Inflation, Deflation & Capacity Utilization 2 More on inflation and capacity utilization
Inflation, Deflation & Capacity Utilization 2
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- 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, the 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.
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