Let's do a Blanchard, shall we?

In one of Olivier's latest articles he deals with the linear vs non-linear debate in macroeconomics, a debate gone over in the profession ad nauseum. This debate goes back to the original MIT assumption that the economy was not a Weiner (no arbitage) process, but could be modelled as an infinitely divisible Euler approximation.  Of course, the Black-Scholes strike price concept came out in the early 70s, so the issue should have been decided then, it was not.

So Blanchard brings up the idea of "dark corners", which are the points where the Weiner process takes a sharp turn and the economy is no longer adiabatic. These are the points of large contractions, the restructuring moments. He does this resonably well ending with:

Let me offer a pragmatic answer. If macroeconomic policy and financial regulation are set in such a way as to maintain a healthy distance from dark corners, then our models that portray normal times may still be largely appropriate. Another class of economic models, aimed at measuring systemic risk, can be used to give warning signals that we are getting too close to dark corners, and that steps must be taken to reduce risk and increase distance. Trying to create a model that integrates normal times and systemic risks may be beyond the profession’s conceptual and technical reach at this stage.

He does this reasonably well, he has always understood the issues. 

I guess there are a few points. 1) Are mathematicians ready to deploy the general no arbitrage model of aggregate statistics? and 2) Can we use regulations to alter the capital ratios such that the strike price is always adiabatic?

Take the second point first, the proton maintains adiabasis   in a uniform compressed environment. So, theoretically it certainly is possible.  To remain adiabatic means that the Peter Diamond search costs always converge faster than segmentation occurs, this is the essential meaning of strike price.  The search costs become the bandwidth of the economy. They are the driver of the hyperbolic second differential which must be sustained. Most importantly, g, the entire vector g from federal to local, has to converge in its search cost function as fast as any non g portion of the economy. There in lies the problem with Brad Delong's policy tools:

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.

Where going to par means a price mismatch, search costs are not matched to rates. These search costs appear in the second derivative. Unlike Euler, the second derivative is not independent, and has to match the primary ratio and the second derivative. 

How long, for example, does it take the California public sector system to recognize the connection between the stock market prices and local government funding restrictions?  We are not sure yet, this is our first quarter with  a flat stock market, and the union pension funds and local governments still are adjusting. We will not know for another quarter. So right there we see the economic bandwidth limited to two quarters. Then, once that pricing adjustment takes pale the question reverts back to DC, can DC then respond with an adjustment of its loans/depost ratio to accommodate the new setting?  DC needs to have enough savings to adjust its own price discovery as we see in this IMF article:

Our study looks at the experience with fiscal stabilization during the past three decades in a broad sample of 85 advanced, emerging market, and developing economies. The message is loud and clear: governments can use fiscal policy to smooth fluctuations in economic activity, and this can lead to higher medium-term growth. This essentially means governments need to save in good times so that they can use the budget to stabilize output in bad times. In advanced economies, making fiscal policies more stabilizing could cut output volatility by about 15 percent, with a growth dividend of about 0.3 percentage point annually.

Now Obama as performed a genius act of getting us close to 'savings', and he is almost there. The current debt levels are stable, taxes are still rising and the deficit is less than 2% of GDP.  So it may in fact be a 'just in time' process. The public sector will adjust its ratio and Obama will have enough savings to respond.  Or, alternatives, both ends of the g spectrum are close enough that a mild deflation will keep them connected. If not, then we get segmentations and grey bar.