Blanchard on Trumponomics

How will Trumponomics work out? This is a question that many people are asking, including Olivier Blanchard (see here). Blanchard focusses on three broad policy characteristics of Trumponomics: tariffs, tax cuts, and mass deportations of illegal immigrants. His analysis is based on "textbook macroeconomic principles." His conclusion is that the president-elect will be disappointed with the results, but that the outcome will not be the catastrophe that many are predicting. This may very well be the case. But the purpose of this piece is not to question Blanchard's prediction. What I want to do instead is evaluate the reasoning he applies to each policy (a reasoning based on "textbook macroeconomic principles."

Tariffs.

Blanchard predicts that a broad-based tariff policy (if enacted) will cause a decline in U.S. imports and an increase in tariff revenue; at least, in the short run. U.S. demand will shift from foreign to domestic goods and services. Since the U.S. economy is close to full employment, the increase in demand for domestically produced goods and services will manifest itself as inflation. This inflationary burst will likely lead the Fed to raise its policy rate. Higher interest rates will strengthen the U.S. dollar, discouraging U.S. exports. Retatiatory tariffs would reduce the foreign demand for U.S. exports even more. Summary: higher interest rates, higher inflation, little change in the trade deficit, unhappy exporters.

This seems plausible. A broad-based tariff is likely to increase the cost-of-living; at least, in the short run. The rate of change in the cost-of-living (the inflation rate), however, is likely only to jump up temporarily; see, for example, how increases in the Japanese VAT correlate with inflation:

Would the Fed necessarily raise its policy rate against a temporary burst of inflation that was not demand-driven? A case could be made that it should not. Given the recent experience, however, it wouldn't be unreasonable to expect policy to tighten. Blanchard believes that this will cause the USD to appreciate, discouraging U.S. exports. But why wouldn't these discouraged exporters then not try to redirect their sales to the domestic market? If they did, this should put downward pressure on domestically produced goods and services, and downward pressure on inflation. Of course, all sorts of things may happen instead. For example, reduced profit margins may lead to layoffs. I'm not sure how many of these effects Blanchard's simple model takes into account.

Immigration

It is estimated that there are approximately 10M illegal immigrants in the U.S., representing about 5% of the workforce. Blanchard believes that deporting immigrants (say, 1M/year) will lead to an increase in the vacancy-to-unemployment ratio (a measure of the tightness of the labor market) which will, in turn, lead to persistently higher inflationary pressure, leading the Fed to raise its policy rate. Again, higher inflation and interest rates is not what the new administration is looking for.

However distasteful one finds the concept of mass deportations, this is not a new phenomenon in the U.S.; see (source):

What is remarkable about the fact above is how almost nobody talks about it. Why the sudden concern on how the policy might affect inflation and interest rates? Blanchard believes that inflationary pressure and employer resentment will mean the deportations will not happen on a mass scale. While this may turn out to be the case, the rationale Blanchard bases his conclusion is not supported in the data.

Tax cuts

I've expressed concerns over the projected path of fiscal policy for a while now; see here. I've also written on how I believe we've switched from a deflationary-pressure regime to an inflationary-pressure regime; see here. I do not, however, see these concerns as being specific to Trumponomics--a new Harris-Walz administration would not likely have had much an effect on the tectonic forces determining these regimes.

One factor I've not emphasized in my discussions is the prospect of a sustained boom in U.S. productivity. Roger Farmer suggests (see here) that regulatory reforms in the oil and gas sector may indeed unleash a productivity boom. The resulting boom in economic activity would make the growing supply of U.S. Treasury securities more "sustainable" (in the sense that USTs would be more willingly held at lower yields and lower rates of inflation). It is interesting to note that "r less than g" continues to be a property of the U.S. economy, though barely:

I suppose the question boils down to "Whither r v g?"

Does high-interest policy constitute fiscal stimulus?

I haven't had much time to blog lately, but I thought I'd weigh in on an interesting discussion I see brewing in Twitterland. The macroeconomic backdrop of the story is how the U.S. economy grew so rapidly in 2023 in the face of a dramatic increase in the Fed's policy rate. Over the period March 19, 2022 - July 27, 2023, the IORB rose from 0.40% to 5.40% and has remained there ever since. In 2023, RGDP grew at 2.5%. PCE inflation in 2023 came in at 3.7% (a decline from the previous year's 6.5%). The unemployment rate remains low (around 3.5%). What's going on here? What happened to the recession so many were predicting?

One idea floating around out there is that high interest rate policy constitutes of a form of fiscal stimulus. Here's Stephanie Kelton expressing the idea:

And here's my friend Sam Levey suggesting the same thing:

For ears attuned to conventional wisdom, this idea sounds bizarre and counterintuitive. But I think there's a way to reconcile these different views. The first step toward reconciliation is to understand the difference between increasing the interest rate and keeping it elevated. That is, we need to make a distinction between change and level.

I think *changes* in the policy rate seem to work the way conventional wisdom dictates (i.e., lowering aggregate demand through a variety of channels). One important channel works through the wealth effect (e.g.):

Once the policy rate remains stable and the transition dynamics work their way through ("long and variable lags"), the higher policy no longer appears contractionary. In fact, high interest rate policy may very well be expansionary, as Stephanie and Sam suggest. How might this work?

In the class of economic models I work with (e.g., see here), monetary (interest rate) policy and fiscal (tax & spend) policy are inextricably linked through a consolidated government budget constraint. A *change* in the policy rate has all the textbook effects of monetary policy--but only in the "short-run." So, for example, while an *increase* in the interest rate puts downward pressure on the price-level, the disinflationary force is transitory (the P-level remains permanently lower if the policy rate remains permanently higher, but the rate of change of the P-level in the long-run remains unchanged).

At least, this is what is predicted to happen if the fiscal policy framework is "Ricardian." A Ricardian fiscal policy is one in which the path of the primary deficit/surplus adjusts over time to anchor a given debt-to-GDP ratio. A Ricardian fiscal regime is often just assumed in economic models. This assumption seems hard to reconcile with the fact that Congress does not appear to implement offsets to Fed policy. At least, it does not appear to do so immediately. It is, however, possible that the offsets (higher taxes, lower spending) are postponed to the future (perhaps after our representatives become alarmed by posts like Marc Goldwein above).

But there is another possibility. It could be that the fiscal regime is "Non-Ricardian." A Non-Ricardian fiscal policy does not anchor fiscal policy in the way a Ricardian regime does--it does not offset higher interest expense (and higher interest income for bond holders) with higher future taxes and/or lower future spending. To finance the added interest expense, it just lets the Treasury issue nominal Treasury securities at a faster pace. If the Fed keeps its policy rate steady (at its higher level), then this additional flow of private sector wealth is likely to manifest itself as stimulus (higher inflation, if the economy is at full employment). Is this where we're at today?

Of course, the Fed is likely to react to the situation described above by *increasing* its policy rate again. But if fiscal policy is Non-Ricardian, the disinflationary pressure induced by the rate change will eventually dissipate. Indeed, it will result in an even higher rate of inflation in the long-run. This is related to the "Unpleasant Monetarist Arithmetic" argument put forth by Sargent and Wallace over 40 years ago; see here: Is it Time for Some Unpleasant Monetarist Arithmetic? And in case you believe this scenario is only hypothetical, consider this paper on the Brazilian hyperinflation: Tight Money Paradox on the Loose: A Fiscalist Hyperinflation. (Note: this is not to suggest that the U.S. is Brazil.)

As always, please feel free to share your thoughts below.

DA