ILE DE RE, France — When David Lipton, a promising economist, was finishing his graduate work at Harvard in the early 1980s, he faced one of those potentially life-changing choices. He had one job offer from the International Monetary Fund in Washington, the multinational institution that for 70 years has served as a lender of last resort and dispenser of orthodox economic advice to countries that get into financial trouble. There was also an offer of a teaching job from the University of Virginia. Unsure of which path to take, he turned for advice to an intellectually restless and charismatic assistant professor, a Frenchman named Olivier Blanchard.
Blanchard’s terse advice: “David, if you go to the IMF, you’ll be throwing your career away.”
Life, however, takes unexpected turns. On Oct. 1, the same intellectually restless and charismatic Blanchard stepped down as the IMF’s top economist after seven tumultuous years that included the worst financial crisis in a generation, a global recession, a three-act Greek tragedy and the near-collapse of the euro. Over his two terms, Blanchard helped wean the Fund off its obsessions with low inflation, fiscal austerity and unregulated flows of capital, resurrecting the economics of John Maynard Keynes at an institution that the great British economist had helped to create but where more recently he had fallen out of favor.
As one colleague put it, Blanchard “changed the way the Fund looked at the world and the way the world looked at the Fund.” In the process, he helped the IMF pull the global economy back from the brink of another Great Depression.
“He was exactly what the world needed at a crucial moment,” George Akerlof, a Nobel laureate, said of Blanchard’s tenure at the IMF.
Blanchard’s story, however, is not just one about an important but obscure Washington-based institution. Nor is it a merely personal tale of a once radical French youth who became one of the most influential economists who most people have never heard of. It is also the saga of an economics profession whose pretense to science has been badly undermined by ideological divisions and a series of crises that it failed to anticipate or even comprehend. Blanchard’s tenure at the IMF has capped a lifelong effort to restore economics as a disciplined way of thinking about the world that is truthful, intuitive and useful.
“Olivier is one of those rare academics who deserve to have a license to practice,” said the IMF’s first deputy managing director, the second in command, sitting in the Fund’s headquarters on Pennsylvania Avenue. “The world is full of economists who are willing to believe only what they can prove. We don’t have that luxury here. What we do has to be based not just on what we know but on our judgment about what we don’t know. Let’s just say we came to trust Olivier’s judgment.”
That deputy director? David Lipton.
As one of the world’s leading macroeconomists, and for 25 years a mainstay at the star-studded economics department at the Massachusetts Institute of Technology, Blanchard was an obvious choice for the twin job of research director and economic counselor. Twice before he’d been offered the job when Stanley Fisher, his MIT mentor and colleague, was first deputy managing director. And twice he had turned it down.
But when Dominique Strauss-Kahn, the Fund’s new managing director, called in spring 2008, Blanchard was more than a little intrigued. Strauss-Kahn was a fellow Frenchman and a graduate of the same French university. As the leading Socialist candidate to be the next president of France, he had the stature and political skills that were crucial in dealing with the presidents, prime ministers and treasury secretaries who ultimately call the shots at the IMF, which was established in 1946 at an international conference at which Keynes was a central figure. Strauss-Kahn promised Blanchard an activist agenda along with a more visible and important role for the research department and its director. No less important, he had the charm and good sense to woo Blanchard’s wife, Noelle, who had grown to enjoy the comfortable academic life in Cambridge.
“He’s a politician, so within two minutes he’s your best friend,” Blanchard said.
Blanchard remembers his first months in Washington as “confusing, exciting, frustrating,” as increasingly desperate world leaders searched for a way to contain the financial and economic contagion that had spread quickly from the United States to Europe and the rest of the world. With the IMF providing much of the economic analysis, leaders of the major economies set aside their previous concern about budget deficits — one that had also become a fixation of the IMF — and committed to increase government borrowing and spending to prevent a global depression. It was exactly the advice Keynes had given to skeptical world leaders in the 1930s.
“We knew that 1 percent stimulus was not enough, but 3 percent we probably couldn’t sell, so we went with a recommendation of 2 percent,” Blanchard recalled.
In an alignment that would become all too familiar over the next seven years, the United States and Britain, backed by the IMF, pushed for more economic stimulus and more aggressive action to rescue banking systems, only to meet resistance from European leaders concerned about runaway deficits and the political backlash from bank bailouts.
The one place European leaders were anxious for a bank rescue, however, was in Ireland, where by fall 2008 banks were already reeling from losses after the bursting of a giant real estate bubble. The Irish government had nationalized one big bank and bailed out several others, but the cost proved so high that two years later the government itself was on the verge of defaulting on its own debts and turned to the international community for help.
The IMF had convinced Irish officials that, as part of any rescue package, those who had lent money to the banks should be forced to share in the pain. But Jean-Claude Trichet, head of the European Central Bank and a key player in any rescue plan, was adamant that there be no “haircuts” for bank creditors.
Trichet’s motivation was not surprising. The biggest creditors of the bankrupt Irish banks were French and German banks that themselves could go under if forced to recognize such losses, requiring costly and unpopular bailouts from their own governments. He also feared that any debt restructuring, as it is politely called, might make it difficult and more expensive for other European banks to borrow. Trichet went so far as to threaten to cut all central-bank lending to Irish banks if their debts were restructured, the equivalent of a death sentence for the Irish banking system.
With no other options, Ireland agreed to guarantee all of its banks’ debts, paying for it with a $67 billion international loan package whose harsh terms would drive the Irish economy into a deep recession and saddle a generation of Irish taxpayers with the full cost of repayment.
Strauss-Kahn, desperate for the Fund to play a visible role in the crisis, agreed to go along with the terms of the bailout. In rationalizing its participation, the Fund was forced to issue what Blanchard and his colleagues knew were unrealistically optimistic predictions about the quick recovery of the Irish economy. It would not be the only time the Fund would buckle to political pressure from European governments that are among its largest shareholders.
“We were in a difficult position calling attention to the fact that the European banking system may have been insolvent,” Strauss-Kahn said in an interview from Morocco. “It was not our job to cause bank runs. Olivier’s intellectual authority on that matter was particularly helpful, if not totally successful.”
With the economies of the United States and Europe in trouble, global investors rushed to move their money to developing countries where they saw better prospects for higher returns. But developing countries had learned from painful experience that such waves of “hot money” often came with unwanted side effects — higher exchange rates, overheated economies, oversize banking systems and bubbles in stock and real estate markets.
To deal with such consequences, a number of countries considered steps to control and limit such capital flows. However, at the IMF, which had championed the cause of global free markets for decades, such controls were viewed with great skepticism. After the Asian financial crisis in 1998, the IMF issued what amounted to begrudging acknowledgment that, under certain circumstances, capital controls might be justified. But in practice, that view had never been fully embraced.
Blanchard set about to change that. In early 2010, the research department began churning out studies showing the dangers created by hot-money flows and cataloguing successful experiments to control them. Although labeled “staff discussion notes,” such studies are often viewed as statements of Fund policy, and publishing them required the acquiescence of other, more powerful departments that were also staffed by economists who didn’t appreciate the interference on their turf.
“At times, it was like trench warfare,” Blanchard said of the bureaucratic wrangling over capital controls. “It was exhausting.” In the end, the IMF declared that a country might consider capital controls, but only after it has tried a dozen other strategies — and even then only if they were drawn so as not to favor domestic investors over foreign ones. But within the Fund it was an early, if partial, victory for Blanchard. The Fund would eventually lend its imprimatur to capital controls in Brazil, Iceland and Cyprus.
What Blanchard learned was that to prevail in a large, entrenched bureaucracy such as the IMF, being the best economist, presenting the best argument or the most compelling data, was not enough to win the day — you also needed allies. He began meeting regularly and informally with directors and staff in other departments, along with influential members of the IMF’s board of directors, in an attempt to win converts for his less orthodox policy ideas.
Under Blanchard, the research department gained a seat at the table where IMF decisions were made. Strauss-Kahn said that at his meetings with top lieutenants, Blanchard “very quickly took the lead, and his opinion prevailed eight out of 10 times.”
In his own shop, Blanchard pushed the 100 staff economists to be less academic and focus their research on questions of immediate concern, with answers to be delivered in a month, a week or even over the weekend. By all accounts, he raised the bar on the quality of IMF research, demanding more rigor in the analysis, along with greater clarity. When one of his colleagues hit a dead end, Blanchard was not above taking out pencil and paper and spending an evening writing out a mathematical model — not the kind of thing research directors traditionally do.
Strauss-Kahn had charged the research department with joining the urgent global debate over income inequality. Blanchard was initially skeptical of the preliminary analysis showing that countries with more inequality experienced slower growth. He worried that the correlation was too weak, or too dependent on a handful of unusual cases, and he suspected that it was just as likely that slow growth caused inequality as the other way around.
It took several years to persuade him, but Blanchard finally signed off on a paper concluding that inequality was an important factor in economic growth rates, with high levels of inequality resulting in growth that is likely to be “low and unsustainable.” The researchers also found no evidence that the level of government redistribution typically found in Europe or North America had any adverse impact on growth rates. Now widely cited and often downloaded, the paper has become the touchstone for what Jonathan Ostry, its lead author, only half-jokingly calls the “kinder, gentler IMF.”
Meanwhile, Blanchard had raised eyebrows when he suggested that the Federal Reserve and other central banks aim for inflation rates of 4 percent rather than the 2 percent target now commonly used. Inflation and easy money are not the sorts of things one usually associates with a conservative financial institution dedicated to ensuring that lenders are repaid and currencies retain their value. But in an era of slow growth and frequent financial crises, Blanchard argued, higher inflation and interest rates in good times would give central banks more headroom to cut rates in bad times to stabilize economies.
“There’s nothing scientific about 2 percent,” Blanchard said. “It comes from nowhere. It’s completely made up.” Although academic economists have been intrigued, central bankers have not been rushing to pick up on his very Keynesian idea.
“We’ve seen a sharp U-turn in the way the Fund views policy, toward more activism and a deep questioning of some pretty established bits of dogma, things we thought true and obvious,” said Ostry, Blanchard’s deputy, who arrived at the Fund in 1988.
As Nobel Prize winner Joseph Stiglitz put it: “Olivier’s played an important role in opening up the Fund to a whole new set of ideas.”
Justin Wolfers, a hot young economist, vividly recalls the first course he took from Blanchard at MIT: “It was about unemployment, and the class was completely oversold. Every corner of the room was packed. The lectures were flawlessly given. To a first-year graduate student, it was profoundly intimidating.”
“Intimidating” is how many people describe their first impression of Olivier Blanchard.
“He struck me as smarter than me,” Ken Rogoff said of meeting Blanchard when both were graduate students at MIT. Rogoff, another former research director at the Fund, is a chess grandmaster when not teaching at Harvard.
“I was struck with how rigorous he was,” said Lawrence Summers, the former treasury secretary who met Blanchard while a graduate student at Harvard. “He required that things be stated with precision.”
The other description you hear is “direct.” “Extremely polite but extremely direct,” a Fund colleague says.
Several years ago, Wolfers — who would go on to write his thesis under Blanchard — published a paper that, for him, was uncharacteristically theoretical, mathematical and complicated. As Wolfers acknowledged, “it was a bit more about flexing intellectual muscles than saying something true or important about the world, which is the folly of young economists. Shortly afterward, I got a note from Olivier: ‘I saw this paper. I don’t care for it.’ It was an incredibly generous thing, taking the time to tell me that I wasn’t being true to myself.”
Andrei Shleifer tells a similar story of when he was an undergraduate and thought he had discovered a mistake in a famous paper by a top economist. He wrote down dozens of pages of notes and mathematical calculations and sent them to Blanchard. Three days later, Blanchard called and asked him to come by.
“He had read them,” Shleifer said. “He understood that I was wrong, and he was really very, very sweet in pointing out exactly why.” Shleifer, a Harvard professor, remains a close friend of Blanchard’s. “Unless you know the sweet part, he can be very intimidating.”
Many friends and colleagues remark upon this hard-on-the-outside, soft-on-the-inside quality. At MIT he was a generous and loyal mentor to students and younger faculty members; at the Fund he made it a point of lunching regularly with interns and junior staff. On take-your-child-to-work day, he once used dominos to explain financial crises to young would-be economists. His farewell party at the Fund in July drew an overflow crowd of more than 500.
Scott Simon, the NPR radio host, describes Blanchard as a concerned father and doting grandfather who’s always up for a game of ping-pong with neighbors when lounging at the pool at the Watergate apartment complex where they both live. (“If he weren’t French, I’d say he put a lot of English on the ball,” Simon said.)
There are in Blanchard’s outward reserve, natural elegance and wry humor strong hints of the French professional class from which he came. His father was a neurologist and pediatrician, his mother a psychiatrist. His grandfather, Maurice Bokanowski, had been minister of the navy, industry and commerce and aviation in the French government after World War I, in those days unusually visible positions for a Jew. He died in an airplane crash in 1928.
By his own account, Blanchard was an indifferent student, “smart but uninterested.” When he dropped to the bottom of his class in middle school, his parents sent him to boarding school in the French Alps before he returned home to attend a Jesuit high school. His grades, however, never improved enough to gain admission to one of the “grandes écoles” that still serve as gatekeepers to the French economic and political elite.
Two things happened while Blanchard was at the University of Paris-Nanterre that would shape his professional life.
One was 1968 student riots that shut down the universities and prompted pitched battles in the streets of Paris as police stormed the student barricades. Blanchard, who was in the thick of it, found it “incredibly exciting intellectually.” But in time he also found the internal struggles among the Maoists and Trotskyites and anarchists tiresome and unproductive. His distaste for pitched ideological battle would later shape his approach to economics.
Also at Nanterre, he developed a fascination with economics and the ways in which it could be used to make the world a better place. It came, unexpectedly, while he was laid up in bed with a long illness, reading a book on the history of economic thought. But as he would quickly discover, the course of study in economics at most French universities was “abominable,” too often given over to “high mathematical abstraction or Marxist rhetoric, with little connection to reality.” To win his master’s degree in economics, he submitted what he describes as “a typically French thesis at the time, 200 pages of largely nonsense with math in it.” It was good enough, however, to earn him the highest grade at Nanterre that year and admission to the PhD program at MIT.
For an economics student, being admitted to the economics program at MIT in the late ’60s and early ’70s was like a young baseball player being drafted by the New York Yankees of that era. The paterfamilias was Robert Solow, the Nobel Prize winner, assisted by Stan Fisher, Franco Modigliani (another Nobelist) and Rudi Dornbusch. Today, their students constitute a who’s-who of the world’s top academic economists and policymakers: Nobelists such as Akerlof, Stiglitz, Peter Diamond, Paul Krugman and Jean Tirole; former Fed chairman Ben Bernanke; and Mario Draghi, the current president of the European Central Bank.
“Olivier was just less nerdy and uncool than the rest of us,” Krugman recalled.
After graduation, Blanchard had teaching offers from Yale, Princeton, Berkeley, Stanford and Harvard. It was only after he’d trekked to the other side of Cambridge that Blanchard realized there is nothing more lowly than an assistant professor at Harvard. The only office he could scrounge up was a converted bathroom with no furniture, forcing him to beg, borrow and ultimately steal the bare essentials from other offices.
It’s not clear whether Blanchard would have earned tenure from the notoriously stingy Harvard Economics Department. It probably didn’t help that he had written an op-ed for the New York Times with a graduate student named Jeffrey Sachs saying that, after adjusting for inflation, federal budget deficits weren’t particularly large or troubling. In response, a prominent alumnus wrote a letter to the Times suggesting both men be denied permanent tenure. But when an offer of a tenured position came from MIT, Blanchard didn’t wait for an answer from Harvard. (Sachs, however, went on to become one of the youngest ever to get tenure from Harvard.)
During 25 years at MIT, Blanchard rose to become department chairman, co-edited the country’s top-ranked economics journal, published a widely used textbook and was consistently rated among the department’s most popular teachers. He also mentored a younger generation of star economists. Blanchard is ranked first in the world for the number of citations his students have received for articles published in top economics journals. (For his own articles, he is ranked No. 11.)
“An economist’s economist,” said Richard Thaler, a leading behavioral economist at the University of Chicago.
According to colleagues and students, what distinguishes Blanchard from other economists is his ability to simplify seemingly complex problems.
“Clarity of expression, clarity of mind,” is how Solow puts it. “There’s a neatness about his mind that stands out. Nothing extra.”
“Elegant, simple, logical, intuitive,” says Maury Obstfeld, Blanchard’s MIT classmate and successor as the IMF’s chief economist.
Among economists, there are those who are good at theory, empiricists who focus on real-world data and policy wonks who try to figure out how to make economies perform better. Blanchard is the rarity who does all three — an “all-rounder,” according to Simon Johnson, his predecessor at the Fund and a former student.
“He was the kind of economist I most admired and tried to emulate,” said Harvard’s Greg Mankiw, a former student who went on to become top economic adviser to President George W. Bush.
In a profession in which reputations are made by mastering subjects that have become increasingly narrow and technical, the variety of topics Blanchard has studied and written about is extraordinary. Indeed, it is because of that breadth that Blanchard acknowledges he is unlikely to win a Nobel Prize. “I did not fundamentally change our view about anything,” he said, wistfully but with no sign of regret. “I tried to provide useful insights on many things rather than obsessing about one.”
A few days later, perhaps thinking of that exchange, Blanchard sent an e-mail saying that he had been rereading a book written by his psychiatrist mother and came across a sentence that she had written about her work that summed up his own approach to economics:
“I am not a guru or a magician. I think of myself as an artisan.”
As he has every summer since high school, Blanchard returned this year to the island of Re off the Atlantic coast of France, west of Bordeaux. Once a working-class enclave, Re has since become the Martha’s Vineyard of France, with high-speed trains from Paris whisking much of the 5th and 16th arrondissements to their August vacations along the salt marshes and oyster farms that dot the island.
Long before the sun is up, Blanchard has been checking on the overnight gyrations of the Chinese stock market and editing the latest drafts of the IMF’s annual World Economic Outlook sent by his staff. By 10, he may be playing tennis with his old friend Lionel Jospin, a former professor and prime minister of France. Afterward, he’ll change into his signature khakis, blue shirt and boat shoes and head off to Le V, the small cafe overlooking the harbor, for a coffee with his brother or the regular gaggle of French civil servants, lawyers, businessmen and journalists who gather there.
Nearby, at the open-air market, Noelle gathers the makings of a picnic lunch they’ll have after bicycling to one of the island’s many beaches. Late afternoons, the lanky economist can invariably be found playing a few rounds of pétanque, the French bowling game, as the sun sets over the nearby dunes. On many nights there will be an informal dinner around the large pine table with old friends and visitors at his townhouse, with the view of an old windmill in the distance.
To some of his countrymen, Blanchard seems at times to be more American than French. Aside from summers in Re, he has lived in the United States for more than 40 years. He’s raised and educated his three daughters here: One now works for the State Department, another manages a restaurant in Brooklyn, where the third is an interior designer. He prefers watching American football to European soccer (“It’s like playing chess but with a physical aspect. Each play is such a beautiful thing,” said the Patriots fan.) And given the intractably ideological nature of French economics and the rigid hierarchy of the academic profession there, he’s never given much thought to returning home. After the IMF, he’ll remain in Washington as senior fellow at the Peterson Institute, the preeminent think tank for international economics.
Yet there is still an unmistakable French accent to Blanchard’s speech, thought and manner. He will tell you why French universities are mediocre, why the 35-hour workweek is a terrible idea and why excessive job security increases French unemployment. He can list the ways French politics and culture have gone stale. Yet when an American offers such criticisms, he is quick to defend his native country.
Ken Rogoff remembers that at a conference years ago, a conservative American economist presented a paper mocking the French for taking summer vacation all at the same time, undermining productivity. When he was finished, Blanchard rose to say that actually, he found it pretty great having all your friends go on vacation the same time you do.
“I think I’m totally French,” he said, “only maybe a bit less cynical.”
In August 2008, the prestigious National Bureau of Economic Research published a paper assessing the state of macroeconomics — the study of the entire economy rather than any one part of it. The paper reviewed how the Keynesian consensus that had dominated economic thinking in the 1950s and ’60s had given way to sharp theoretical, methodological and ideological divisions in the 1970s, and how a burst of fresh thinking and research was on the verge of creating a new consensus. “The state of macro is good,” concluded the author, Olivier Blanchard.
The timing could not have been worse. Six weeks later, Lehman Brothers collapsed, triggering a financial meltdown and deep recession that few economists predicted, fewer still understood and many had thought were no longer possible. “How Did Economists Get It So Wrong?” asked Paul Krugman in a New York Times Magazine essay.
In truth, Blanchard’s article was far more nuanced than the self-congratulatory declaration that Krugman had suggested. But for Blanchard, who had spent the better part of his career helping to build the new consensus, the crisis had not only revealed the inadequacies of what had been done so far but raised questions about whether it was possible to come up with one all-purpose economic model.
It was at a conference organized by the Federal Reserve Bank of Boston in 1978, just as Blanchard was setting out in his career, that the revolution against the old Keynesian consensus was launched.
“That the predictions [of Keynesian economics] were wildly incorrect, and that the doctrine on which they were based was fundamentally flawed, are now simple matters of fact, involving no subtleties in economic theory,” wrote two brash young economists, Robert Lucas and Thomas Sargent.
According to Lucas and Sargent, the 1970s stagflation — high inflation and high unemployment — had undermined the theoretical underpinnings of the Keynesian economic framework, which held that the two could not coexist. The pair also asserted that people’s economic behavior was not primarily driven by fear and greed — “animal spirits,” as Keynes had called them — but by rational calculation of what would happen in the future.
These observations led Lucas, Sargent and their followers to a wholesale rejection of Keynesian economic policies. In their view, recessions were not things to be prevented or shortened — rather they were the natural and healthy adjustment and self-correction that markets go through in response to sudden and unexpected changes in technology.
Moreover, even if government were to try to smooth or speed these adjustments by lowering interest rates or increasing government spending, these traditional Keynesian tools would not work in stimulating spending and investment. Instead people would see through these manipulations and ignore them, knowing that they would have to pay higher taxes or higher interest rates in the future.
The “New Classical” economists, as they came to be called, also had a methodological beef with the Keynesians. Keynesian macroeconomic models were based solely on data about how the economy had performed in the past, without any theory or explanation for why people behaved the way they did. For such models to be truly scientific, the revolutionaries argued, they needed to rest on logically coherent theories on how each of the individual parts — labor markets, product markets, financial markets — of the economy operated. “Microfoundations” they called them.
Solow, who was at the Boston conference that day, was as dismissive of Lucas and Sargent as they had been of the Keynesian consensus. But his MIT colleagues Fischer and Dornbusch had already acknowledged that there was some truth to the critique and set out to find ways to incorporate “rational expectations” and “microfoundations” into the Keynesian model. Blanchard would join them a few years later and eventually become a central figure in that effort.
“The MIT tradition was to model people as rational, but only up to the point where it conforms to what we see in reality,” Krugman said.
Starting with smaller “micro” models, the MIT gang began to show the various ways in which market competition was less than perfect — and that because of these imperfections, wages and prices did not always adjust quickly enough to bring supply and demand back into balance. It was this “stickiness,” they argued — not technology shocks — that explained why recessions happened. And because these imperfections prevented markets from self-correcting, government fiscal and monetary policy not only could be effective but were necessary for getting the economy back on track.
In the end, these “New Keynesians” arrived at the same policy conclusions as the old ones had, only this time by a different and more rigorous route. Blanchard contributed a number of key insights and tools to that effort.
In one paper with Nobuhiro Kiyotaki, now at Princeton, Blanchard showed how prices do not readily adjust in markets where competition is dominated by a few large firms, resulting in large fluctuations in the economy’s overall demand for goods and services. An early paper with MIT colleague Peter Diamond on frictions in the labor market showed that it was an overall pullback in spending rather than technology shocks that account for most spikes in unemployment. With Summers, Blanchard showed why the structure of union wage bargaining might explain the slow, steady rise of unemployment rates in Europe during the 1980s. A 1992 paper with Harvard’s Larry Katz showed that the way regional economies respond to rising unemployment is not that wages fall, as classical theorist had assumed, but that unemployed workers simply move to other regions. It was among the first papers to question the wisdom of a common currency in Europe, where workers are permitted to move across borders but don’t.
But while economists at MIT, Harvard, Berkeley and other “saltwater” schools would spend the next 20 years trying to incorporate market imperfections into their macroeconomic model, Lucas, Sargent and their followers at “freshwater” schools such as the Universities of Chicago and Minnesota stormed off in the opposite direction. By assuming that markets were perfectly competitive and self-correcting, they were able to devise models that were logically elegant and internally consistent — and also fundamentally at odds with what most people observed or experienced or how economies had actually behaved. As one of Lucas’s students, Paul Romer, explained in a recent series of blog posts, they simply “retreated from scientific engagement with any macroeconomist who disagreed with them and gave up on such basic scientific principles as using evidence to evaluate models.”
As a result, the economics profession found itself divided into two intellectually warring camps that Blanchard, in his 2008 paper, likened to the Bolsheviks and Mensheviks of the Russian Revolution. Members of the two economic camps rarely talked to each other, contributed to each other’s journals or hired each other’s graduate students.
“It was religion, just like the Trotskyites and the Maoists back in Paris,” Blanchard said. “I’ve tried to stay away from that.” But even he acknowledges it was not always possible to avoid the tribalism of a profession that now offered the world two incompatible and incomplete frameworks for thinking about economic activity.
By early 2008, enough progress had been made in refining each of these models that Blanchard and others saw signs of an emerging consensus — one that might yield a single model of the economy that was at once theoretically sound, empirically grounded and reliable for forecasting. But their optimism was short-lived. A financial crisis and global recession would upend much of what they thought they understood.
“It was a humiliating lesson for the profession,” said Blanchard’s IMF colleague Gian Maria Milesi-Ferretti.
For starters, the crisis revealed that “even the New Keynesian models had relied too much on rational expectations,” said another former student, Adam Posen, who as president of the Peterson Institute will be Blanchard’s new boss. In that respect, Keynes was right all along: In times of turbulence, people act emotionally, not on the basis of rational calculation of future events.
The models were also based on an overly simplistic view of the financial system — not just how it works, but also the interplay between finance and the rest of the economy.
“We ignored the financial plumbing,” Blanchard said. “We thought we could model it with a few simple equations,” he explained, based on what turned out to be false assumptions about the ready availability of buyers and sellers and the easy substitution of one financial instrument for another.
Another problem was “linearity.” In nearly all macro models, the relationship between cause and effect is assumed to be regular and smooth — that for every X percent change in one thing, there is a Y percent change in another. But what the crisis reminded economists is that there are times when relatively small shocks — a modest decline in housing prices, for example — can lead to outsize consequences. Sometimes markets reach tipping points at which prices or activity can suddenly take off or crash. At other times, feedback loops take hold in which selling begets more selling that begets still more selling, creating a self-reinforcing dynamic that does not easily self-correct or return to some stable equilibrium.
Incorporating this kind of complexity and nonlinearity makes macroeconomic models difficult to construct and to use, but by assuming them away — by ignoring what Blanchard called the “dark corners” — economists allowed themselves to be blindsided by the financial crisis and the prolonged recession that followed.
Perhaps most fundamentally, the crisis raised serious doubts about the ambitious project that Blanchard and others macroeconomists had been working on for close to 50 years: developing a single, scientifically based model that could be used at all times for all circumstances. To skeptics inside and outside the profession, it was becoming clear that, despite all the gains in computing power and mathematical technique, economies were so complex that the search for one big model was quixotic. As economist Dani Rodrik suggests in a new book, “Economics Rules,” perhaps the best that can be hoped for is for a good set of smaller models — along with economists such as Blanchard who have the experience and intuition to know which ones to use in any particular situation.
While acknowledging the immediate need for better, smaller models, however, Blanchard seems unwilling to give up the quest for something bigger and more ambitious. “We need all kinds of models,” he said.
The prime minister was not pleased.
It was April 2013 and Blanchard was in London, giving a live interview on Sky News. Earlier that year, the IMF had lowered its growth forecast for Britain, citing the negative impact of deep budget cuts that were at the heart of the economic program pushed through by Chancellor of the Exchequer George Osborne. Now here was Blanchard declaring that by continuing to pursue a policy of fiscal austerity, Britain was “playing with fire.”
“The danger of having no growth, or very little growth, for a long time is very high,” Blanchard told the TV interviewer. “You get a number of vicious cycles that come into play.” He recommended that the government dial back on its austerity program.
It wasn’t long before the phone was ringing back in Washington in the office of Christine Lagarde, the Fund’s new managing director. Britain’s David Cameron was on the line.
“There were strong interactions” is all that Blanchard will now say about the ensuing conversations, an impish grin appearing on his expressively lined face. In the end, however, Cameron and Osborne cut spending less than originally promised and economic growth rebounded more than the IMF had predicted, allowing both sides to claim they were right.
Blanchard’s foray into British politics was part of larger campaign on his part to restore Keynesian policies to their rightful place and discredit the notion that reducing budget deficits can pull economies out of recession. The idea had been first proposed in a 1998 paper by Italian economists Alberto Alesina and Silvia Ardagna and represented a wholesale rejection of the Keynesian idea that governments should temporarily borrow and spend more during recessions, when consumers and businesses are spending less. Using selective evidence from several countries, Alesina and Ardagna theorized that any economic drag that would come from cutbacks in government spending would be modest and would be more than offset by the extra confidence that businesses and investors would get from credible plans by government to put its fiscal house in order.
Blanchard, in fact, had once defended the idea of “expansionary austerity,” but he limited it to circumstances in which previous governments had been reckless in their spending and now presented credible plans for reining it in. But such conditions did not apply to Britain, Germany and the United States. So beginning in 2011, Blanchard’s research department began churning out a series of studies showing that, in most advanced countries, fiscal austerity was a bad idea.
One, authored by Blanchard and a young colleague, Daniel Leigh, showed how economists had systematically underestimated the negative effects of austerity by using standard assumptions that a dollar in government spending cuts reduced economic activity by 50 cents. But Blanchard and Leigh found that in countries that were already in recession, and in which the central-bank intervention was limited by the fact that interest rates were already at zero, the “multiplier” turned out to be much higher: A dollar of belt-tightening could result in more than a dollar of lost output.
Another study found that in advanced nations, it would be better to let the country gradually grow out of its high debt levels than to try to pay down the debt by belt-tightening.
Within the IMF there were still pockets of resistance, but in time Blanchard and his Keynesian allies prevailed. “Olivier won the economic argument on balancing austerity and growth,” Lipton says. “The only arguments left involve politics and diplomacy.”
Nowhere did the austerity debate grow more heated than in the five-year struggle to find a solution to the financial and economic crisis in Greece.
At the outset of the crisis in 2010, Blanchard and his allies had failed to convince European officials — and even some of his IMF colleagues — that imposing too much austerity too quickly would be counterproductive. They were equally unsuccessful in pushing for restructuring of Greece’s 300 billion-euro debt by forcing lenders to accept less than they were owed. As in Ireland, French and German banks held large quantities of the outstanding bonds, making any restructuring a potential threat to the solvency of the European and American banking systems. And with the fallout from Lehman Brothers still fresh in everyone’s mind, Jean-Claude Trichet and his colleagues at the European Central Bank remained insistent that forcing investors to take a “haircut” on their Greek bonds would trigger panic selling of the bonds of Italy, Spain and Portugal.
The IMF agreed finally to participate in the initial 110 billion-euro Greek rescue that Blanchard and many of its officials believed was doomed to fail. To justify its own loan of 30 billion euros, the IMF had to argue that the structural reforms being required of the government — deregulation of labor and product markets, an overhaul of the pension and tax collection systems, the sale of government-owned monopolies — would provide such an immediate boost to the Greek economy that they would offset the negative effect of budget cuts in government spending equal to 10 percent of GDP. The official forecast of a short, mild recession was so improbable that few inside or outside the Fund really believed it.
At the tense meeting to consider the Greek loan, IMF directors were also told they would have to break their own rule that prevented them from making loans that were unlikely to be repaid, creating a new loophole in cases where there were risks to the global financial system. As the meeting was drawing to a close, one skeptical director asked John Lipsky, the first deputy managing director, what the Fund’s “Plan B” was if Greece was unable to pay back the loan.
“There is no Plan B,” Lipsky shot back, according to an exhaustive report on the behind-the-scenes maneuvering, written by Paul Blustein of the Center for International Governance Innovation (and a former Post reporter). “There is Plan A and a determination to make Plan A succeed.”
Blanchard was now keenly aware of the tension faced by all policymakers between what is ideal and what is possible. “I was sure the debt was not sustainable, but we felt we had no other choice but to take the political constraint as given and go along with a package we were rather skeptical about,” Blanchard said.
While the bailout allowed Greece to avoid a default, the Greek people would wind up paying a steep price. Income and economic output would shrink more than 20 percent, while unemployment would rise to 27 percent as even more debt was piled on debt. For European voters and their politicians, this seemed like a fitting outcome for a profligate country with an uncompetitive economy and a government so corrupt and incompetent that it could not even collect the taxes it was owed. What was never mentioned, at least in public, was that in bailing out the Greeks, European governments were really bailing out their own banks.
Within a year, Trichet was gone from the ECB, the threat of financial contagion had receded and the IMF had resumed its behind-the-scenes campaign to push for a restructuring of Greek debt. With a new plan in hand, Strauss-Kahn headed to Europe to try to persuade political leaders to take a new approach to Greece. He never made it. En route, he was arrested in New York for allegedly sexually assaulting a hotel maid, a charge he denied and for which he would never be convicted — but that led to his resignation from the IMF.
Strauss-Kahn’s replacement was Lagarde, who in her previous role as French finance minister had vigorously opposed any consideration of debt restructuring. As a non-economist, she came to rely heavily on Blanchard’s advice and soon became a convert to the cause of Greek debt relief. The following year, a restructuring was announced that cut the value of outstanding Greek bonds by more than half.
Unfortunately, it proved to be too little, too late. The Greek economy was on its back, and Greek politicians and voters were in no mood to push ahead with the structural reforms they had promised. Although the previous government had pushed through many of the required spending cuts, the deficit remained stubbornly high because the deep recession had reduced tax revenue and increased the number of Greeks qualifying for assistance. Greece was again on the verge of default as a new left-wing government demanded not only relief from fiscal austerity but further debt relief as well. And once again, Europe offered another loan package requiring continued austerity without any debt restructuring.
Only this time, the IMF refused to go along. In June, Blanchard used a blog post to declare that no rescue would succeed unless Greece was granted additional debt relief in the form of lower interest rates and a lengthy moratorium on repayments. The following month, an IMF review of the Greek program criticized the government for failing to make good on its promises of structural reform but acknowledged that the imposed austerity had been overly harsh, that the forecasts had been overly optimistic and that Greek debt was now unsustainably high. In August, Lagarde confirmed that the IMF would not participate in the new round of funding unless it was accompanied by substantial debt relief. New talks have begun, and the betting now is that some sort of restructuring is inevitable.
As crucial as debt relief may be, however, it will not be a silver bullet. Defending the IMF’s handling of Greece, Blanchard warned in the blog post that even if all of its debts were wiped out — an unlikely scenario — the Greek government would continue to run significant deficits requiring fresh loans that nobody is willing to provide without a credible and enforceable plan to restructure its economy and bring the budget into balance.
For an academic who had spent a career searching for economic truth, having to reconcile the supposedly scientific insights of economics with political and bureaucratic realities proved even more challenging than Blanchard had anticipated. What he found most surprising, he said during a relaxing moment on Re, was how quickly a consensus can develop around some question on the basis of what decision-makers read in the press or hear over dinner. People on the outside, he said, have no idea how much time and energy is spent responding to or anticipating the reaction of the media and critics.
“There’s a big risk of people agreeing on something without thinking about it or doing the hard analysis,” he said. In the face of incomplete information and genuine uncertainty, he said, it was disquieting “how easily bad ideas become entrenched.”
“It’s a strange process,” he mused, but one he is likely to miss.
Pearlstein is The Post’s economics and business columnist. He is the Robinson professor of public affairs at George Mason University.