In a few of my recent posts I have referred to “economic overheating.”
I don’t think I ever encountered the term “economic overheating” in any of my undergrad or graduate economics classes, as an economist colleague reminded me recently. I don’t think I ever found the term in any seminar or working paper, or during formal or informal conversations with fellow students or professors. Perhaps at the schools I attended "overheating" is like "Voldemort": a word that it is best to avoid. At any rate, you won’t come across the word easily in academic journals and textbooks. But I do find “overheating” in the media, and in policy and financial reports in the non-academic sphere. Even the IMF (see the foreword, to begin with) and some people at the Federal Reserve use it.
So, for those people who do use the term, what does “overheating” mean? After pondering this for a few weeks, I realize that I can characterize the term, but not define it. Here’s my humble characterization:
Economic overheating is a syndrome characterized by a majority of the following symptoms: increasing growth of credit to the private sector; rising growth of asset prices, including real property prices and equity prices; a decline of the current account balance (declining surplus or widening deficit); a decline in the national saving rate; above-trend growth of private investment or consumption; lower-than-average (and possibly negative) real interest rates; increasing external net financial inflows; above-trend currency appreciation; a decline in foreign exchange reserves; and above-trend output growth and below-average unemployment.
Before you spring off your chair and start firing off a reply, let me acknowledge the lack of objectivity or even preciseness of this characterization. What is exactly “a majority” of these symptoms? More than 50%? Can we take a weighted average? It is difficult to say, but the more symptoms I observe, the more confidence I would have in my diagnostic of overheating.
Also, it seems like I cannot decide whether we should observe a rising growth rate (the second derivative), a deviation from trend, or a deviation from the long-term level. I think it depends. Depending on the variable and the economy under consideration, one should consider deviations of the level from the trend level, deviations from a long-term “equilibrium” level, or deviations of the growth rate.
Some commentators throw in increasing inflation as a typical sign of overheating, but that seems to require the Phillips curve, which I am not ready to assume.
I must insist that not every episode of overheating manifests itself in all the symptoms that I listed above, and my list may not be exhaustive. Also, notice that there may be overlap among these manifestations. I would also like to add to the list a symptom from the banking sector, but at this point I cannot characterize it (would it be a rising ratio of loans to deposits, or a declining capital ratio, or something else?).
Implicit in the concept of overheating is the idea that the economy is developing “imbalances,” both internal and external. Certain parts of the economy are growing “too fast for their own good,” and these imbalances are often accompanied by leveraging. Some analysts stress the real economy side of overheating (unemployment, output growth), while others put the emphasis on the financial side (credit, asset prices).
OK, so we have a list of manifestations of economic overheating. But what are the “deep” economic forces that produce it? The concept of overheating is begging for an economic model. I find “Keynesian” or “neo-Keynesian” too vague of a description. In fact, if you remove unemployment, output and inflation from the list of symptoms, the model might have very little “Keynesianism” left in it. Narrowing down the features of such model is beyond the scope of this blog post, but I do hope to revisit the topic and refine the definition and characterization of this thing they call “economic overheating.”
I encourage readers to chime in, particularly for this post, in the comments.