What is an overheated economy?
An overheated economy is one that has experienced a prolonged period of good economic growth and activity which has led to high levels of inflation (due to increased consumer wealth). This sharp rise in prices results in inefficient supply allocations because producers overproduce and create excess production capacity in order to take advantage of high levels of wealth.
Unfortunately, these inefficiencies and inflation will eventually hamper economic growth and can often be a precursor to a recession.
Understanding an overheated economy
Simply put, an overheated economy is one that grows at an unsustainable rate. There are two main signs of an overheated economy.
Rising inflation rates are usually one of the first signs of an economy overheating. As a result, governments and central banks will generally raise interest rates to reduce the amount of spending and borrowing. While central banks can fight rising inflation by raising interest rates, they can often come too late. As inflation is a lagging indicator, policy changes may take some time to reduce the rate.
Between June 2004 and June 2006, the Federal Reserve Board increased the interest rate 17 times as a gradual means of slowing the overheating of the American economy. However, two years later, inflation in the United States reached 5.6%, a record level. This rapid rise in prices was followed by a crippling recession, which saw inflation plunge below zero in six months.
The second sign of an overheated economy is an unemployment rate lower than the normal rate for a country. Ideally, full employment should be good news. But full employment also means higher inflation, because everyone has a job (which means productivity is at an all-time high) and money to spend.
In all recessions after World War II, the unemployment rate fell below 5% in the years immediately preceding the period. The Congressional Budget Office (CBO) estimates that the unemployment rate has varied between 4.7% and 6.3% since the Second World War. The unemployment rate fell below 5% in the years before the Great Recession. There are other characteristics of overheated economies, such as abnormally high levels of consumer confidence followed by a sudden reversal.
Key points to remember
- An overheated economy is one that grows at an unsustainable rate.
- The two main signs of an overheated economy are rising inflation rates and an unemployment rate below the normal rate of an economy.
- The causes of an overheated economy range from external economic shocks to asset bubbles.
Causes of an overheated economy
The two main signs mentioned above are also the cause of an overheated economy. Other causes of an overheated economy include asset bubbles and external economic shocks. An example of these are the oil shocks that occurred for much of the 1970s and 1980s. They resulted in recessions of varying duration and intensity, as the cost of oil imports from the United States increased to meet increased demand for gasoline.
Asset bubbles are an unsustainable increase in the prices of certain assets. It is a sign of overheating. The bursting of the Internet bubble in 2001 caused a recession. More recently, the 2008 financial crisis was the result of a bubble in real estate mortgages. The bubble had far-reaching implications across geographies and resulted in a protracted recession that spanned multiple geographies.
Example of an overheated economy
The great recession of the late 2000s was preceded by an overheated economy. The unemployment rate fell continuously until 2007, peaking at 4.6% (below the normal rate) that year. Meanwhile, the inflation rate, which had risen steadily, peaked at 5.25% in 2006, when Ben Bernanke became president of the Fed and just before the crisis. Another sign of an overheated US economy was the housing asset bubble that burst in 2007 and sent shock waves across the entire American financial ecosystem. Government spending has compounded these problems. During President Clinton’s years, the federal budget had a surplus. However, President Bush’s tax cuts have turned this surplus into a deficit. In 2005, the Congressional Budget Office (CBO) estimated that there would be a budget deficit of $ 368 billion that year and that it would be followed by a deficit of $ 295 billion next year. In short, the US economy has shown the characteristics of an overheated economy in the years leading up to the recession.