New Solutions to Old Problems

There was an interesting exchange over the last couple of days between two of my favorite bloggers; Frances Coppola, aka Femina Spectabilis, and Brad DeLong, aka Distinguitur Oeconomicarum. Frances delivered a talk at my alma mater,  Manchester University, on the need to use non-linear models and to recognize the importance of multiple equilibria. Brava! Brad Delong, over at Equitable Growth, takes umbrage at Frances’ charge and rushes to the defense of his former teacher, Olivier Blanchard, aka Nobilis Vir. 

Here is Frances at full tilt

… some of the most influential people in macroeconomics have spent their lives developing theories and models that have been shown to be at best inadequate and at worst dangerously wrong. Olivier Blanchard’s call for policymakers to set policy in such a way that linear models will still work should be seen for what it is – the desperate cry of an aging economist who discovers that the foundations upon which he has built his career are made of sand. He is far from alone.

Perhaps a little harsh. But Frances has a point here Olivier. It's one that was made sometime ago by my emeritus colleague Axel Leijonhufud who referred to what he called corridor effects. Using Axel’s metaphor, Olivier is simply calling for policy makers to keep the economy in the corridor. And who could disagree with that?

Not Brad DeLong for sure, who is supportive of this position. And Brad has a prescription for what it means... long as you can keep the economy on the upward-sloping rather than the flat part of the LM curve, linear models should be good enough for practical purposes. And the government has mighty fiscal policy and credit policy tools at its disposal that it can use to keep high-quality bonds, even short-term bonds, from going to par. 
Quite! The key in this paragraph is the call for policy makers to use  ‘credit policy tools’ in normal times as an additional component of stabilization policy. What might that involve? In my view, central banks and treasuries must recognize their responsibility to counteract the wild swings in asset markets that are the root cause of financial crises.

Horror! Surely, we should leave the allocation of financial capital to those who know best. The decisions of billions of people, freely contracting in markets, can surely make better choices that a cadre of appointed mandarins who purport to understand the economy  better than the markets. Not so. As I argued in the Guardian last year,
The ratio of the stock market price to cyclically adjusted earnings, the PE ratio, is a highly persistent, volatile process. It has been as low as 5 in the 1920s and as high as 45 in the 1990s. When the PE ratio is above its long run average, an investor can profit from selling the market short. When it is below its long run average, a winning strategy is to borrow money and invest it in shares. But although that is sound investment advice in theory, in the real world there is no private investor with a long enough horizon and deep enough pockets to make those trades. As Keynes famously said: "Markets can remain irrational for longer than you can remain solvent."
What can possibly go wrong with private markets? Quoting again from my Guardian op Ed,
Economic theory teaches us that free trade in markets leads to efficient allocations. But a precondition of that doctrine is that everyone who is affected by trade is free to participate in the market. That condition does not hold in the context of the financial markets. We cannot buy insurance over the state of the world into which we are born.
The problem of excess financial volatility is one that cannot be solved by any individual; but it can be solved by government. The Treasury has the power to make commitments on behalf of future generations. The FPC, by exercising that power on behalf of the Treasury, can make trades in the financial markets that capitalise on the inefficient boom-bust financial cycles that are the source of so much human misery. In this way, the FPC will at the same time stabilise volatility in the market and promote financial stability.
There is a growing awareness that free trade in the financial markets does not lead to Pareto efficient outcomes. And, as we have learned only too painfully; pain on Wall Street leads to pain on Main Street. Monetary policy cannot ensure financial stability and stable prices with only one instrument. We must manage the risk composition of the central bank’s balance sheet as well as its size.