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.