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  • Abiye Alamina

Defying Inflation: When Does an Expansion Become Overheating?

The Unemployment rate for May just dropped to a historically low 3.8%, its lowest since 1969! This is great news, or is it?

US Unemployment Rate (Source: BLS)

The business cycle phenomenon is an interesting short run economic proposition that posits that modern economies go through bouts of growth and stagnation explainable by alternative theories. Real GDP grows positively over some time period hits a peak in economic activity and then starts to experience negative growth, hits a trough, and repeats.

What is fascinating though is not so much what happens in the stagnation phase, as we understand for the most part that this is where a recession happens and lots of jobs are lost and nobody likes that, but rather why or how the assumedly desirable growth phase could be accompanied by an undesirable economic malady.

The issue here for the most part is inflation. A situation where there is a general and sustained increase in prices of both goods and resources, such as leads to inefficient resource allocation and economic hardship for some.

To be sure, we might experience inflation in the stagnation phase, where we have another economic problem aptly called stagflation, but inflation is by and large the problem that shows up in the growth phase.

The growth phase, often referred to as an economic boom or expansion is the desired phase that economies want to be in, at all times if possible. So how does this phase get entangled in this inflation problem which we would like to avoid?

The Inflation Problem

During an economic boom spending levels are very high, driven perhaps by increased optimism by businesses and consumers the boom continues to get reinforced. However spending by itself cannot generate more products beyond what an economy is capable of producing given the limits, over any period of time, on its resources and the state of knowledge on how these get transformed into productive goods and services.

This is how inflation enters the picture: businesses respond to the continued increased spending by looking for ways to raise the productivity of their existing resources, being unable to find dormant resources elsewhere. This scarcity causes resource prices (including wages) to go up as higher payments have to be offered to bid workers and other resources away from their jobs to other jobs. The higher costs associated with production then lead to higher prices, hence we have price inflation.

Economic Growth as a Moderator of Inflation

It should be understood however that economies are not doomed to suffer inflation as an inevitable problem inextricably linked to an economic boom. One way to see this is by noting that a long run dynamic can be superimposed on this short run process. That long run dynamic is what is called economic growth.

Economic growth is described as a long run increase in living standards within an economy, and it is often visible in a long run positive growth trend in per capita income.

To keep it intuitive, think of economic growth as what removes the constraints that limit either the availability of resources, or the state of knowledge on how to transform these resources into valued production or both.

Immediately we see how crucially important this concept is. Now we are ready to answer the question posed by the title of this post. When does an economic expansion become overheating? In other words when should we be concerned about inflation resulting from an economy that is overheating - experiencing too much spending growth compared to the growth of its output?

Economic growth does not just happen by chance. What many growth researchers have found is that it takes a confluence of viable resources, appropriately designed incentives, and well matched economic, social and political institutions to drive this process.

Viable Resources

Not all resources are equal..., at least at any static point in time. A major role of education is to enhance the productive capability of labor, transforming it into some form of human capital, able to produce beyond just raw physical effort on the job.

Having highly skilled workers is great, but these workers also need to have the right tools that align with their upgraded training. A major role of spending on research and development is to produce such advanced knowledge/ tools.

Appropriately Designed Incentives

So we know we need highly skilled workers, and we need advanced tools and equipment, but how do we go about obtaining these? The economics answer is "Incentivize their accumulation". In other words make it easy for people to choose to spend what resources they have today on accumulating these and make the future rewards of having acquired them very attractive.

Well Matched Institutions

You cannot have appropriately designed incentives existing in a vacuum. The structure of society has to be such that it generally creates the aforementioned incentives on its own, and further that people are also generally motivated by those incentives 'naturally' with little consideration that any thing could 'go wrong' for the most part.

Economic institutions that encourage private property ownership and voluntary exchange - like free markets and trade - directly provide those incentives, through the price mechanism.

Political Institutions with effective checks and balances on the distribution of power and the policy process will likely produce policies that strengthen economic institutions and put in place policies like patents, copyrights, and competition, that both incentivize innovation while restricting monopoly behavior in markets.

Social institutions that encourage inclusiveness, ethical behavior, and "outside of the box" thinking that are not subject to circumscription, enable the development of newer, possibly better ideas, as well as help mitigate the tendencies in the above discussed institutions towards the creation or fostering of perverse incentives.

Putting It All Together

Economic growth works, if you will, behind the scenes, where the mechanisms that encourage it are present. We observe its effects typically over a longer time frame of decades (and sometimes even a half century to a century).

Its effects may be accelerated at points in time - such as when the innovations they engender become increasingly adopted. This may cause the normal short run business cycle to be bypassed, such as when we would normally expect the economy to overheat from the presence of very strong growth, like we are experiencing now... and it does not.

Here is one way to see this. If, as we have observed, the unemployment rate has just fallen to a historically low rate of 3.8%, then it could be that the natural rate of unemployment is not really at 4.5%-5% as we have assumed, perhaps because there are now more rapid processes that move workers from being frictionally and chronically structurally unemployed to finding jobs more readily.

So if the natural rate of unemployment is actually say more around 4% or even lower, then we should not expect to see rapid inflation per se presently. How might we explain the observed wage growth? Well, we can plausibly link it to the trickle down from tax reform and increased demand for labor as businesses look to meet increased spending.

So while some economic historians may bewail the erosion of our institutions, it should be interesting to note the resilience of these institutions in their long run impacts. We may yet see future adverse effects from any actual erosion of these institutions, but presently we may still be experiencing their growth driving effects as by and large we have, at least in the past, put in place those processes that are important drivers of economic growth.

The Difficult Challenge of Prediction

The foregoing serves to highlight the challenge economists face when trying to predict the future economic landscape. It is not uncommon for us to provide these predictions like a charlatan with two hands:

In this case, on the one hand, we see inflation in the near future and everything, we argue, points to this. On the other hand, we do not see inflation, and the reason is because, well, we might be experiencing a confluence with long run economic growth processes that mitigate this.

One final thought here. Could we be seeing a vindication of Supply Side Economics propositions? Could the tax reform and ongoing deregulation, by removing some policy driven constraints on production, in effect be keeping inflation at bay?

Possibly. The Jury is still out on this one though the theory suggests it is possible to see such effects, and perhaps future research will confirm this and give a nod to reinstating its propositions as a mainstay in mainstream economic thought.


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