Blanchard on Recession, Expansion, and Inequality after Elections

Olivier Blanchard, PIIE


Will the economic program of President-elect Donald Trump lead to a recession or to an expansion? Before the election, many predicted a recession. But last week, markets clearly predicted an expansion.

Who is right? It is obviously hard to tell. Announced programs are never implemented as such. Political realities and the need for support by Congress force minor and major adjustments. It is safe to assume that only those measures not too inconsistent with the views of Paul Ryan, Mitch McConnell, and their own constituencies will see the light of day.

Under this assumption, what happens to the US economy depends mainly on the balance between macroeconomic and trade measures.

On the macroeconomic front, signs point to larger fiscal deficits, as a result of both higher infrastructure spending and corporate and personal tax cuts. (Promises to finance infrastructure spending largely through private funds, and to find savings to offset the tax cuts, must be taken with the usual grain of salt). Tax cuts fit both the Trump agenda as well as the older agenda of supply-siders. The main limits to deficits might be the need to convince those Republicans who see debt as evil to vote for the spending and tax measures.

If deficits take place, they will lead to higher spending and higher growth for some time. And with the US economy already operating close to potential, deficits will lead to higher inflation. If the current relation between inflation and unemployment (the so-called Phillips curve relation) holds, inflation may not increase very much, but it will increase, potentially leading the US Federal Reserve to react by increasing interest rates faster than it intended to before the election.

Will the Fed indeed clamp down on demand and increase interest rates to prevent overheating? While Donald Trump the candidate criticized Fed Chair Janet Yellen for being too dovish, Donald Trump the President is likely to have a different view. Some of his advisers are however more genuinely hawkish, so the new appointments, now and in coming years, may move the Fed in a more hawkish direction. If so, the deficits will have less effect on output and more effect on interest rates.

To the extent that both growth and interest rates are higher, the dollar is likely to appreciate, leading, ironically, to larger US trade deficits, which Donald Trump the candidate indicated he wanted to fight. This leads me to trade issues and trade measures.

A major part of the pre-election program emphasized the use of tariffs to reduce imports and reestablish a “level playing field.” Imposing tariffs on a major scale would decrease growth and make a recession more likely.

The arguments are well known, but worth repeating. Tariffs by themselves may indeed reduce imports, increase the demand for domestic goods, and increase output (although, even then, as pointed out by Robert Mundell more than fifty years ago, the exchange rate may appreciate enough to lead to lower output in the end). But the “by themselves” assumption is just not right: Tariffs imposed by the United States would most likely lead to a tariff war and thus decrease exports. And the decrease in imports and exports would not be a wash. On the demand side, higher import prices would lead the Fed to increase interest rates further. On the supply side, and in my opinion more importantly, the tariffs would put into question global supply chains, disrupt production and trade, and decrease productivity. The effects might be hard to quantify, but they would be there.

Given this, and presumably heavy lobbying by exporters, it is reasonable to think that the Trump administration will go slowly, starting with mainly symbolic measures as a sign of a longer commitment. But one cannot be sure, and things could quickly escalate. When Mexico is asked to pay for the border wall, it may react badly, leading to a tariff war. If and when China is labeled a currency manipulator, it may well react by imposing tariffs on some US goods. And, to return to macroeconomics, as fiscal deficits lead to larger trade deficits, the pressure to reduce them through more tariffs, as misdirected as that strategy is, will likely increase.

So, in the end, expansion or recession will depend on the balance between macroeconomic and trade measures. My own guess is the first will dominate, and growth will be sustained, at least for some time. Will it be enough to satisfy those who voted for Donald Trump, worried about their incomes and their futures? I am not so sure. Growth will indeed lift most boats. But many measures will push in the opposite direction. Lower corporate taxes, lower personal taxes on the rich, and financial deregulation will increase the share of output going to capital (this probably explains in part what is happening to the stock market). The (now partial?) dismantling of Obamacare, if it is to happen, will not help the twenty or so million who benefit from it today. Tariffs on foreign goods may save some middle class jobs but will destroy others and increase the cost of living for those at the bottom end of the income distribution. Inequality may well go up, not down.

Take these remarks for what they are, an early analysis of a still unknown set of measures, all with complex effects. Actual measures will differ, accidents will happen. But predictions of recession were too pessimistic. If macro measures dominate trade measures, we may be in for a Trump expansion, at least for a time.