What If We’re Thinking About the Hot Economy All Wrong?

This week, we have a guest author: Alex Williams, senior economist at Employ America, a think tank and advocacy organization that promotes macroeconomic policies that create and sustain tighter labor markets. You can find more of Alex’s economic musings (and music recommendations) on X, @vebaccount. 

Judging by the top-line macroeconomic indicators, we’ve got what many describe as a “hot economy.” Unemployment is historically low, labor force participation and prime-age employment are historically high, and we’ve seen wages rise, especially for workers at the bottom of the income distribution. GDP growth remains strong, and even after adjusting for inflation, US GDP is growing faster than that of its peers.

For some, these headline macroeconomic data points are a sign that the economy is “too hot.” Fed officials have recently been hinting at the possibility of further rate hikes, while others like the IMF have suggested that inflation be fought by rolling back fiscal spending. Marquee names like Jason Furman and Larry Summers have criticized the scale and scope of both demand-side stimulus and industrial policy during and after the pandemic for fear that both contributed to overheating. But in 2024, the economy also has “cold spots” that are only getting colder as the effects of fiscal stimulus give way to those of restrictive monetary policy.

There’s another challenge making this debate less productive. Right now, it’s hard to find agreement on what a “too hot” economy actually means.

Some definitions make it seem like the economy is an engine that could blow a gasket, while others imply that wealth accumulation just gives off heat. In any event, “heat” always has to be a metaphor—the actual economy isn’t any warmer (well, maybe a little on average, on account of climate change) than it was 10 years ago, but it is absolutely running differently.

Once we know whose “heat” we’re interested in, we can better explain how a hot economy could have cold spots, and what to do about it. We just need the right metaphor to describe what we’re seeing.

The easiest one to reach for—a pot of water boiling on the stove—tells us little, as it doesn’t capture the complexity of our economy. Although it takes a little more effort to set up, thinking of “heat” in the context of managing the plumbing of an old house in winter gets us much closer.

The Oversimplified Metaphor: Economy as a Pot of Water

Think of the economy like a pot of hot water on the stove that society uses to accomplish its goals—say, cooking pasta. Government policy works like a knob to control the level of the burner. Lower interest rates and higher fiscal spending turn the heat up, while higher interest rates and lower fiscal spending turn the heat down. If we see price inflation, it means that the heat is too high, and if we see unemployment and slow growth, that means the heat is too low.

If the economy “overheats,” it boils over and if the splashing water puts out the burner’s flame, there might be an economic downturn in which the economy then gets too cold, the spaghetti never cooks, and everyone is left waiting and hungry.

The trick is to get the burner set to the right level so that the economy remains sustainably hot—resulting in the perfect bowl of slightly al dente noodles after approximately 9 to 12 minutes. When water starts boiling a little too fast, the government should change monetary and fiscal policy to turn down the heat. If at seven minutes—when you are impatient and hungry—the water that you prematurely added the pasta to still isn’t boiling, the government should crank the heat.

Exactly how that works, as a compromise between fiscal and monetary policy authorities is the subject of over a hundred years of economics literature. But ultimately, the metaphor is easy to understand and gives policy advice, so it has a clear appeal.

The problem is, although its straightforwardness is compelling, this metaphor dramatically oversimplifies the problems, the solutions, and the space of action available to policymakers. And unfortunately, we’re trying to cook spaghetti and rigatoni and penne and orzo and elbow noodles all at once, with drastically different cooking times.

The economy has a more complex structure than a pot of water on the stove: Monetary and fiscal policy have different effects through different channels. Each of those different channels themselves can be hot or cold, as the economy does more than one thing. They can happen simultaneously, independently or interrelatedly, and the sequencing can matter. It’s a glib metaphor for a serious question.

The More Accurate Metaphor: Economy as an Old House in Winter

Although it takes a few more steps to work through, it’s worth thinking of the economy as an old house whose plumbing must be watched in the wintertime so that the pipes don’t freeze. The plumbing is important, making sure that every part of the house gets water, but when temperatures get too cold, those pipes may freeze and burst. When this happens, it means the water won’t work right until costly repairs are made, and it may even cause flooding or further damage if ignored.

Even worse, the pipes can freeze long before the rest of the house gets noticeably cold. Unlike the pot of water on the stove, the house only has to get too cold in one spot to have problems. Some of those pipes might be in the basement or inside drafty walls—places that are colder than the rest of the house and which one might not check on as often.

The goal of the government in this metaphor is to make sure that every part of the house—the economy—is kept warm enough for the plumbing to function. It’s not hard for some far corner of the basement, or some distant part of the attic to get cold enough for this to happen while the living area is still warm enough to be comfortable.

But what does this change in metaphor mean for how the government should think about industrial policy in a “hot” economy?

If we follow the pot of water metaphor and look for a single knob that controls the temperature, we find it quickly: the thermostat. The thermostat controls the heat in the living area, and can adjust the air temperature there up and down. Direct fiscal stimulus and monetary policy—both of which act across a wide range of economic sectors with little precision—work much like this thermostat: Give households or businesses money and the whole economy will heat up, decrease spending and it will cool off.

We can easily read this into some recent episodes. Many kinds of economic turbulence—whether on the demand side like 2008, or on the supply side like 2021—work like a cold snap in this metaphor. During the Great Recession, the Fed turned the thermostat way up on monetary policy, but the pilot light for the furnace was out (thanks to a classic Keynesian liquidity trap), which meant temperatures inside the house did not rise as expected, and some pipes decidedly froze. Over the pandemic, both the Biden and Trump administrations made sure the pilot light was lit, and turned up the thermostat on fiscal spending through massive cash distributions to businesses and households. At the same time, the Fed raised the thermostat on the monetary side by dropping rates to zero while working hard to prevent financial markets from locking up. Today, as that burst of heat continues to dissipate, it is time to start looking for the places where things are already getting cold.

But there is an issue with only using the thermostat. If it’s cold enough outside, turning the heat up enough to make sure that none of the pipes in the basement freeze usually makes the actual living area uncomfortably hot and stuffy. Luckily, the thermostat isn’t the only way to heat the house. Instead of paying to heat the whole house up enough to keep the pipes warm, it is possible to make targeted interventions to keep the pipes warm. As many homeowners know—my parents especially, taking care of a house in Vermont—you can find the parts of the house that get cold first and set up space heaters there to keep them warm.

These space heaters are like the targeted industrial policy programs to specific sectors mentioned above. They keep specific parts of the plumbing warm no matter how the thermostat needs to be set to keep everyone comfortable. And in fact, research may show that some sectors simply need better insulation, opening up further possibilities for policy targeting.

By making these targeted investments, the government can sustainably warm up the cold spots in a hot economy. And if it doesn’t do this, it’s reasonable to expect bigger and more intractable problems in the medium term, like housing inflation from underinvestment in the supply side; care work inflation from supply and affordability constraints; and electricity inflation from underinvestment in the grid and decarbonization.

Right now, while the labor market is tight, and the living room is warm, the government should be figuring out what parts of the economy will need space heaters instead of waiting until those places have started to freeze. If further investment into industrial policy seems unwise because it might “overheat a hot economy,” it might be time to check your metaphors: A pipe can burst in the basement while you’re watching water boil on the stove.

If You Ask Eleanor

People everywhere like economy, but I think they are beginning to see that sometimes, when things are really needed, it is better to meet these needs as quickly as possible.

– Eleanor Roosevelt, My Day (April 24, 1956)