Olivier Blanchard on Inflation

By

Marc Lavoie

Professor Emeritus, University of Ottawa

Professor Emeritus, Université de Sorbonne Paris Nord

Managing Editor, European Journal of Economics and Economic Policy

and

Louis-Philippe Rochon

Full Professor, Laurentian University

Editor-in-Chief, Review of Political Economy

Founding Editor Emeritus, Review of Keynesian Economics “

"In the end, Blanchard’s views on conflict inflation should be embraced by post-Keynesians, and represent certainly a path towards a potential dialogue. … We would argue this would be a good place to begin: many of the ingredients are there, representing a ripe opportunity to advance the post-Keynesian views further.”

In a series of recent tweets on December 29 and 30, Olivier Blanchard, former Chief Economist at the International Monetary Fund and now the Robert Solow Professor Emeritus at the Massachusetts Institute of Technology, argued that inflation is the result of conflicting claims, a position that is very close indeed to the post-Keynesian view. He argues that “Inflation is fundamentally the outcome of the distributional conflict, between firms, workers, and taxpayers. It stops only when the various players are forced to accept the outcome” (December 30, 2022).

This statement took many post-Keynesians and heterodox economists on Twitter by storm, and the response was equally swift, with many who saw in this statement a Johnny-come-lately attempt to zero in on an argument that has been the purview of heterodox economics for decades, as initially proposed in Bob Rowthorn’s 1977 article in the Cambridge Journal of Economics, “Conflict, inflation and money”, but which could also be found in the macroeconometric model of the Cambridge Economic Policy Group of Godley and Cripps, as presented in Economica (1976) As usual, some were saying, the mainstream takes our argument without acknowledging our work. On December 31, in another Tweet, Blanchard acknowledged the contributions of post-Keynesians.

In a way, this reaction on Twitter is understandable, given that many post-Keynesian ideas are creeping up in some corners of the mainstream with no mention of the post-Keynesian literature. There are some exceptions, however, as in the recent Fed paper by Ratner and Sim (“Who Killed the Phillips Curve? A Murder Mystery”, 2022), with its references to Rowthorn and Kalecki.

In this blog, we wish to do two things. First, we wish to argue that Blanchard is not late to the inflation-as-conflict game, but rather has been one of its leading proponents, as he has been espousing these views for almost 40 years. Second, his views are in fact very close to those of some post-Keynesians, such as Eckhard Hein and Engelbert Stockhammer, leading to the possibility of open dialogue and some potential collaborative research in the future.

Regarding the first argument, Olivier Blanchard has espoused these views for quite a while, and is part of his Wage-Setting/Price-Setting (WS/PS model) or the Blanchard Kiyotaki model. Some of these ideas in fact date back to the author’s 1986 article in the Quarterly Journal of Economics, “The Wage Price Spiral”, in which Blanchard (p. 543) articulates a position close to the conflicting claims model espoused by some post-Keynesians, starting with Dutt (“Alternatives closures again”, Cambridge Journal of Economics, 1987) and including the model in Rochon and Setterfield (2007) with its different target wage shares for firms and workers, respectively.

Consider, for instance, the following quote from Blanchard: “the spiral could start from a desire by workers to increase their real wages, or from firms to increase their profit margins, or from the attempts by both sides to maintain the same wage and price in the face of an adverse supply shock. These would also start a wage price spiral, lead to ‘cost push’ inflation, and through the effect of inflation on real money balances, lead to a recession.” The author concludes further that “After an increase in demand, attempts by workers and by firms to maintain or increase real wages and markups lead to a general increase in nominal prices and wages that lasts until output is back to its equilibrium value” (p. 560).

Within the framework of Blanchard’s WS/PS model, the PS curve, often horizontal (which depends on the firms’ markup), determines the real wage set by firms, and the WS curve determines the real wage aspired by workers (as in Rochon-Setterfield, as stated above); everything also depends on the tax wedge (including the generosity of the unemployment insurance program), which increases the gap between these two real wage targets. The unemployment rate makes it possible to equalize the two real wages and to limit inflation, because the WS curve is such that the real wage rate targeted by workers is inversely related to the rate of unemployment. The WS/PS model could also be found in the LSE models marketed by Layard, Nickell and Jackman Unemployment: Economic Performance and the Labour Market (1991), and then in various papers by the OECD, which attributed unemployment to supply-side effects and hence advocated supply-side policies only.

Regarding the second point, and the relationship with post-Keynesians, the WS/PS model above all is a model for determining what mainstream economists believe to be the natural rate of unemployment rate (or the NAIRU), but Blanchard links his WS/PS model to the Phillips curve, where inflation depends on the actual rate of unemployment, by assuming that the constant in the traditional Phillips curve depends on these three determinants (markup, union power and the tax wedge). By assuming that current inflation depends fully on expected inflation, and adding that expected inflation is past inflation, Blanchard recovers the vertical Phillips curve and the natural rate of unemployment, which thus depends on the constant and how strongly inflation reacts to a change in actual unemployment. What remains to be explained is what determines the realized rate of unemployment. In mainstream economics today, it is mainly the level of the interest rate relative to the “natural rate of interest”, as found in the conflict-inflation Macroeconomics textbook of Carlin and Soskice (2015).

In contemporary conflict inflation post-Keynesian models, there are some affinities with this WS/PS/Phillips curve model, such as in the models developed by Hein and Stockhammer (“Macroeconomic policy mix, employment and inflation in a post-Keynesian alternative to the New Consensus mode”, Review of Political Economy, 2010), where aggregate demand in a closed economy will mainly depend on fiscal policy and income distribution.

The other main difference between the mainstream and the post-Keynesian conflict inflation models, is that the natural rate of unemployment, if it exists, is endogenous in the post-Keynesian view, being attracted by the actual rate of unemployment, as higher levels of employment and economic activity will tend to induce technical progress (the Kaldor-Verdoorn effect, see Productivity Growth and Economic Performance: Essays on Verdoorn’s Law, edited by John McCombie, Maurizio Pugno, and Bruno Soro). Ironically, these path-dependent effects, or hysteresis effects so much emphasized by post-Keynesian authors, were once also underlined in the 1980s by Blanchard himself (with Lawrence Summers; see “Hysteresis in Unemployment”, European Economic Journal, 1987), then entirely forgotten, only to be resurrected lately by these two authors, as an attempt to understand the events that occurred during and after the Great Recession of 2008.

In the end, Blanchard’s views on conflict inflation should be embraced by post-Keynesians, and represent certainly a path towards a potential dialogue. Post-Keynesians have for a while debated how to build stronger ties with some mainstream or mainstream dissenters, which has been explored in Lee and Lavoie’s book of a decade ago, In Defense of Post-Keynesian and Heterodox Economics: Responses to their critics.

We would argue this would be a good place to begin: many of the ingredients are there, representing a ripe opportunity to advance the post-Keynesian views further.