Olivier Blanchard wants the economy to keep away from “dark corners”:
From the early 1980s on, most advanced economies experienced what has been dubbed the “Great Moderation,” a steady decrease in the variability of output and its major components—such as consumption and investment. There were, and are still, disagreements about what caused this moderation. Central banks would like to take the credit for it, and it is indeed likely that some of the decline was due to better monetary policy, which resulted in lower and less variable inflation. Others have argued that luck, unusually small shocks hitting the economy, explained much of the decrease. Whatever caused the Great Moderation, for a quarter century the benign, linear view of fluctuations looked fine. (This was the mainstream view. 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.)
The Great Moderation had fooled not only macroeconomists. Financial institutions and regulators also underestimated risks. The result was a financial structure 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 realizing it.
Macroeconomic policy also has an essential role to play. If nominal rates had been higher before the crisis, monetary policy’s margin to maneuver would have been larger. If inflation and nominal interest rates had been, say, 2 percentage points higher before the crisis, central banks would have been able to decrease real interest rates by 2 more percentage points before hitting the zero lower bound on nominal interest rates.
The crisis has been immensely painful. But one of its silver linings has been to jolt macroeconomics and macroeconomic policy. The main policy lesson is a simple one: Stay away from dark corners.
Blanchard insists in saying that if nominal rates/inflation had been higher before the crisis, monetary policy´s margin of maneuver would have been larger. Implicitly, he assumes monetary policy is interest rate policy. Few see that the Great Moderation was all about Nominal Stability, under the purview of the Fed. It was nominal stability, in the guise of a stable growth of spending along a level trend path that helped keep the economy away from “dark corners”. In other words, it was not the “nature” of the shocks that changed, but how “good policy” was “good” exactly because it was managed in such a way as to contain the propagation of the shocks (avoid the “dark corners”).
Bernanke´s Fed sacrificed nominal stability in the altar of inflation targeting. The result, as Brad Delong has just defined, was a “Greater Depression”!