Inflation, deflation, and capacity utilization 2 Video Lecture - Economics

In the last video I spoke a
bunch about the determining
factor on whether we have
inflation or deflation.
It isn't so much the money
supply, although the money
supply will have an effect,
it's really capacity
utilization.
Capacity utilization is
driven by demand.
And I made that distinction
because-- I gave that example
of the island, where you could
have a very small money
supply, for example, one
seashell, but if the velocity
is really high, then people are
expressing that demand.
And you'll have very high
utilization of all of the
capacity in the island and you
might have inflation, even
though the money supply
is one seashell.
On the other hand, let's say, we
found a bunch of seashells,
but everyone stops transacting,
so the velocity
were to slow down a bunch.
So in that case, even though the
money supply is huge, or a
lot larger than it was, people
aren't expressing demand.
So demand will be a lot
lower than capacity.
As we showed in the cupcakes
economics video, when you have
a lot of unused capacity, it's
everyone's incentive to try to
sell that extra unit and
they all lower prices.
So you can have an increased
money supply but, if the
velocity slows down or if
demand is slowing down--
because that's what's causing
the velocity to slow down--
then you could still have a
deflationary situation.
Actually, we touched on the
chart where we showed that
every major inflationary bout
was actually stimulated, or
was actually preceded, by a
pretty big upturn in capacity
utilization.
And the inflation really started
going once capacity
utilization got into
the 80% range.
You could imagine that if, on
average, the world is running
at 80% that means that some
people are running at 70%,
some people are running
at 90%, 95%.
And those people who are running
at 95%, those are the
people who say, gee, instead of
trying to run at 96%, 97%,
98% utilization, why don't I
just raise price and not have
to worry about producing
that extra unit?
And obviously their inputs go
into other people's; their
outputs go into other
people's inputs.
And then you get a generalized
price inflation.
Now with that said, actually, I
want to make another point.
In the early `70s-- everyone
always talks
about the oil shock.
In 1973 you had the
Yom Kippur War.
We resupplied Israel, and then
you had all the OPEC countries
that essentially stopped selling
oil to the U.S. and a
lot of other western nations.
And people say, you know, oil
prices shot through the roof
and that's what drove inflation,
that supply shock.
That probably contributed
to it, but 1973 is
right around there.
So if you actually look at this
chart, we're already kind
of on an inflationary
spectrum.
The generalized prices were
already increasing.
And capacity utilization had
really preceded that.
That probably just added
fuel to the flame.
With that said, the question
that everyone's wondering
about is, what's going
to happen now?
So before the current financial
crisis, we had a
certain amount of capacity.
Let's say this is everything,
this is the U.S. output.
Let's say this is
U.S. GDP, right?
GDP is just output.
So in a normal developed
environment, so that you go
back into the `60s-- and I
should probably get the
Bloomberg chart on this too,
because it's pretty
interesting-- about 60% of our
GDP was on consumption.
And consumption always
isn't a bad thing.
Consumption isn't always
a bad thing.
It's actually what
we use to have a
good standard of living.
If I have a nice sofa, and a TV
set, and I go on vacations,
that's consumption.
But it improves our standard of
living and the goal of all
countries is really
to improve that
average standard of living.
But the remainder is savings.
In a traditionally responsible,
developed nation
you save 40%, maybe 30% to
40%, depending on whether
you're Japan or whether
you're Western Europe.
Now what savings turns into, is
essentially new investment
to raise your ouput.
So this savings is what allows
you to increase your output in
the next year.
If you don't save even a little
bit, your output will
actually decrease, because no
one will invest in factories
and the factories will get old
and the roads will stop being
usable and all the rest.
Whenever someone's investing,
that's someone else's savings.
And it's very important to
realize that investment and
savings are really two sides
of the same coin.
If no one's saving, then
there's no money for
investment.
But just going back to this
example, when people are
saving that's what not only
maintains output, but actually
increases total output.
So this would be in the next
year or the next decade.
And then, when we consume 60%
of this, we're consuming 60%
of a larger number and our
standard of living will go up.
And this is a very sustainable
and good situation.
What happened, unfortunately,
really since the early `80s,
is that we had a constant
expansion of credit.
We started lending more and
more money to everyone and
other countries started
lending more and
more money to us.
And most of that got expressed
in more and more consumption.
So if you look at U.S.
output-- This is GDP.
If you actually go to 2007, the
average American consumed
more than we produced.
We had a negative savings.
If I were to draw that,
it looks like this.
In 2007, consumption was larger
than our total output.
So the question is, how
did this happen?
Everyone talks about money
and currencies.
Essentially we borrowed output
from other people.
When we borrow money from the
Chinese, which we use to buy
their goods, we're essentially
just borrowing
their output, right?
We're borrowing their goods.
So when we give them a dollar
bill, that's a promise that,
in the future, they could use
that dollar bill to come back
and use some of our output.
But over the course of the last
several decades, we were
just borrowing other
people's output.
And we became net debtors.
So when your consumption is
actually larger than your
output, you immediately start
to realize that this isn't a
sustainable situation
for too long.
And maybe we borrowed a little
bit more money and, actually
it did turn out that way, that
we borrowed some people's
output even more to fuel some
of our investment as well.
It's not like no investment
was going on for
the last 20, 30 years.
We had a lot of investment.
But essentially, the consumption
and investment was
being financed by other
people's output.
And, of course, when you have
consumption touching up
against-- you're fully utilized,
that makes it even
more an incentive to invest.
So all of these people were
willing to invest in the U.S.
What happened now is, you
realize that a lot of the
financing or a lot of the debt
that was being taken on, it
was being facilitated by
people's homes and home equity
loans but people really
aren't good for it.
And now all of a sudden, the
banks dried up, liquidity is
gone, people can't borrow
money, and you
have a demand shock.
So what you have is a situation
where a considerable
amount of this consumption, and
actually a considerable
amount of that investment that
was being fueled by financing,
disappears.
And now that we're in a global
world, we really should think
about global output.
But it doesn't matter,
we could talk
about just U.S. output.
But now that this demand has
disappeared-- if this is U.S.
output and let's say, this is
output that we were taking
from China or Japan or wherever
else-- and our
consumption has now
fallen down here.
And it's not because, all of a
sudden, people became prudent.
It's because people aren't
willing to lend them, to go to
Williams-Sonoma and buy a $50
spatula or whatever else.
They just can't get another
credit card loan or a home
equity loan.
So you have the situation
now, where you have low
utilization.
And this comes back
to what we talked
about in the last video.
That when you have low
utilization, it's everyone's
incentive to lower prices.
When you have a bunch
of vacant houses,
people lower rents.
When the car factories are
empty, people lower the price
of car factories.
When people are underutilized,
wages go down.
You see this shock, more
recently, right here.
As we said in the last video,
the orange line is U.S.
capacity utilization.
And it dropped from about
the 80% range.
If it had gone up here, I would
have started getting
worried about hyperinflation.
But, you see, right around
summer of 2007 it dropped off
of a cliff and it's down
here someplace.
Now you see a little bit later,
inflation dropped.
So that dynamic that we've been
talking about, capacity
utilization falling off, because
we essentially had a
demand shock.
And then that's led to
a decrease in prices.
So the question is, everything
that the Treasury is doing,
and the Fed is printing money,
and Obama spending a
trillion-dollar stimulus,
is that
going to lead to inflation?
My answer is, just watch the
capacity utilization numbers.
And, just you know, the stimulus
plan, the whole idea
about it is, the government
doesn't want us to enter into
a deflationary spiral.
If consumption drops like this,
we have all of this
capacity and prices go down.
If prices go down a little
bit, it doesn't affect
people's behavior
in aggregate.
But if people start having
expectations that wages will
go down, that prices will go
down then, they all go into
panic mode and they
stop spending.
Let's say they stop spending,
then utilization goes down
even more, then unemployment
goes up even more, and this
also makes fear go
up even more.
Unemployment going up and fear
going up makes people stop
spending even more.
And this is that deflationary
cycle that all the economists
and all of the government
officials are afraid of.
You saw that during the
Great Depression.
Let me draw a zero point
to show you where.
That is zero.
That's the dividing
line between
inflation and deflation.
You see we've had a couple
of bouts of deflation.
And they normally aren't good
times in the world.
This is the Great Depression
right here.
This is post World War I, and
the Great Depression actually
lasted all the way until-- we
entered the war in the late
`30s-- right about
here to here.
We had a little bit
of inflation.
You had the first wave of the
New Deal stimulating some
spending, but it really never
got us to any significant
level of inflation.
Just so you have a sense, I
would consider anything above
5% inflation as really,
really bad.
And let me draw a line there.
So that's the 5%
inflation mark.
So we really didn't get above 5%
inflation until you end up
with World War I, and then you
have the postwar period, we're
under Bretton Woods, and then
in the `70s we had, as I
talked about before, the oil
shock and all of the rest. The
rest is history.
But as you see, the deflationary
periods are
things that government officials
want to avoid
altogether.
So the idea of the stimulus is
for the government to borrow
money, because no-one
else can.
And they can essentially fill
up the gap where the
consumers left off.
Now the question is, are
they going to fill
up enough of a gap?
Actually I realize that I'm
running out of time again.
I don't like to make these
videos too long, so I'll talk
about that in the next video.