Is the Philippine economy overheating?

By: Fernando Fajardo December 13,2018 - 10:03 PM

Some sectors are concerned that the economy is overheating. JC Punongbayan in his September 28, 2018 Rappler article cited the International Monetary Fund, the World Bank, the ASEAN+3 Macroeconomic Research Office, and Fitch as among those which have cautioned us against “early signs” and “increasing risks” of economic overheating.

An overheating or overheated economy is one that has experienced a prolonged period of economic growth that has led to high levels of inflation as higher income and wealth among the people raise aggregate demand faster than what the economy can produce.

In an attempt to capitalize on the increase demand, business may also tend to overproduce and misallocate resources.

The increase in demand and inflation and consequent resource use misallocation may eventually lead to overcapacity and to a recession later on.

Overheating, however, is not just about our actual real GDP exceeding our potential real GDP when all our existing resources are utilized.

Overheating can also happen even before we reach our full potential or what in economics called our production possibility frontier.

This is because our ability to harness all the existing resources for production maybe very limited by institutional constraints in the way Acemoglu and Robinson defined in their book, Why Nations Fail.

In our country, this constraint lies in our weak political institutions in the sense of being unable to craft and implement good economic policies, programs, and projects essential for economic growth and development.

Weak government results from the country having elected and appointed into high office the inept and corrupt among us and having a private sector that is more interested in quick profits by seeking government favors rather than using their ability to produce and compete fairly in the market.

Fact is that we still have a long way to reach our production possibility frontier.

Just look at our high combined under and unemployment rates, the poorly tilled or unutilized lands in the countryside, and capital that are used more for ostentatious projects like malls and condominiums instead of putting them in industries or agriculture.

What we have reached so far is only the limit of our institutional capacity to muster our existing resources to their best and highest use efficiently.

Inflation is one of the most common signs that an economy is overheating.

To correct this, central banks usually raise interest rates in an attempt to lower the amount of spending and borrowing.

While central banks can fight inflation by raising the interest rate, its impact is not immediate.

Inflation being a lagging indicator, it can take a while for an increase in interest rates to reduce the inflation rate.

Rapid growth in money supply, along with rapid growth in credit, is another sign of a heated economy.

More loans means more economic activity, which generates more employment and income, leading to higher aggregate demand and inflation.

Other signs of overheating include an increasing current account deficit.

According to Punongbayan, if the current account deficit is widening, this suggests we are not saving enough and we are financing our investments by borrowing from the rest of the world.

A growing current account deficit can also result from trade deficit, that is, when our import exceeds our exports, resulting in the outflow of foreign exchange and depreciation of the local currency.

A growing fiscal deficit is also another sign of an overheating economy.

A large fiscal deficit usually results in inflation, increase imports, and currency depreciation.

An overheating economy goes with flourishing financial market.

This may look bullish but lacking in the necessary foundations for sustained long term and inclusive growth.

Are we overheating?

I think so.

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