The pros and cons of running the economy hot

Arthur Okun, a famed economist, noted in his seminal 1973 paper that a high-pressure economy might provide a boost to economic mobility. A high-pressure economy refers to a situation in which actual output is, at least temporarily, maintained above its potential level, thus pushing utilization rates of economic resources momentarily above their long-run sustainable levels. Unsurprisingly, the “Great Inflation of the 1970s” dealt a blow to proponents of the high-pressure economy approach, as curtailing rapidly surging inflation took precedence over aggressively boosting aggregate demand.

Following a decade of persistently low inflation in the aftermath of the Great Recession, and amid growing concerns regarding rising inequality and the economic struggles of various marginalized groups in the U.S., Okun’s hypothesis has regained some of its lost luster. 

President Trump’s highly expansionary fiscal policy agenda (the 2017 Tax Cuts and Jobs Act (TCJA), the 2018 Bipartisan Budget Act (BBA) and a near-trillion-dollar budget deficit in 2019), in combination with the Federal Reserve’s decision to abandon its rate-hike cycle and instead engage in three rounds of rate cuts in 2019, appeared to provide a real-world test case for Okun’s high-pressure economy hypothesis. Just prior to the pandemic, the unemployment rate was near a 50-year low of 3.5 percent, and there was very little evidence of a buildup of inflationary pressure. Furthermore, there was noticeable improvement in the employment prospects of less-advantaged groups.

As President Biden’s administration pushes for another round of fiscal stimulus, an intriguing new debate has emerged in macroeconomic policymaking circles regarding the benefits and potential costs of running the economy hot in the second half of 2021 and into 2022. 

Okun’s high-pressure economy hypothesis is based on the rationale that, in an economy running hot, firms facing tight labor markets would extend their labor search pool and hire workers belonging to underrepresented segments of society. This would provide long-term benefits by increasing employment opportunities for marginalized groups. Also, by providing the less-advantaged workers with the prospect of skill-upgrading, it would offer those groups a chance to climb the income ladder and ultimately achieve upward economic mobility. Okun also noted that firms will be more likely to invest in productivity-boosting technologies and thus generate long-term benefits for the economy. 

Two important recent studies provide fresh analysis regarding the impact of a high-pressure economy. A study by Mary Daly, the president of the Federal Reserve Bank of San Francisco, and her research associates found that running the economy hot does provide extra labor market benefits, especially to some disadvantaged groups (in particular, women and African-Americans). Another study, by economists Julie Hotchkiss and Robert Moore, offers a more nuanced view of the net benefits associated with a high-pressure economy. They find that benefits accruing to disadvantaged groups from a high-pressure economy are not enough to offset the often-severe outcomes borne by such groups during economic downturns, and, consequently, argue that limiting economic volatility may offer greater rewards over the longer run. 

In the context of President Biden’s ongoing push for further stimulus aid and the recent refusal by Federal Reserve Chairman Jerome Powell to commit to an earlier gradual tapering of the Fed’s asset purchase program, a careful evaluation of the benefits and potential downside risks associated with running a hot economy is necessary.

Assuming that vaccination rates continue to rise rapidly in the U.S. (a likely outcome given the potential availability of two additional vaccines relatively soon) and that vaccines offer protection against new COVID-19 strains, the unprecedented levels of fiscal stimulus and an extremely accommodative monetary policy stance imply that the second half of 2021 will see exceptionally strong economic growth that may continue into 2022.

On the fiscal side, stimulus measures directed at boosting vaccination efforts and curtailing the spread of the coronavirus are clearly needed and widely supported. But the proposal to send further $1,400 stimulus checks to a broad segment of the American population is more controversial. The latest U.S. personal income and saving data suggest that the balance sheet of many U.S. households is relatively stable. Aid should be better directed to those in dire need of economic help and to those who are facing the brunt of the pandemic shock. Overstimulating short-run demand is more likely to boost imports (especially from China) and create supply bottlenecks that may lead to a spike in inflation. An unexpected inflation surge may pose a threat to the sustainability of the recovery.

The greatest risk associated with running a hot economy lies on the monetary and financial side. Many have rightly commended the Federal Reserve for quickly injecting liquidity and acting as a lender-of-last-resort during the early stages of the pandemic shock. But the central bank’s continuation of its massive large-scale asset purchase programs and its commitment to maintaining near-zero rates for an extended period are creating financial distortions, furthering racial and wealth inequality, and contributing to speculative frenzy in certain assets.

A case can be made for a well-targeted fiscal stimulus program than can potentially generate strong and broad-based economic growth. But over-reliance on monetary stimulus poses multiple risks. As a consequence of running a hot economy, if the U.S. ends up with higher-than-expected inflation, it could lead to a sudden spike in market interest rates and a rapid deflation of asset prices. In an economic environment characterized by record levels of public and non-financial corporate debt, such a shock would prove to be quite debilitating for the U.S. economy.   

Vivekanand Jayakumar is an associate professor of economics at the University of Tampa.