Will ‘Running the Economy Hot’ Really Help Workers?


It’s an increasingly popular view, including within President Joe Biden’s administration, that the U.S. should allow labor markets to “overheat” to increase both employment and wages. It sounds like a good idea, especially after several decades in which ordinary workers have not always done well. But the economics do not withstand rigorous scrutiny.

One theory about the benefits of an overheated labor market stems from the work of Robert E. Lucas in the 1970s, which in turn built upon ideas from Milton Friedman. In Lucas’s model, if the central bank boosts the money supply and the rate of price inflation, some people will work more or expand their businesses because they think there is a real and enduring increase in the demand for their output.

That makes sense theoretically, but subsequent empirical studies showed the effect is typically small. In 1986, Lawrence H. Summers wrote a critique of these and related ideas, and the economics profession rightly decided to move on. Inflation does change people’s work and production plans, but not by very much.

A second argument has remained more robust: the Keynesian idea of money illusion, outlined in Keynes’s General Theory. According to Keynes, a central bank can boost the rate of employment by inflating. If nominal wages are sticky, and the rate of price inflation goes from 0% to 5%, inflation-adjusted wages will suddenly be 5% lower. Businesses will hire more workers.

Even if you are an unreconstructed Keynesian economist, you might notice a problem with this mechanism: It boosts employment but not real wages. In fact, it boosts employment by lowering real wages, which is a pretty typical economic mechanism. So if the idea is to “run labor markets hot to raise worker pay,” this approach isn’t going to help. Instead it will increase the temptation to solve employment problems by looking for ways to cut real wages, not raise them.

Another way to make labor markets “run hot” is through the supply side. In the current context, that might mean providing more vaccinations more rapidly. This will indeed create more jobs, especially for face-to-face employment, and over time it will raise worker pay, especially for those who are more productive in safe, face-to-face environments.

So smart supply-side remedies can increase both employment and pay in a sustainable fashion. But that has been known to economists since the days of Adam Smith. The new macroeconomics, as it is being formulated, is looking for a way to bring about the same effect through the demand side.

Another set of tactics to run labor markets hot invokes the notion of increasing returns to scale. That is, a boost to one part of the economy can stimulate other parts of the economy, causing many sectors to rise in unison. There is now a whole branch of macroeconomics on increasing returns to scale.

Still, the idea deserves closer examination. Increasing returns to supply-side benefits, such as vaccinations, are currently likely. But again, this is an old story, and it does not resuscitate the idea of running the labor market hot through demand-side macroeconomics.

How about increasing returns to scale from the demand side? Well, advocates of the $1.9 trillion American Rescue Plan have been saying that right now the multiplier is relatively low, to justify the large amount of money being spent. That puts them in a poor position to be arguing that the spillover effects are strongly positive.

Here is one way to look at the problem: Even with a partially vaccinated population, gains in one sector do not easily boost the ailing sectors of the economy. Just because I am making a lot of money running a pet store, for example, it doesn’t necessarily follow that I will book an expensive Caribbean cruise.

The upshot is that the most plausible demand-side mechanism for “running an economy hot” is the Keynesian story about money illusion — the idea that people tend to see their wealth and pay in nominal terms, not real terms. And that scenario will not be good for most of the workers who already have jobs, as in many cases their real wages will fall. Of course that is most workers, because even in bad times the unemployed are a clear minority.

Nonetheless, expect talk of “running the economy hot” to continue. It sounds good, and it conveys the notion that the economy is making up for years of neglect following the subpar recovery from the 2008 financial crisis. It allows politicians and officials to show determination and convey a sense that they are brave fighters for the working class.

Unfortunately, this kind of talk is the rhetorical equivalent of vaporware, promising something that will never ship. Simply wishing for better outcomes, and describing them with catchy language, does not suffice to bring them about.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Tyler Cowen is a Bloomberg Opinion columnist. He is a professor of economics at George Mason University and writes for the blog Marginal Revolution. His books include "Big Business: A Love Letter to an American Anti-Hero."

©2021 Bloomberg L.P.

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