What have we learned from this experience, and how has macroeconomics as a discipline fared?" And you and Larry Summers are working on a paper called *Back to the Future* where you go back and appraise the discipline, what have we learned, what are the lessons, what do we need to improve? And you talked about three lessons learned in that. So can you share those with us? What are the big lessons you think we can draw from the past decade?

Three Lessons from Macroeconomics in the Past

Blanchard: So it's a complex set of issues, so let me try to think about them. So the first of the three lessons, the first one is the obvious one, which is the financial sector is important, it's very complex. There had been some work on the financial sector, there was some work which was not in the mainstream. I mean, Hyman Minsky is an important player in that, but he was ignored. There was some work within the mainstream, and Ben Bernanke had written important papers, but it was more about the channel for which, for financial system would mollify the effects of shocks, was not so much about financial crisis.

Blanchard: And I think what we learned is there can be financial crisis, there can be very bad, and difficult to handle. So I think that's the first lesson, I mean, everybody has learned that lesson. The second is I think it goes beyond this, I think we learned that, going into the crisis or before the crisis we had come to the conclusion that fluctuations were fairly regular, that we knew how to handle them, that the economy was stabilized by itself. Policy was useful, but it was a fairly stable environment. You had to design simple rules, the Taylor rule was kind of a quintessential rule, interest rate rule for the central banks.

Blanchard: Many people had come to a conclusion this was the way advanced economies were, and we kind of knew what to do. And I think that the last 10 years have shown that we were a bit, there was a lot of hubris there, that we understood things much less well than we thought we did. In particular, it's very clear that the economies are not self-stabilizing, that there are these things we call non-linearities which stand in the way, and things can go from bad to worse rather than from bad to better. The fact that 10 years later we're not back to the old output trend makes you think that maybe financial crisis, all the shocks have long run effects which should be taken into account, this notion that we always return to some stable potential output path, which underlied a lot of the thinking before is probably wrong.

Blanchard: And so I think there's a much larger re-examination of macro than there would have been absent the crisis, which is triggered by the financial crisis, but I think forces us to think about what are the macro dynamics, can we be confident that the economy will return to health? Don't we have to be more aggressive in terms of policies?

Blanchard: So that's the second lesson. And the third is not a lesson from the crisis, but a lesson about the environment in which we now are, which is what Larry has called secular stagnation, going back to Hansen, which is a situation in which interest rates which we need to sustain demand are very low, what in the jargon we call the Wicksellian rate or the usual rate, this is vital. So monetary policy has to basically choose these rates in order to maintain demand, but they are very, very low. And that's an unusual environment, and from the point of monetary policy it makes it more likely that you're going to run in to what is known as the zero lower bound, namely the inability to decrease the rate forever, and then monetary policy becomes much harder to use. We've learned that we can use it, but it, kind of complicated.

Blanchard: Then from the point of fiscal policy, if the interest rate is less than the growth rate, we're in this world which I never thought we would be in in which in principle you can issue debt and never repay it, you can do all kinds of strange things, but which are very relevant, which means should you be gung-ho on debt consolidation in that environment or can you be more relaxed? In terms of financial policies I think we now think that the low interest rate lead to risk-taking, for various reasons I think. Human nature, agency issues, all kinds of issues, but the result is this is an environment in which people want return and are willing to take risks, but risks as we've learned can be very dangerous, it can lead to financial crisis or ... That environment is probably there to stay. We can't be sure, but it looks like rates are going to be low for a long time. If you look at the rates in the yield curve, it looks as if they are very, very low for a long time. And so the sum of the three lessons is what we look at in this paper with Larry, and we try to think about what this implies for monetary policy, fiscal policy, financial policies.

Beckworth: Before we get into what it implies for policies, you mention in that article, the part that I read, that you're not sure all of these lessons will be taken in by policymakers, you're not sure that it's going to truly be internalized, what we've learned.

Blanchard: I'm worried. I was going to use the we, which was not a royal we, but I don't want to attribute anything to Larry that-

Beckworth: Okay, sure.

Blanchard: ... hasn't checked. And if you look at monetary policy, there are some people who say "Well, the problem with the financial crisis is we didn't stay with a Taylor rule and if we had stayed with a Taylor rule and we had a simple rule, everything would be fine." I think that would be a crazy conclusion, given what we've learned.

Blanchard: On fiscal policy, if monetary policy is not going to be as usable of as it used to because of a zero lower bound, and if the interest rate is very low relative to the growth rate, which means they'd raise much more room to use fiscal. At this stage there is just no movement in that direction. There has been no work on automatic stabilizers, for example. Zero work, at least in the policy sphere. There are one or two papers in research, but nobody has worked on it. The notion that we should use fiscal policy Much more aggressively from a stabilization point of view is not on the map.

Blanchard: And on financial regulation, macroprudential, and there has been a lot of things done, but as you can see, maybe for political reasons, there seems to be pushback. Banks are saying "You complicate our lives terribly, we can't do what we want to do," which is exactly what we should be pushing for, but they don't like it. Therefore, politically quite powerful, so you can see that we've gone back on a few things. So I'm a bit worried by laziness, by, because of the political economy of the thing, we go back to something close to what we had before, and then something like what we got happens again.

Beckworth: Well, I guess if it's any comfort, after the Great Depression it took a long time to figure out what really went wrong, right? I mean, if I use an example, Milton Friedman, he's many decades after ... He says money matters, and the Fed could've done more, arguably.

Blanchard: Right.

Beckworth: But it took a long time to get to that point, to that conclusion. Is that similar, maybe, what we're seeing today?

Blanchard: I think, I mean in terms of response to the crisis, I think a bit the same as what happened in the Great Depression, which is policymaking went ahead of research.

Beckworth: Yeah.

Blanchard: I think on that, monetary policy was remarkable. The initial fiscal expansion at the beginning was very good. So I think policymakers did the right thing, and there's an enormous amount of research going on on what happened, what we should do, and so on. So it's happening, it's happening faster, I think, because there are many more economists, maybe.

Beckworth: Yeah. We have a discipline of macro today, back then we did not.

Blanchard: Exactly, I mean the Great Depression created macro in a way. We had macro before the financial crisis, and not all of what we had is wrong, most of it is right. So we have something to build on, I think it's happening. There are still, I mean, in this paper with Larry we argue that we still don't understand many things in the financial sphere, and that this has implications for the way we think about financial policies in the future, which we're not ready, basically, to handle the next financial crisis, we still have questions about exactly what happens. But it's happening, and there's a lot of theoretical work on the issues that we just faced in the last 10 years.

Monetary Policy Pre and Post Great Recession

Beckworth: No, I do share your concern. I do think should another recession strike, we're going to have our hands tied in terms of policy. There's not a lot of a change. I used to be a really big fan of QE, I think QE1 made a big difference, but I've become less convinced over time that QE2 and QE3 packed as much punch.

Blanchard: We used to think that basically financial assets were nearly perfect substitutes, so that the demand was incredibly elastic. What we've learned is that there's some slope. It's a small slope, which means you need enormous movements in supply to get effects. I think you can do it, and so if there was another financial crisis I would try very hard to buy and sell stuff-

Beckworth: More QE, yeah.

Blanchard: ... More QE, on a scale which would be even more scary than I think what we've done, but it doesn't work as well as moving the policy rate.

Beckworth: Right, right. We didn't have a robust recovery-

Blanchard: First of all, moving the policy rate gets you a lot of leverage, leverage in the usual sense, not the financial sense.

Beckworth: ... Yeah.

Blanchard: It works. When you get to zero, there are still things you can do, and we've learned that we can do more than we thought we could. But it doesn't work as well, it has complex effects, it has adverse effects at some margins. So if we need to use it, we'll use it again.

Beckworth: I guess my critique would be we didn't have a robust recovery, right? I mean-

Blanchard: No, no, because we we had-

Beckworth: ... And the Fed-

Blanchard: ... limits on what we could do.

Beckworth: Well, I think the Fed had higher hopes for QE, right? The Fed was hoping it would maybe deliver-

Blanchard: I think it was, well, you made the distinction between QE1 and then the other QEs, because I think as long as the markets were dislocated in a way, when you go in, you provide liquidity, you have a big effect, and much of QE1 was that. After this, when the markets kind of work, then you really have to dump an enormous amount of stuff and the market'll buy an enormous amount to get a few basis points. You can do it. I-

Beckworth: It's something, yeah.

Blanchard: ... I'm not sure that the Fed was, it was kind of a jump into the unknown. I don't know if the Fed was disappointed or not disappointed with what happened, but it's clear that we had a very, very slow recovery. And that came from the fact that monetary policy nearly at full speed was not quite enough to do the job, right?

Beckworth: Yeah, when I think of QE2, QE3, I think of the Wallace critique about open market operations, the limits they have, where QE1 seems to be a place where that doesn't apply, it was very-

Blanchard: Yeah, no, QE1 is providing liquidity to markets which have lost it.

Beckworth: ... Right.

Blanchard: That works.

Beckworth: Yep. I think-

Blanchard: After this, you're talking about what's the difference ... Who is buying 10 year bonds as opposed to 30 year bonds. We used to think it's the people, said "Doesn't make any difference what you" ... But we've learned, no, there's some people in the 10 year market, some people in the 30 year market. So if you buy and sell a lot you can actually change the relative yields, the relative spreads. But again, we have 4.5 trillion-

Beckworth: ... To get a little bit of extra growth.

Blanchard: ... to get maybe 100 to 200 basis points.

Beckworth: Let me go back to the pre-2008 macro kind of consensus, and I want to maybe … for a little bit. You mentioned, had good stuff back then too, but I think if we look back, there were from insights that could've been used, maybe politically it couldn't have been used, but some of the work, for example, done on Japan by folks at Princeton, the Princeton group, Ben Bernanke, Lars Svensson, Michael Woodford. They all had been worried about what was going on in Japan, and others, that the zero lower bound. And they all argued "Look, you need like a price level target, you need permanent increase in the monetary ... you need some kind of permanent 'irresponsible-'"

Blanchard: Right.

Beckworth: ... Now, politically, maybe it wasn't possible, but there were ideas out there that could've been use, right? Pre-2008.

Blanchard: Yeah, I mean, although, I think pre-2008, again, you have many macroeconomists, so some of then were right and some of them were wrong. But the mainstream view was Japan has made policy mistakes. Financial crisis shouldn't be that bad ...

Beckworth: Okay.

Blanchard: Is a clue they're not doing the right thing. But I think what we've learned is they were trying to do the right thing, was just not enough, financial crises are really bad. So I think there's a reinterpretation of Japanese history now which would be quite different from the one that prevailed. But you're right that there was work on if we hit the zero lower bound, what will we do?

Blanchard: I think there was too much optimism, and that's very relevant today, about "Oh, if we get there, let's promise a lot of inflation." And so if you promise a lot of inflation, although the nominal rate is zero, the real rate is negative, and you get out of the hole and everything is fine.

Beckworth: Yeah.

Blanchard: There's still this view today, some people still believe that. I think we've learned that it's incredibly hard to move expectations in that context. You're in a context, you're at the zero lower bound. Inflation has decreased because of depressed activity, right? You can't even kind of reach your target, which is still the case today. And you say "No, no, I'm going to have a lot of inflation later," that nobody believes it. And I think Japan, if we've learned something from the last 10 years in Japan is they have done crazy stuff, they have announced crazy things. People have looked and have not changed their expectations.

Blanchard: So I think one of the lessons which is very relevant today is one of the ways out of a zero lower bound, of a liquidity trap, which was, well, you're just going to move expectations maybe by having a price level targeting and so on, I'm a bit skeptical. That's very much the issue today, which is, as you said, if there's another recession today, we don't have a lot of room. So we should be thinking about it now. So one way is you increase average inflation to 4%, and if you do it long enough people will expect 4%, which is something that I pushed when I was at the Fund. But maybe 4% is not great, but at least it gives you some room.

Blanchard: And then there's the more sophisticated way, which is, oh no, you still keep it two, but when you get to the zero lower bound, you promised things. Now, if that worked, it's clearly better, because most of the time you have low inflation. But I'm a bit skeptical that it works. So I think that should be the debate today, which is what do we do? And I think the issue about the inflation target is still on the table.

Beckworth: Yeah, it's interesting. So is this an issue of … it just takes a long time to persuade people, or is it a question of technical know-how? We just haven't pressed the right levers yet to get people to freak out, to think higher inflation. Or is it just a lot of behavioral econ that people don't change-

Blanchard: I have another paper in the pipeline in which I look at expectations. So there are two reasons. At this stage, expectations, in the US if you like it, expectations of inflation, they don't move. And there are two stories. The first is that the target inflation rate has become totally credible, and so people believe two no matter what.

Beckworth: ... Right, to a fault.

Blanchard: Right? And if it were true it would be good, because when we were saying credibility of a central bank, in effect, can announce that no wit's four, and given the credibility, everybody moves there, right?

Beckworth: Mm-hmm (affirmative).

Blanchard: There's another one, which is that at very low inflation nobody cares and nobody thinks about it, which I've called a lack of salience. Which case, the conclusions are quite different, which is the central bank can say "Well, we're going to a four," but people are just not looking, they don't care, they don't move.

Blanchard: So I did the following, which is I looked at the expectations of professional forecasters and the expectations of people from the Michigan survey. And so for professional forecasters, the first explanation seems to be right, which is that if you distinguish between core inflation and the rest, they put a lot of weight on core, and they ignore ... So if a gas price goes up, they don't adjust expectations very much, which indicates they believe that the Fed will do whatever is needed to keep-

Beckworth: Okay, interesting.

Blanchard: ... But Michigan survey, zero weight on the core, they don't know what it is. But when the gas price goes up, they just move expectations. So I think maybe what we need is another OPEC shock or something like this which would-

Beckworth: Wow, I hope we don't need that to get ...

Blanchard: ... Or something which, no, you know-

Beckworth: Yeah.

Blanchard: ... some bad harvest which increase the price of food. No, I mean how you move expectations, I think, again, there are different players here. How you move expectations in the bonds market is a very different thing from how do you move expectations to lead people to ask for higher wage increases, and we have to separate the two. But it's not easy.

Beckworth: Well it's interesting, because I've been a big advocate of nominal GDP level targeting, which in my mind would solve some of these problems, but I've often had people criticize me and say "Hey, the average person isn't going to wake up at 5:00 in the morning, say 'Oh great, nominal GDP's targeted at 5% this year,'" where the bond market might know it, it's maybe tough to communicate that down to the average person.

Blanchard: Now Larry, for example, believes that nominal income targeting would be an improvement, I think it would be an improvement on inflation targeting, but how you communicate this to the great public is ... Price level targeting is more appealing from a conceptual point of view, it's simpler. And it's great on one way, which is when you want to have more inflation-

Beckworth: Come back down, right.

Blanchard: ...the back down, there are nominal rigidities, and the back down, which is you're now at full employment, but you have to undo five points of inflation. And you can only do this for recession, in fact. It's very unappealing, right?

Beckworth: Yep.

Blanchard: So I don't think there's a magic recipe. But we have to do something, because if we don't do anything, we're going to be stuck again.

Beckworth: Well let me throw out my radical proposal.

Blanchard: Okay.

Beckworth: At the expense of exposing my radical ideas. So I've actually written this in an article, so it's not a secret, but I would like to do nominal GDP level targeting and then have a Treasury backstop to it. So the Fed says "Look, we're going to hit 5% nominal GDP level target this next year," and the mechanics of it I haven't thought out real carefully, but let's say it undershoots its target. Then it'd be kind of like in New Zealand where the finance minister steps in after a while if the central bank hasn't hit its target. What would happen is the US Treasury would step in and either create new bonds, basically if they undershot it would take new bonds, deposit them at the Fed, take that money, and through this infrastructure, distribute it directly to people. And it would keep sending that money out until spending got back up and nominal GDP increased.

Beckworth: And it could go the other way as well, if the Fed's let nominal GDP growing too fast, it could reign it in by putting bonds at the Fed and the Fed would sell those bonds to pull money in. But you would have the treasury backstopped and credible-

Blanchard: Why not have straight fiscal policy? And why this complicated scheme? Total respect for your scheme, obviously, but why not have fiscal expansion? If there's an output gap, just go for it-

Beckworth: ... I think because politically-

Blanchard: ... I mean, I don't care about inflation, per se.

Beckworth: ... Yeah, right.

Blanchard: ... I mean, if inflation is, two, four, all I care about is basically having a higher sustainable level of activity, right? And it seems to me that in your scheme, yeah, public investment, tax cuts maybe even, is the way to go. And there should be some coordination between the monetary authority and the Fed and then the Treasury. But I think we can use fiscal policy much more than we do, especially this-

Beckworth: Well, don't you think there's political challenges, though? I mean ...

Blanchard: ... Well, I mean look, in the US, we're talking about a political environment in which discussing rational policymaking is a bit difficult. But as economists we have to argue that fiscal policy should be used. And I think we can do things. But a fascinating thing is automatic stabilizers, which is, and I saw this at the Fund when I was there. Which is, when you talk about discretionary fiscal policy, policymakers don't want to hear it, they just are scared. But they all let the automatic stabilizers play.

Blanchard: Now, it's crazy, because the automatic stabilizers were never designed to stabilize, they stabilize by accident depending the progressivity of the income tax, things like this, which have nothing to do with stabilizing, per se. But all the policymakers are willing to let automatic stabilizers play, but then they stop there. And so they stop in very different places. I mean, in the US they stop much earlier, but in places where the progressive income tax is much more progressive ... So my sense is we should as economists propose better automatic stabilizers, and there's a chance that they would be accepted. So I think things can be done maybe even in a crazy political environment.

Beckworth: Yeah. Well, let me ask one more experience from this crisis. Since you were at the Fund, you have a great perspective on this. And this is Israel, this is when Stan Fischer was at Israel. So I know Israel hasn't done as great lately, but during the 2008 ... they did relatively well as an economy, and one thing you see is that they tolerate a temporary overshoot of inflation there. So I think they have an inflation target around 3%, there's a band, I forget the exact numbers, but close to 3%. But they allow the inflation to temporarily rise to about 5%, they overshot, and I think they did massive foreign exchange intervention, they were very aggressive. Inflation was allowed to overshoot, so even though real GDP went down, the combination of higher inflation, a slight decline in real GDP led to a stable nominal income, stable aggregate demand overall, better response during the Great Recession. So is that a fair interpretation of what happened in Israel, or is it different-

Blanchard: You know much more than I about that-

Beckworth: Okay, well I-

Blanchard: ... Sounds interesting and I'll go back and look, but no, I have nothing to add.

Beckworth: ... Well it's just, it seems like the, and again, one of the, if I had to criticize that example, Israel's a small country, maybe it's a little more nimble than the US in responding to policy crisis and stuff. All right, well, let's move on then. Fascinating paper, we look forward to reading it when it comes you, your and Larry paper and your other paper as well that you've mentioned.

Beckworth: We've talked about the lessons learned, and really we've touched on some of the policy implications, but do you want to spell out the policy implications from all of this in the paper with you and Larry? Succinctly, since we've kind of jumped around on them.

The Policy Implications of *Back to the Future*

Blanchard: Yes. So I think I would say the policy implications, we face risks, and a larger set of risk than we thought, because financial crisis will happen again. We face a number of mechanisms which are potentially destabilizing, because of what we learned, and then the lower rates which make things worse. And so in that environment I think we have to be, demand policies have to be very aggressive, very proactive, very reactive.

Blanchard: In terms of monetary policy, we've talked about, I think that we really have to think about how can we get more room to use monetary policy? On fiscal, again, the fact that r is less than g, to use jargon, really says that we can use and we should use fiscal policy much more.

Beckworth: Can you define r and g for the audience?

Blanchard: Yeah, so we very often talk about r and g. r is the interest rate, g is the growth rate, and the normal situation is r is bigger than g. This is normal, this is what should happen. But sometimes r is less than g, in which case all kinds of strange things can happen. For example, when you issue debt, you never have to repay it back, you never have to raise taxes. So this is why we, this is a shortcut for a situation which things are very stretched.

Blanchard: On financial, I think we have to keep trying. I mean, I think it's a very ... The financial system is really different from the rest. It moves very fast, it is very reactive, very reactive to regulation, very able to do regulatory arbitrage. I don't think we'll ever get to some stable financial regulation which works for all time, so we have to keep trying. But I think we have to be, again, what we've learned is that there can be bad shocks and they can be damn hard to handle, and so let's decrease the probability that they happen and be ready to really act very strongly when they happen, I think that would be the general message. And we can go into specifics, but that's the general message.

Beckworth: Okay, well that's very interesting. Well let's move on, let's talk about macroeconomic models. So another consequence of this discussion is how do we do the profession, how do we think about these issues? And we use our models to help us think about them, and you've written quite a bit lately, you've been on a tear there with, a number of pieces have come up. And it began with an article on DSGE models, dynamic stochastic general equilibrium models, and the title of the article is *Do DSGE Models Have a Future?* And then you also had a follow-up piece, *Further Thoughts on DSGE Models.* So maybe share with our listeners your thoughts on DSGE models, and then after we get to that we'll talk about your more recent piece where you talked about the need for at least five classes of models. But let's first talk about DSGE models.

The Basics of DSGE Models

Blanchard: The two are related, right?

Beckworth: Okay.

Blanchard: So we need a class of models which are dynamic, stochastic, general equilibrium because this is what macro is about. And they are needed, I think, for a very specific task, which is we can think of various mechanisms in partial equilibrium, we can study them, we should study them, but then we want to know how they interact with the rest of the economy in various circumstances. And we need fairly specific models, tightly-specified models to actually think about it. So there has to be, to have this discussion of the relevance of various mechanisms, of various assumptions, there has to be some more or less common structure, which is going to be fairly complex, in which we can discuss these things.

Blanchard: So if you say "I think this really would make an enormous difference to dynamics," then there has to be some basic model in which you can put it in and then you show what it does and people will say "No, no, because you've basically misspecificed." So the model has to be fairly tight theoretically, fairly rich because there are many mechanisms you may want to have, and that's the only way, I think, to have what is a needed discourse, which is how do all these mechanisms interact?

Blanchard: Now, do I like the existing DSGEs? No. Because of history, they probably are too much based on what we used to call rationality, but which is a very special kind which is what I would call an economist-type of rationality, which is not the way people act. They, if you look equation by equation, which is what this piece was about, most of the equations are very unappealing. They are derived from so-called micro foundations, but they just don't fit reality closely. The consumption behavior is incredibly forward-looking, I mean I don't want to go into details, but it's based on this thing called the Euler equation, in which you have infinitely long-lived people looking into the infinite future, which is not the way most of us ... First we'll die, probably, and in addition, that's not the way we act. The characterization of price and wage setting is based on this incredibly convenient so-called Calvo assumption, Poisson assumption.

Beckworth: The Calvo fairy.

Blanchard: Calvo fairy, which is very convenient from an analytical point of view and has been very useful in small models, but is not a description of reality, only as assumption, but as implication. So these models I think at this stage are mostly wrong. But I see a need for that class of models, and I think we can, I don't know if you call it repair or more than that, redesign, but we can have a more realistic consumption function, we can have a more realistic investment function, we can have a more realistic description of wage and price setting, which takes into account some of what we've learned from behavioral economics, from values constraints which exist, and which can build on what has been done. I mean, the technology of DSGEs is incredibly useful… MATLAB are tools that we should all use.

Blanchard: So that has to exist, right? And so I've argued that basically have to repair them, improve them, but the idea of "Let's dismiss SDGs" is that nonstarter, because I don't know how we discuss things. In the other piece that you mentioned, I've argued that that's one class of models out of many. What I object to in the profession at this point is that it has become, I'm looking for the right word in English, but dominant is an understatement. I mean, basically, you cannot basically submit a paper to a macro journal unless it has some DSGE closure, which typically is not going to add much to that paper. I think there should be papers which basically look at partial equilibrium mechanisms and use data and show something, then later on they can be integrated, but these are different things.

Blanchard: And I think we need different types of models, which is what I was arguing. For example, at the Fund, we also need, and we needed and we have, very large quantitative models, because I want to be able to give some reasonable answer to the question of suppose that growth in China decreases by 2%, what will be the effect on Brazil? Now, that's something I cannot do in my head. I can do many things in my head, but I can tell you-

Beckworth: Right, that's not one of them.

Blanchard: ... it stops long before that. So for this you need a model. Now, can you have a tightly-specified micro founded model of all the countries in the world in which you actually get the answer? Well, maybe in some alternative universe you could, but in practice you can't. And so there you need models which are quantitative but go away from so-called micro foundations and fit the data better or are more flexible in the trade-off between fitting the data and being true to theory.

Blanchard: And we need these models, and so this is another class of models that we need. So these are even more complex models, but they are closer to the data. Then you have models in which, suppose you're in forecasting. At this stage, it hasn't been proven that having a structural model will actually improve your forecasting abilities. It will allow you to tell better stories, and it's useful, but if my job is forecasting, I may want to be purely statistical about it and ignore completely theory. I mean just basically use some [inaudible] filter or whatever it is that you want, and that may work best, in which case there is no need for micro foundations. The same way as translation programs, you probably know the story of translation programs, which is initially they were built on writing down the grammar and then using this to translate, and they have been beaten completely by programs which have no clue as to what grammar is, but basically look at a billion sentences in the other language, find one, there is one which seems to correspond, do a purely statistical job, and dominate.

Blanchard: So again, forecasting may be like this, I don't know. Then you have the models which you use to explain things, and models to explain things are small, simple. They ignore all kinds of aspects of reality, but they help you think. So the IS-LM, Mundell-Fleming, Dornbusch model of exchange rates, diamond model, overlapping generation model, these are great models. They do not pretend to explain everything, but they go down typically to some kind of graph with two curves which hopefully cross, and you get it. And that's terribly important, not just from a pedagogical point of view, it's essential, but from a conceptual point of view, which is that when I think about something, I need first for my own sake to actually reduce it to something nearly trivial, not quite, see if I understand it, and then maybe I go back and I do the algebra in a bit more complex way, and maybe I even do it in a DSG, but ...

Blanchard: So I think there's a need for that class of models as well. And we need all these things, and so I think what I object to is the dominant role of DSGEs rather than the existence of DSGEs. DSGEs are needed, but as part of a panoply of things.

Beckworth: It was interesting, your piece, you wrote, as economists we believe in comparative advantage and unless we talk about these models, people think everyone has to do a DSGE, and you're like "No, not everyone does have to do that." People can specialize in different areas of macroeconomics and have contributions that way.

Blanchard: Right, so there is macro as art and macro as science. And I think the small models are closer to art. You cannot be pedestrian about it, you have to find some way of eliminating this and putting this in and making it look good. So there have been great artists. I think Dornbusch, Rudi Dornbusch was probably one of the greatest, but Robert Mundell, when he was younger, was also a splendid graph maker. And you get it.

Blanchard: But this was art. And not everybody can be an artist. And most of us are more plumbers, and so I think that in this case you feel much better using some DSG, which exists, and then doing some twist. And I'm not belittling it, I think it's useful, and it makes it easier for other people to understand what you did because they use kind of the same machine. So I think some people are gifted at some kind of art, and some people are gifted at just using MATLAB in a better way or in a stronger way or-

Beckworth: It's interesting the way you frame that. Because today, if you were to do a simple model, you get looked at as "Oh, you idiot," right? "You need to be doing a DSGE model." But what you're saying is it actually takes some kind of genius to do a good smaller model, to be an artist, it takes a different kind of-

Blanchard: ... Yes, I say this, but I also know, look at the world of artists. There are a few good ones, and ...

Beckworth: ... Okay, there's not many good artists.

Blanchard: There are many bad ones. So this may be pretentious, but it may be that most of us should give up on art and be Plumbers, or scientists, whichever word we want to use, and leave the art to a few. And so when you're teaching in a PhD program, you want to teach to the potential artists there, or do you want to make sure that everybody kind of does things reasonably well? Again, not everybody can be artist. In the times of Dornbusch, say, or the times of the '60s, for one beautiful paper which really got the essence of something in two equations, there were 10 really boring bad papers which also had two lines crossing. So again, art is art.

Beckworth: So you're saying there's still room for artists, if they're really good.

Blanchard: Yeah.

Beckworth: Okay.

Blanchard: I think so.

Beckworth: So as a former policymaker, and I know you've also worked with central banks, have consulted with them and stuff. In practice, do they use a variety of models, or they focus on one type of the other, what do you see policymakers actually doing?

Policymakers and Economic Modeling

Blanchard: It depends. I mean, some central banks are more eclectic than others. The DSGE faction is very strong. I mean, you're not a serious central banker unless one, you do inflation targeting, and two, you have a DSGE model. I'm not kidding, it's the reality of things, otherwise you're kind of a second rank central banker. So all the central banks have kind of developed DSGE. Some of them I think have gone too far and have one DSGE model, which is not enough. Some of them are much more eclectic. I think the Fed is a good example of eclecticism, and they have this model called FRB US, which is a mix between a DSGE and the kind of model I talked about, the Brazil/China type model.

Beckworth: Yeah.

Blanchard: And they have people who realize the limits of the DSGE model, and there's a lot of human input going into policy which is beyond DSGEs. There are central banks which are enamored with DSGEs because it looks complicated and technical and 21st century, so there's a mix. I mean, if I look at the ECB, they now have a panoply of models, and I think that's probably the way to do it. Competition between models within the bank is a good thing. But some central banks do it well, some central banks don't.

Beckworth: Yeah, it's interesting, someone, I forget his-

Blanchard: And the Fund has all kinds of models which compete.

Beckworth: ... Right. An individual at the ECB gave a recent speech and his name escapes me now, but he mentioned that they're going to be using a model more similar to the FRB model, more of a structural macro kind of-

Blanchard: They are building one like that.

Beckworth: ... Yeah, and they're not going to rely as much on this DSGE model. So that was an interesting development in light of this discussion.

Blanchard: And I think these are, again, they are trying to do slightly different things, but they can have competitions, right?

Beckworth: Mm-hmm (affirmative). I guess, you brought up another interesting point, you said there's DSGE models that some of these banks are highly reliant, depending upon them, but there's also human thinking. So if you're an FOMC member or original Fed president, you're coming to vote at the FOMC meeting, and you're in a discussion, I mean, when it comes down to it, are you looking at your notes from the DSGE model or you're thinking of a simple IS-LM model, aggregate demand aggregate supply model in your brain?

Blanchard: I think it depends on who is sitting at the FOMC. What I find is that DSGE models are extremely poor devices for non-insiders. You learn an enormous amount playing with the DSGE model. I've played with a few, and you do a shock and you're sure that, what the output is going to be, and it turns out to be completely different and you have to decide, is the model stupid or am I stupid? Typically it's a mix of the two. And then you go back and forth, and it's actually very useful and very productive.

Blanchard: When you talk to somebody else who is also into DSGE mode, you can have the same discussions and it's very good. But for people outside the DSGE circle, who read the notes saying "These are the results of the simulation of our DSGE model," what do they do with it? There is a risk for some of them that they take it too seriously. There's the risk and the reality that some of them will just dismiss it completely and do the IS-LM in their head and use that. So again, there is the issue of how do you explain things to others, in particular to policymakers, and they're either words or either a bit more into economics, simple models. I think the IS-LM is something that, rich IS-LM, not the caricature of the IS-LM, is a way of explaining things to ministers of finance with a bit of training in economics, but the DSGE is not.

Beckworth: Okay. Well, let's move onto a different issue, it's another macro issue. You've written another policy brief titled *Will Rising Interest Rates Lead to Fiscal Crisis?* And in this piece you highlight that public debt in advanced economies has risen dramatically since the crisis, and there's been a series of developments, slower productivity growth, the rise of populism, also interest rates at some point are expected to grow as well, but this can all come together for a dangerous mix. Tell us about that and some concerns that may arise.

The Societal Implications of Higher Public Debt

Blanchard: So clearly one of the legacies of a crisis is this high, by historical standards, these high levels of debt. And some people say that "Oh, but when interest rates are going to go up again, all hell is going to break loose." And that's a reasonable worry. Now, the question is, when you actually look, should you be as worried as some people are? And I concluded in that piece that maybe not. The first thing is interest rates look like they are going to be very low for a long time, so in many cases, the maturity of the debt is not very long, which means that the goverments really have protected themselves. Even if the short rate goes up, and they basically have … the long rate, and that's going to be fixed.

Blanchard: So I think that's one. The second is interest rates may indeed go up, but why would they go up? I think one of the main reasons they might go up is activity becomes stronger, growth increases, and the Fed and the other central banks feel that they have to increase interest rates. Well, in this case you get an increase in r and you get an increase in g, and what matters for the dynamics is r minus g. So again, you don't worry too much.

Blanchard: And the third element is, again, this long maturity of the debt, which means that, suppose that suddenly people get very scared and the short rate goes up by 300 basis points. Now you say 300 basis points times 100% of GDP, that's 3% more that I have to find right away. The fact that these bonds now have long maturity means that in fact the increase in interest payments over time initially is much smaller, and I take the example of Italy in that piece, in which I show that 300 basis points increase in the short rate would basically not have a big effect on the fiscal situation.

Blanchard: Eventually something would have to be done, but they would have 10 years to do it, not three days. So I think these are all reasons not to be worried too much. One reason to be worried is that what I'm saying is I think governments can handle an increase in interest rates, but the question is, this is assuming responsible government. And if you have a populist government which decides to basically go for large deficits and not care about that, and clearly can be bad. But subject to the assumption that governments will be responsible, I think they can handle what's coming.

Beckworth: This raises an interesting question about the issuance of these long term bonds. So the governments have been issuing, average maturity's moving out, which means they're refinancing more and more with longer term debt. There's been a push to issue really long term, 50 year, 100 year bonds. What are your thoughts on that?

Blanchard: I think it should be done.

Beckworth: Okay, so go for it while you still can, lock those rates in now while they're still low.

Blanchard: I mean, it should be done. From the point of view of a government, why not longer rates? You and I if we had this opportunity, which unfortunately we don't have ...

Beckworth: We don't live forever, yeah.

Blanchard: Should do it. Then there's a larger question, a deeper question, which is, so this would transfer the risk to the private sector, away from the government, right? Where do you want the risk to be? And my sense is maybe the government is better able to deal with risks than the private sector. I think it has an ability to tax, it has an ability to find revenues that a private firm or you or me don't have. I mean, if we have a debt problem we have a debt problem. We can't just say "Oh, well let's just increase revenue." I mean, maybe you can do Uber, but it's limited.

Beckworth: There's a limit.

Blanchard: Well, the state really has deep pockets. It can tax, right? And so the question in general is where do you want the risk to be, and maybe a lot of the risk-taking should be taken by the state, in which case that kind of scheme goes against it. It looks good from the point of view of government, but it has basically put the risk somewhere else where maybe the somewhere else is not able to handle it.

Blanchard: And there's the same issue with index bonds. Index bonds protect the government, because if growth is low then they have less to pay, so it sounds great for the government. But who is taking the risk? The creditors. And this means that in bad times, they will get less danger, right? So the answer to your question is yes from the point of view of a selfish government, maybe not yes from the point of view of a benevolent government.

Beckworth: I guess if there's an appetite for both parties at this ... mutual exchange from trade, then go for it.

Blanchard: Yes, but I'm a bit skeptical as to, people on the other side are people who buy Bitcoin as well, right?

Beckworth: Okay. It's interesting to think this issue from the perspective of the US coming out of World War II. So it really ran up debt to GDP but it came down. And it didn't come down because we suddenly reduced our debt, it came down because growth-

Blanchard: Inflation.

Beckworth: ... and inflation, right? Inflation was the main, okay, inflation. So that's one possible way out of this is ... And I want to go to Japan along those lines. So in Japan, you mentioned this, they've got, I think the gross level's over 200%, the net's 100 and some percent, and yet interest rates don't budge, there's no sign of the bond market freaking out. And yes, Bank of Japan has been, lately on the margin maybe helping depress those yields, but still you'd think if they were truly concerned there would be some indications, velocity of money picking up, something happening, and it hasn't.

Blanchard: Yes, I mean there's two things. And the first thing is why Japanese investors continue to basically lend at negative rates ...

Beckworth: Yeah, that is interesting.

Blanchard: To the Japanese government is, I think requires an understanding of Japanese society which goes beyond economics. Then the issue is, and one has to assume, first, that at the margin, this is a nice paper by [inaudible], at the margin the foreign investors are going to become more relevant, in which case they will probably ask for higher yields. And then, it can become very difficult for the Japanese government to handle. So what should the government do? I have a piece with Adam Posen two years ago in which we said basically, what you should have now is relatively high inflation, not crazy high, but maybe 5%, which would, with zero interest rates, start decreasing the debt.

Blanchard: If you don't do this, then there'll come a point where you'll basically get people wanting 300 basis points more, and then you'll have hyperinflation, in effect. So the choice is between reasonable but higher inflation now, or a bad ending. The only issue is how do you get inflation up in Japan? How do you get unions to want to have higher wages? In this strange world in which we're begging, policymakers in general and Japanese policymakers in particular, we're begging the unions to please ask for higher wages, and they say "No, we can't, because we would lose competitiveness and we can't do that." "Increase wages, prices would increase, we'll depreciate the exchange rate, everything will be fine, you will not lose competitiveness-"

Beckworth: Real terms-

Blanchard: ... and they say "No, we don't increase wages."

Beckworth: ... Yeah.

Blanchard: But for Japan I think, again, the right policy solution is to reduce the debt through reasonable inflation.

Beckworth: I like your summary, there's two choices here. Either you tolerate a little bit higher inflation, or you're going to have a crisis. There's no other option, and maybe this hasn't been understood or articulated to the population.

Blanchard: I think there's also, surely hasn't been understood. The question is, again, is it that they are stupid or we're missing something? Because in this discussion about the Japanese debt, for the last 10 years, I think non-Japanese economists have all said "That cannot last. The investors are going to ask for something, you're on the verge of trouble, it's coming." Now, crying wolf for 10 years and the wolf hasn't come and the rates are still zero or negative, makes the Japanese think that maybe foreigners don't understand everything, so maybe we should reread Shogun to understand the cultural differences, but-

Beckworth: It's amazing, I mean, 0% on a 10 year bond.

Blanchard: ... Yes.

Beckworth: That's just mind-blowing. I mean, it's nuts. So let me throw one of my theories out there for why I think this hasn't exploded yet and why it continues to go on. I ran it by Paul Krugman, he didn't buy it, but I'll throw it by you anyways. So my theory is tied to the demographics of the country, it's getting older and its population is shrinking. But a large part of the population is old, they hold the bonds, they lived on fixed income, they don't want inflation. So no matter what Abenomics says, no matter what the prime minister says, the fact is the seniors are in charge of the country and they're not going to tolerate it.

Beckworth: At some point, though, this becomes an intergenerational issue. The young people say "Hey, we are not going to bear the cost of the older generation," and that's when the crisis emerges, right? But do you think there's a political economy story-

Blanchard: Yes, I mean, the debt is held internally, which is very different from other countries in which a large proportion of the debt or most of the debt is held by foreigners. So yes, this is a transfer from the old to the young, and the old are not particularly open to the idea of losing 5% of their wealth a year. But again, that's, unfortunately the solution in Japan is a transfer from the old to the young.

Beckworth: ... Yeah.

Blanchard: And inflation is one way of doing it.

Beckworth: So there's going to be intergenerational strife at some point in the-

Blanchard: There is already.

Beckworth: ... Already is, okay.

Blanchard: I think that's part of the explanation.

Beckworth: All right. Well, on that very sober note, we have run out of time.

Blanchard: Good.

Beckworth: Thank you so much. Our guest today has bene Olivier Blanchard, thank you so much for coming on the show.

Blanchard: Thank you, it was a pleasure. It was fun.

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