CF40 Interview with Olivier Blanchard: Tariff Shock and the EU's Opportunities
Olivier Blanchard is Senior Fellow at the Peterson Institute for International Economics (PIIE), and Robert M. Solow Professor of Economics emeritus at the Massachusetts Institute of Technology (MIT).
Q: If there is only one major topic in the world economy this year, it might be Donald Trump 2.0 and the tariffs. How would you summarize the disruptions to global economy, trade and production from President Trump’s tariff policy to date?
Prof Blanchard:
You’re right that the main issue for the world is the actions of President Trump on tariffs and trade. I thought that the effect would be more disruption than actually has happened.
I thought that it was not so much the level of the tariffs, but the uncertainty associated with the change of positions one day to the next, which would lead many firms to think about investment and say, “we don't know what's going to happen, so let's just wait”. Among economists, we call this the “option value of waiting”, and it makes a lot of sense for a firm to do that. You wait 6 months to take a decision, but if it's a decision which is going to affect you for 20 years, you probably want to wait.
Surprisingly, at least for me, the effect has been relatively small. The investment in the U.S. has done decently, and growth is quite good. As for the rest of the world, if you're a foreign exporter to the U.S., you would think twice about what's going to happen. And although the effect has been there, it is not major, except for a few countries, for example Vietnam.
We can come back to inflation and various other aspects of it, but in general for the moment, the effect has been an enormous amount of noise and extreme complications for firms which have to think about what this implies for them, but no short-run catastrophe.
At the same time, I think the less visible but longer lasting damage is that the traditional rules of trade are no longer respected, and so the whole trade system is in trouble. When you actually agree to something, is it going to last? Which countries do you want to work with? And so on. There has been an enormous loss, not the loss which is going to lead to a sharp recession, but a loss which is going to lead to less trading and less growth over time. It’s much less visible, but clearly there.
Q: What are the implications of the U.S. tariffs for the European Union's political and economic landscape? What is your outlook on the European economy and the main risks it faces?
Prof Blanchard:
We have to think about where Europe was pre-Trump. It was not in great shape. The German business model, which was based on cheap energy from Russia and large markets in Asia, including China, was in trouble already before Trump. And Germany has been in recession now for a while. In general, consumers are not depressed but pessimistic and they don't spend much, and the savings rate is relatively high.
Trump and Putin are adding to it in ways which are both bad, obviously, but potentially good, which force Europe to act together vis-a-vis both Trump and Putin. And I'm not terribly happy with the deal which has been agreed—I don't know if it has been signed yet—between the European Union and the U.S., but at least all the countries have agreed to work together as the European Union, which is a plus.
On the other side, the fact that Putin is acting the way he is is forcing us to think about defense. Defense is clearly a European issue, not a national issue, and so it's forcing us to think about what we can do.
These are good things, but I'm not very optimistic about the next few years. I'm not going to give you a number, but it seems to me that, again, we had low growth before Trump. We now have tariffs which are not helping. We are having stronger competition from China because China has lost much of the U.S. market and is looking elsewhere, rather successfully. So this is not good for Europe.
In addition, we have a fairly strong appreciation of the Euro, which was not anticipated and reflects that investors are looking around and like the Euro a bit more. Then not in all countries, but for example, in France, we have fiscal issues and fiscal adjustments. So put all this together, and you get a mediocre forecast.
I see “mediocre” as the way to characterize it. I don't see any unexploded bomb. For example, I think the financial system is in decent shape, and the places where you typically look for things which are not right and have to change, I don't see that. The fiscal situation in France is not great, but we're not going to get default in France in the next few years.
Maybe this is in the nature of risks, which is that there are many you don't see, but at this stage I don't see any major risk. I think the major risk is clearly on military, defense and how we deal with Russia, or how Russia deals or tries to deal with us.
Q: How do you evaluate the U.S. economy and inflation this year to date? Why didn’t the expected recession or surge in inflation materialize?
Prof Blanchard:
There are two parts to the answer. The first one is that Trump has been lucky that something else has happened, which is making nearly as much news as his actions, and that is artificial intelligence (AI). There is a boom in AI investment. There's a number of companies which are investing a whole lot, so investment is strong largely because of AI and that's helping. In a way, this has nothing to do with him, but he's lucky to have it, because the recession is probably not going to happen.
But if we leave AI aside, I think there's a question of: Are the tariffs working for the U.S.? We all understand that they are not good for the world, but we know that sometimes a country can benefit from putting tariffs.
If the U.S. puts a tariff, and the foreign exporters decrease their price in order to remain competitive, the price after tariff doesn't change. Then who pays the tariff? The exporters.
Is this what's happening? Not quite. What we see is that the exporters, for the most part, have not cut their price, but they have kept the same price pre-tariff. And therefore, the post-tariff price is higher. But what has happened is that what we call the “middlemen”, namely the importers and the distributors in the U.S., have absorbed it in their margins, so that the consumer prices have not shown the same increase as the post-tariff prices just after the importation.
So for the moment, the effect on consumer prices and on inflation are relatively limited, because at this stage, what's happening is the margins of the distributors are smaller.
The result is that it looks rather good: consumers don't see large increases in prices, and inflation has not increased very much. But we have to assume that the distributors will have to reestablish margins over time. You cannot just take a big hit in margins and continue, you go bankrupt. So you can do it for a few months, but I think that, over time, as the margins are reconstituted, we're going to see some pressure on inflation.
That's what we see in the U.S. for the moment: AI helping a lot, tariffs having some negative effect on investment decisions, but not major ones; and for the moment, there is not much inflation. But we have to wait.
Q: The US labor market is softening, while consumer spending remains strong. Does this mean the “AI revolution” has introduced structural changes to the US economy?
Prof Blanchard:
There is this striking feature of the numbers in the U.S., which is growth is fairly strong, albeit not exceptionally strong, and the labor market is not very strong. It's not bad either, but employment is growing much less than output. Another way of saying this is that we are having in the U.S. very good productivity growth, because productivity growth is the difference between output growth and employment growth. So that's good news. The question is, where does it come from?
You can think of it as coming from two sides. Is it that AI is already used so much that it's increasing productivity, or is it just a boom in investment and for a while there's an increase in productivity? Does the good performance come from AI as an investment (as demand), or come from AI as part of the production process? We don't know.
But it's clear that at this stage, productivity growth in the U.S. is strong. If it continues, that's clearly very good news. A higher growth rate, even if it's just by half a percent a year, makes an enormous difference.
On AI in general, it clearly is a transformative technology. It has the potential to increase productivity growth very much. It also has the potential to increase unemployment very much. In the past, that kind of innovation has not led to much higher unemployment. People who lost their jobs were able to find some. But this is the past and this one is a different beast.
At this stage, what we see is a lot of hope that it's going to lead to more productivity growth and higher profits. We’ve seen this in the stock market. What it does to the labor market is less clear, and it comes with risk. The reason you see people moving to gold and others is that they perceive there is more risk in the world. AI can be great or it can be catastrophic leading to layoffs and political reactions. We have to see. That's clearly an even bigger issue than Trump, because it will be there even when Trump is gone.
Q: How do you interpret the Fed’s cut in September? What is your outlook for U.S. economic outlook and interest rate in the next stage?
Prof Blanchard:
My comparative advantage is not to give you precise figures. All I know is for the moment the economy is doing well, and I think it's going to continue to do fairly well because of AI. The pull-down from tariffs is going to be less than the pull-up from AI.
I thought the Fed looked and thought the labor market was a bit soft. Inflation seemed to be slowly coming down. It concluded that they could decrease rates a little bit. I think that was the right decision.
There is a question of what happens to interest rates going forward: Is the economy going to be so strong that the Fed actually has to keep interest rates the same or even increase them? If you look at output, it looks like the economy is nearly overheating, the numbers are very good; but if you look at the labor market, because of higher productivity growth, it is not very tight. So I think the Fed will do what it has said it would do, which is it's going to keep assessing. If it feels that inflation is not a big issue, but activity is, it will decrease rates, and otherwise it will not. But I'm happy to leave the job to them. I'm not going to give you forecasts.
Q: How do you foresee the final outcome from the Fed’s struggle to maintain independence? What would a loss or partial loss of Fed independence mean?
Prof Blanchard:
There is a larger issue about democracy in the U.S. which goes far beyond the Fed. What's going to happen to all kinds of institutions?
In the case of the Fed, I’m relatively optimistic that it will withstand the pressure. The reason is the rules, which is Trump cannot just fire the whole board and put anybody he wants there. There are rules, and he has to respect some. And if I look at the board, even if he were to put somebody who is just following orders as the chair, the decisions of the Federal Open Market Committee (FOMC) are taken by a majority, not by the chair.
I’m fairly confident that the board members, both those which were appointed by Trump earlier, and the ones which were not appointed by Trump, take the mandate of the Fed seriously. So I don't think that the chair who says “we have to decrease rates a lot to help Treasury pay a lower interest rate” would succeed if he doesn't get the majority of the board.
I think the Fed will be able to resist, but there is going to be pressure, and there are going to be insults. It is going to be unpleasant. But I'm decently optimistic that that institution will withstand the attempt by the administration. I think the loss or partial loss of Fed independence is not going to happen.
But if I am wrong and there are indications that the board tries to go in the direction of Trump, namely decreasing interest rates when it's not justified by macro conditions, then investors will ask themselves questions about what happens next. And given the evolution of public debt, they might say Trump is going to be able to get the Fed to have low rates, and we may see inflation. Short of this, investors think may say: We don't want to hold 10-year Treasuries, because God knows where we are in 10 years. So the interest rate on long-term Treasuries will go up.
Q: The US national debt has surpassed $37.8 trillion. How do you assess the United States’ debt sustainability, and the prospects for its fiscal policy?
Prof Blanchard:
I think the current evolution indicates that if the U.S. does not do something, there will be a debt explosion that is unsustainable. We have large primary deficits, and given the combination of forecast of growth rates and interest rates, this means that to stabilize the debt, we have to decrease the primary deficit or deficit not including interest rates by about 4% of GDP.
In a well-functioning democracy, this would lead the various parties and the government to get together and decide how to reduce this deficit. But in the current environment, it's clear that the party in power has no desire to do anything except words, and that the opposition is not in a position to do anything. So at this stage, it continues, and it's likely to continue for some time.
There's an aspect of it that is more traditional, which is what we call “wars of attrition”: both sides may want to decrease the deficit, but, to caricature, the Democrats want to increase taxes, and the Republicans want to decrease spending, and they just wait for the other to give up. We have seen this in the past, it is very standard.
I think there is more than that. There is an utter irresponsibility of the political process in general, which is specific to this episode. My guess is that it will go on for a while. It takes a long time for markets to decide it's not acceptable. We may see signs, but investors are worried. We saw one in last April or last May, and we may see more. Will this be enough for the two parties to sit together and do something? Eventually (this might happen), but it might be 2 years, 5 years, or maybe more. But it is not sustainable as it is.
Q: Is the erosion of the risk-free status of US Treasury bonds temporary, or is it likely to become a long-term trend?
Prof Blanchard:
I don’t see it as temporary. I think the investors realize that something is wrong, and it probably will be repaired in some way. But the repair might be more inflation or some form of restructuring of the debt. The notion that Treasuries are completely safe and will be safe forever has been and is being challenged. Therefore, I think investors are going to look around for alternatives.
I think the issue is that the Treasury market is about 30 trillion USD, which is a big number. And so, if you want to move from that market, there's no other market in the world which is that large. For example, the market for German public debt is about 2.5 trillion Euros.
I've been pushing very hard the notion that this is an opportunity for Europe to issue a large amount of Eurobonds, and transform at least part of the national bonds into Eurobonds. And the reaction I get from investors is that if this was possible, they would actually buy those bonds.
So, the major message is that the path of fiscal policy in the U.S. which is very worrisome, and the perceived attempt of the Trump administration to get the Fed to do what it wants should and does worry investors, and they are looking around for something else. At this stage, there is no good alternative to U.S. Treasuries, so I see a challenge and an opportunity for Europe to develop a Eurobond market, which would be attractive and allow investors to move part of their funds from the U.S. to Europe.
Q: How do you assess the likelihood of a U.S. debt default or debt crisis?
Prof Blanchard:
Some form of debt crisis, with a risk premium on long U.S. Treasury bonds, has positive probability. For default, I'm not going to give you a number, but I think it's still very small. We've invested a lot in the credibility of the U.S. and the Treasury market. I just can't think about it. That doesn't mean it cannot happen, but it remains highly unlikely.
Q: How do you foresee the future development trends of the international monetary system? How might the international monetary status of the Dollar, the Euro, and the Renminbi evolve?
Prof Blanchard:
I think that the Dollar will lose a bit of its status. More transactions will be priced in Euros or Yuans. Euro will become a bit stronger is my guess. Then the Yuan will also over time if you can develop a deep, liquid, easily accessible, no-capital-controls market, then investors will hold more than they do today.
Q: What are some of the pragmatic moves you have in mind to expand Euro’s international role?
Prof Blanchard:
I think what we can do to attract more people to use the Euro is to have a good financial system and have a Eurobond market.
We have to understand what we mean when we say the Dollar is an international currency or reserve currency. There are various aspects, but the main one is that the U.S. Treasury market is very large, very deep, very liquid. So if you want to buy, say, $1 billion of stuff, you need the market which is very, very large, like the Treasury market.
There are cases in which you really want to have access to your liquidity in a few hours. You don't want the price to move against you if you try to sell. This is why investors put their money in US Treasuries. That makes a lot of sense.
So starting from there, what do you have to do? You have to have the deep, liquid, large, safe market. And the only place in the world which can do it today, I think, is Europe. I think the only provider of these assets is Europe. Not China for various reasons. China may try and may open markets to these investors and help, but in terms of the ability to do it on large scale with credibility, I think only Europe can do it.
Therefore, this is why I think a Eurobonds market is very useful. If you think about the European financial system, can you think of a system in which you rely, for the safe asset, on an asset in a different currency? You have a whole financial system in Euros, but the safe asset is in Dollars. That's very unattractive. You basically want the safe asset to be in Euros, it seems to me. So when people talk about completing the financial market or some system of financial markets in Europe, it must include something like Eurobonds, a large market in which you can buy and sell short-term Euro Treasuries.
Q: You already mentioned deep, large, liquid. What are the other fundamental conditions you see that could enable a Eurobonds market?
Prof Blanchard:
My list stops there: deep, liquid, large. But there are some people who say, no, you need more, and fiscal policy has to be under control.
So there's a question of whether we can move to Eurobonds at the time at which some countries, like mine, France, doesn't quite have fiscal policy under control.
I think we can do this if the Eurobonds are liabilities of the European Union, not of the countries themselves, and that the countries commit to putting some funds aside to cover the interest payments to the EU, so it's double safety. The EU commits to pay, and it's worth a lot; and then the member countries commit to, say, using 1% of their value added tax (VAT) receipts to pay the interest.
Q: What obstacles stand in the way for this Eurobond market effort?
Prof Blanchard:
There are political factors. There are perception factors. I’ve written with Ángel Ubide a proposal on that, which is not an increase in debt, but a partial swap of national bonds for Eurobonds. It does not increase total debt in the European Union. We're not arguing for more debt, but some people think that this proposal is the door open to using that market to issue more debt and to have larger deficits.
I think it's more or less based on the fundamental worry about debt, and then misperceptions about the specific project. So I spent much of my time trying to explain why this is not deficit finance.
Q: What key institutional breakthroughs do you think are needed to enable a Eurobond market? Would a centralized fiscal authority be necessary? Or do we need a renewed relationship between the EU and the Eurozone?
Prof Blanchard:
The Eurobond proposal doesn't require anything major. There is a Directorate-General for Budget in the EU, which is already managing Eurobonds that exist, but in small quantity. And they could just do the job. So this is very minor.
In terms of completing the market, as much as I have reservations about the fiscal rules at the EU level, I think they are better than nothing, even if they are not great. We just have to refine them, but I don't have a sense that a central fiscal authority is needed.
More financing of some of the spending at the European level would make a lot of sense. Defense spending is clearly a European issue, not a national issue. It should basically be organized and financed at the EU level. I think that there should be more spending going through Brussels which does not necessarily mean more deficit spending—it could go through Brussels, but it could be financed by taxes, either EU taxes or taxes at the national level, which are transferred to the EU. So I don't think we need fundamental changes in the structure of EU before we develop Eurobonds, but we have to build on what we have.
This is another theme which I’ve explored, “coalitions of the willing”, which is that one of the issues in the EU is that many decisions have to be taken unanimously. That's an issue because some countries are not playing the game, so it paralyzes the EU in various dimensions. So we have to revisit when unanimity is actually essential, and when you can have a number of countries less than 27, whatever number that is, that is willing to do it, doing it together is the way to think about the future. I think that's probably the big issue facing the EU.
Q: What roles do you think digital currencies, including stablecoins, will play in the future evolvement of the global monetary system?
Prof Blanchard:
This would require another hour to discuss. I think there's a lot of hype about stablecoins. Let's leave aside the non-stablecoins and bitcoin and the rest, but just talk about stablecoins.
At this stage, when I want to transfer money to you or to anybody, I have to go through a bank. And this takes a day, sometimes more. So you can think of a digital currency in which it goes directly from me to you instantaneously. That's basically what stablecoins, digital currency, and central bank digital currency can do.
Now, does this sound like a major breakthrough? Yes, you'll get the money there within 5 minutes as opposed to a day. It's probably not going to make an enormous difference to you, but it's worth something, and for some firms, this may be useful. So there’s a bit of a role.
The problem with digital currency, whether it's stablecoins or central bank digital currency, is that you may decide that you don't need the bank. Therefore, you're going to take your money out of a bank and buy stablecoins, or be unbanked. For you, it doesn't make any difference. But for the bank, it's fairly major. You have to worry about the fact that if people have access to stablecoins or central bank digital currency, they are going to move out of banks. And then who is going to give credit to firms? Banks can get the funds by borrowing from the central bank, but it is much more expensive than relying on demand deposits. There is going to be a credit crunch. One has to be very careful. The issue is there whether it’s stablecoins or it’s central bank digital currency from the point of view of banks: if the money goes away, they are in trouble.
Are there differences between the two at this stage? Why would you in China or me in Europe hold dollar stablecoins? How often do you have a transaction which requires you to use dollars and has to be done within 5 minutes? I suspect once in a while, maybe you buy a plane ticket, but it's very limited. If you had a stablecoin in Renminbi, maybe you start thinking. Or if I have a stablecoin in Euro, I start thinking. But for the moment, the dollar stablecoins are not terribly useful to the rest of the world, except in countries where the banking system is weak and people prefer to avoid it altogether
So the issue is more about if the European Central Bank (ECB) issues its own digital currency and offers it to everybody, isn't there the risk that the banking system collapses? This is the issue they face. So what they can do is offer a wholesale digital currency, which is available to banks or financial intermediaries, but not to you and me, in which case the banks get preserved. But how to do this exactly is where the complexity is.
I think too much is made of stablecoins. One worry is not stablecoins themselves. It is the platforms that you can go to with your stablecoins in which people on the other side try to sell you investments, which often promise very high and implausible yields, and because this is not regulated, it’s very dangerous. But the problem is not stablecoins themselves, it is their use. It's just that there is a part of the financial system which is not regulated, and this we have to think about.
Q: As the U.S. takes a step back from its roles in the international system, how do you foresee the global governance and economic and trade landscapes will change? How do you suggest that China and the EU could build an open, rule-based economic order with third party countries outside of the United States?
Prof Blanchard:
It's clear that we have to rethink. This goes back to the first question you asked, which is the Trump actions, not just the tariffs, but the non-respect of the rules, are costly, not terribly costly in the short run, but the very costly in the long run. The question is, what do we do? What I've pushed for, and I'm not the only one, is “coalitions of the willing”, which is that maybe it's going to be very hard to get multilateral agreement where all the countries agree, because there are some countries which are not going to want to play the game. It's just not Trump, it's more and various countries in the world.
I think we have to look for volunteers of countries which are willing to be reasonable, and when they give their words they actually keep it. We form a “coalition of the willing” on particular issues, say, an agreement on the use of carbon taxes, and then we have border taxes on those who don't want to. If the U.S. wants to participate in any, they are welcome. But if they continue to do what they do, I think the world can probably survive without them.
The EU has to work with Asia and China, in particular, to actually try to preserve traditional trade rules, which is tough, because it's clear that there is a potential conflict between the need for China to export and for the EU to protect itself. But we're grown-ups. We can sit down and try to work it out. I think that can be done. China and the EU have to sit down, and think about all the things they can do together, not just them, but other countries as well.
On climate, if some countries think that the earth is not getting warmer, fine, they get out. And there are carbon border taxes if they want to get in, so you create carbon clubs, and at the border you have carbon border taxes and so on.
For taxation of multinationals, it’s the same thing. It would be good, obviously, if all countries were willing to play, but we can have a number of countries which agree to do something together, and if some countries decide not to join, they can be taxed or punished in some way.
This has to evolve. It's incredibly complex. But my sense is there are a lot of countries which are willing to play by the rules (some old ones surely have to be revisited).
Q: Do you have any other advice for China and the EU to work together to improve their bilateral economic relations?
Prof Blanchard:
No, I just hope they do. I really do. We should not be naive. It's not as if we have exactly the same interests. It's not as if we don't have tensions. We have tensions, we have differences of views. But at this stage, it's absolutely essential that the EU and China sit together, look at where we agree, where we disagree and what we do. And I'm happy that you asked that question, because for me, it's probably the number one challenge that the world faces at this point.