Olivier Blanchard is worried that the Biden administration’s proposed $1.9 trillion covid relief bill is too large and risks igniting unwanted inflation.
Blanchard, a Frenchman, is not exactly a household name but he is one of the world’s leading economists. His work is said to be the most cited of any living economist. He was the chief economist at the World Bank from 2008 through 2015. He’s a professor emeritus at MIT and a Senior Fellow at the Peterson Institute for International Economics.
In other words, he’s a big deal among economists, especially liberal establishment economists sympathetic to the Democratic Party. And that makes his critique of Biden’s spending proposal all the more potent.
Blanchard argues that the hole in the economy created by the pandemic—the output gap, as economists say—is much smaller than $1.9 trillion plus the $900 billion authorized in December. In a blogpost for the Peterson Institute, Blanchard writes that figures from the Congressional Budget Office would imply a shortfall of around $900 billion.
But that figure is “undoubtedly an overestimate of the gap that could be filled by an increase in demand.” Because the pandemic has restrained our economy’s ability to produce goods and services, boosting demand through higher government spending will not necessarily be met with more supply—and the jobs and investment that would go with it. Some things we just are not going to do until the pandemic is behind us.
What’s more, it’s likely that the spending will have a “multiplier effect,” meaning that for every dollar of government spending more than a dollar of demand will be generated in the economy. While conceding that it is hard to estimate exactly what the multiplier will be, he says that it is likely to be enough that the excess demand generated by the $2.4 trillion of spending will be high. And, Blanchard notes, it is likely that as the economy reopens much of the unusually high household savings that have accumulated during the pandemic will be spent.
That extra demand would likely cause prices to rise. In his recent press conference, Fed chairman Jerome Powell agreed that prices would rise but argued that this would not lead to sustained inflation. Blanchard is not so sure. He warns that excess demand would push unemployment to ultralow levels and that, in turn, could lead inflation expectations to change—and that that change in expectations would trigger inflation to rise.
A relevant comparison here is what happened in the 1960s, shown in the figure below. From 1961 to 1967, the Kennedy and Johnson administrations ran the economy above potential, leading to a steady decrease in the unemployment rate down to less than 4 percent. Inflation increased but not very much, from 1 percent to just below 3 percent, suggesting to many a permanent trade-off between inflation and unemployment. In 1967, however, inflation expectations started adjusting, and by 1969, inflation had increased to close to 6 percent and was then seen as a major issue. Fiscal and monetary policies tightened, leading to a recession from the end of 1969 to the end of 1970.
That, in turn, would likely trigger a reaction by the Federal Reserve, raising interest rates. Alternatively, if the Fed did not react, inflation would continue to soar and much of the central bank’s credibility when it comes to price stability would erode.
“If inflation were to take off, there would be two scenarios: one in which the Fed would let inflation increase, perhaps substantially, and another—more likely—in which the Fed would tighten monetary policy, perhaps again substantially,” Blanchard writes.