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Inflation and deflation 3: Obama stimulus plan

Is the stimulus large enough to offset the demand shock caused by the contraction in credit? Will it lead to inflation? Created by Sal Khan.

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  • blobby green style avatar for user Aric Diamond
    I don't understand why the credit crisis is going to cause the savings rate to go back up to 10% again, can anyone explain?
    (19 votes)
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    • leaf green style avatar for user Robert Percival
      His theory was that people had perceived savings near 10% anyway. But the real savings was dropping because people were using credit to make more purchases than they should have been.

      As we approached zero it all started blowing up because we finally realized that a whole lot of people using credit to buy stuff were doing so by borrowing against savings that didn't really exist. (i.e. a house whose upwardly moving "value" was only moving upward because of the apparent demand created by tons of other people getting easy access to loans to buy said house.)

      Then once we're mostly done closing down offices we institute tighter regulations on borrowing, and everyone is scared to lend money anyway. So you end up with consumers being completely unable to spend; resulting in net savings percentage across the nation going up.
      Keep in mind that doesn't mean that an individual who was borrowing money is now saving, but it does mean that they are no longer offsetting someone else who was and still is saving.

      BTW - I think it is interesting to note that since this video was originally posted the savings rate has increased. And, despite being quite volatile it is following an upward trend at roughly the same rate as it came down. Which would bring us back to an average savings % above 7.5 by 2020.
      (32 votes)
  • blobby green style avatar for user jakekraft
    If you don't have access to a Bloomberg Terminal, what's the best website to get current graphs of the 'US Capacity Utilization' and 'US Inflation'?
    (17 votes)
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  • leaf green style avatar for user khan.student
    When the government implements its stimulus plan, how do they actually consume the goods? Like do they just send random government agents to buy 1 trillion dollars worth of spatulas at Williams Sonoma or something?
    (17 votes)
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    • blobby green style avatar for user Edward Franklin
      one thing they buy is bonds in companies - this forces down yields - this means people who had the money in the bond that the government bought will buy other bonds (as the potential profit of the prior bond has fallen) and thus investment gets flowing

      government also tends to give money to the very poor. This is because they do not save much so they stimulate spending better than the rich
      (13 votes)
  • blobby green style avatar for user Jose Prado
    What is the rational for those who argue that obama stimulus plan will cause inflation?
    (4 votes)
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    • old spice man green style avatar for user pardijoe
      I think they basically believe that the U.S. government will never stop over-spending and will just keep printing money to pay off future debts. They believe as you print more and more money the value of the existing dollars will drop drastically, meaning that a $2.00 loaf of bread will now cost $5.00+ because a dollar bill is now worth less. They use hyperinflation in the Weimar Republic as an example.

      From what I gather listening to talk radio or Fox News, that's why they think it will cause inflation. Anyone if I am misconstruing please correct me (by the way, I have no clue who is right, that's why I'm here).
      (12 votes)
  • leaf green style avatar for user khan.student
    I'm soo confused... I don't know half of what he's saying.

    "The Feds would lower interest rates." What is the Feds?

    "We would pump more and more money into Fannie and Freddie Mac" Who are Fannie and Freddie

    "We would create incentives for securization" What's securization?
    Bear Sterns? Collateralized debt obligations? AIG? Credit Default swaps? Huh???

    Somebody pleaseeee explain this!
    (5 votes)
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  • blobby green style avatar for user yads12
    At , if buying a share of IBM from someone who isn't IBM not savings, what then would constitute savings in the real world. Are people who put their money into a mutual fund not saving?
    (5 votes)
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    • spunky sam blue style avatar for user prakhar.nishant
      Purchasing share from someone who is not IBM is investing based on the perception that the share price is going to rise and one might be entitled to a larger dividend in future. However, a Company has already issued shares and has borrowed money by doing so. Thus, there is no underlying real economic value which directly benefits the Company. It is merely transfer of "risk and rewards" of ownership on such share. For example- Assuming you purchased an Uber share at IPO for $ 30/share and Uber share price increases at $ 100/share that does not mean that Uber has that $100 with them. If Uber issued 10,000,000 shares at IPO it would probably have $ 300,000,000 which would have been invested in the Company towards Capacity utilization/expansion, etc. Subsequent increase in the price is driven by the perception that Uber share will pay annual dividends and/or the share price shall continue to grow higher . Think of it like the "Home Equity" and "Home Equity Loans" explained by Sal in an earlier video.

      It could be Yes or a No. Mutual funds do buy shares during IPO but they also buy publicly traded stocks and hope that they are benefitted by (taking the Uber example) increase in share price, dividends, stock splits or share repurchase of shares by Uber.
      (3 votes)
  • blobby green style avatar for user lionelm.MR
    It would be very nice to have a part 4 to this video. Especially with a 10-year retrospective on the current economy and whether the Obama stimulus plan worked or not.

    I do not mean this in a news-flashy or overly political standpoint, just as a couple of added lessons learned from real-world economics.
    (4 votes)
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  • blobby green style avatar for user hartoghartog
    Any chance of full playlists of introductory micro and macroeconomics? It seems like it would be right up your alley!
    (3 votes)
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  • blobby green style avatar for user MarkJ.A.Barbour
    Would it not be better for the government to, instead of printing more money to spend that isn't really representative of intrinsic goods and services based on voluntary exchange, but cut spending in an equivalent amount and reimburse tax payers with that savings? Since the government doesn't actually produce anything, they get their revenue by taxing productivity, they are just redirecting spending, not actually producing anything.
    (3 votes)
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  • blobby green style avatar for user gnuGabe
    I have heard claims that the US is becoming more of a service based economy and that tax revenue is based on industrial production and consumption. 1) Is this a fact? 2) How does capacity utilization relate to services like consulting or design compared to physical production?
    (3 votes)
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Video transcript

I finished the last video touching on the stimulus plan and whether it's going to be big enough and what its intent was. But I was a little handwavy about things like savings and GDP and I thought it would actually be good to get a little bit more particular. This isn't just me making up things. So a good place to start is just to think about disposable income. And people talk about it without ever giving you a good definition. It's important to understand what disposable income is. So this box right here is GDP, so it's all the goods and services, essentially all the income, that we produce. The disposable income is essentially the amount that ends up in the hands of people. So the U.S. GDP, I don't know what the exact number is, it's on the order of I think $15 trillion. And so some of that money goes to taxes. I don't know. Let's say $3 trillion ends up in taxes. And these are round numbers, but it gives you a sense of the make-up. Then maybe about another $1 trillion is saved by businesses. So let's say that I'm Microsoft and I make a billion dollars a share. Microsoft makes a lot more than that, but I make a billion dollars. And I just keep it in a bank account owned by Microsoft. I don't give it to my employees. I don't dividend it out to the shareholders. I just keep that. So corporate savings, let's say, is another trillion dollars. These are roundabout numbers. And then everything left over is, essentially, disposable income. I'm making some simplifications there, but everything left over is disposable income. And the idea is, what is in the hands of households after paying their taxes: disposable income. That check that you get after your taxes and everything else that is taken out of your paycheck, that money, that is disposable income to you. So the interesting thing is where this disposable income has been going over the last many, many years. So this right here, this chart, is a plot of the percentage of disposable income saved since 1960. I got this off the Bloomberg terminal again. And just so you get a good reference point, let me draw the line for 10%. Because I kind of view that as a reference point. That's 10% personal savings. Actually, you could go back even further than this, and you can see from the 1960s all the way until the early `80s, the go-go `80s, people were saving about 10% of their disposable income. Of what they got on that paycheck after paying taxes, they were keeping about 10% of it, putting it in the bank. And, of course, that would later be used for investment and things like that. But then starting in the early `80s, right around, let's see, about 1984, you see that people started saving less and less money. All the way to the extreme circumstance, to 2007, where, on average, people didn't save money. Where maybe I saved $5, but someone else borrowed $5. So on average, we didn't save money. Actually we went slightly negative. And all of this, and this is kind of my claim-- and it can be borne out if you look at other charts in terms of the amount of credit we took on-- is because we took on credit. I guess there's two things you could talk about. We took on credit and we started having what I call perceived savings, right? If I buy a share of IBM a lot of people say, oh, I saved I saved my money, I'm invested in the stock market. But when I bought a share of IBM, unless that dollar I paid for the share goes to IBM to build new factories-- And that's very seldom time. Most of the time, that dollar I gave to buy that IBM share, just goes to a guy who sold an IBM share. So there's no net investment. It's only investment, it's only savings, when that dollar actually goes to invest in some way, build a new factory or build a new product or something. So I think you had more and more people thinking that they were saving when they weren't. Maybe thinking that they were saving, as their home equity in their house grew, or as their stock market portfolio went up. But there wasn't actual aggregate savings going on. In fact, if anything, they were borrowing against those things, especially home equity. And the average savings rate went down and down and down. So now we're here in 2007, and maybe you could say 2008, where this is the capacity. We should probably talk about world capacity, because so much of what we consume really does come from overseas, but this is the capacity serving the U.S. And let's say, going into 2007, this was demand. Supply and demand was, let's say, pretty evenly matched. If you go to that top up here, you see that we were at 80% utilization, which isn't crazy. So if anything, you could say that demand was maybe right around here. But that's a good level. You want to be at around 80% utilization. That's the rate at which you don't have hyperinflation, but you're utilizing things quite well. Now all of a sudden, the credit crisis hit and all this credit disappears. And I'd make the argument that the only thing that enabled us to not save this money, is more and more access to cheap credit. Every time we went through a recession, from the mid `80s, onwards, the government solution was to make financing easier. The Fed would lower interest rates. We would pump more and more money into Fannie and Freddie Mac. We would lower standards on what it took to get a mortgage. We would create incentives for securitization. We would look the other way when Bear Stearns is creating collateralized debt obligations, or AIG is writing credit default swaps. And all of that enabled financing. Until we get to this point right here, where everything starts blowing up. So you essentially have forced savings. When people can't borrow anymore, the savings rate has to go to 10% because most of this is just from people taking on more credit. There were a group of people who were probably already always saving at 10% of their disposable income. But there's another group of people who were more than offsetting that by taking credit. Now that the credit crisis hits, you're going to see the savings rate-- and you already see it with this blip right there-- the savings rate is going to go back up to 10% of disposable income. Now if the savings rate goes back to 10% of disposable income, that amount of money, that 10% of disposable income, this gap, is 10% of disposable income that cannot be used for consumption. And let's think about how large of an amount that is. Right now, the U.S. disposable income, if I were to draw disposable income-- this number right here, I just looked it up-- it's around $10.7 trillion, let's say $11 trillion for roundabout. So this 10% of disposable income that we're talking about, this gap between the normal environment, the environment that was enabled from super-easy credit, that's 10% of disposable income. 10% of $11 trillion is $1.1 trillion per year of demand that will go away. That's per year. So all of a sudden, you're going to have a gap where this was the demand before and now the demand's going to drop to here. And all of this $1.1 trillion of demand is going to disappear, because credit is now not available. And then you do get a situation where you might hit a low capacity utilization. Unfortunately, the capacity utilization numbers don't go back to the Great Depression, and we could probably get a sense of, at what point does a deflationary spiral really get triggered. But because that $1.1 trillion in demand disappears, you're going to see this orange line just drop lower and lower in terms of capacity utilization. And that's going to drive prices down. And what Obama and the Fed and everyone else is trying to do, is to try to make up this gap. Now, everyone else can't borrow money. Companies can't borrow money. Homeowners can't borrow money. But the government can borrow money, because people are willing to finance it. At the bare minimum, the Fed's willing to finance the government. And so the government wants to come in and take up the slack with this demand and spend the money themselves with the stimulus. Now we just talked about, what's the magnitude of this demand shock? It's $1.1 trillion per year. While the stimulus plan is on the order of a trillion dollars. And that trillion dollars isn't per year, although I have a vague feeling that we will see more of them coming down the pipeline. This stimulus plan that just passed is expected to be spent over the next few years. So in terms of demand created over the next few years, it's going to be several hundred billion per year. So it's not going to be anywhere near large enough to make up for this demand shock. So we're still going to have low capacity utilization. So the people who argue that these stimulus plans are going to create hyperinflation, I disagree with that, at least in the near term, because in the near term it's nowhere near large enough to really soak up all of the extra capacity we have in the system. And if anything, it's going to soak up different capacity. So the stimulus plan might create inflationary-like conditions in certain markets where the stimulus plan is really focused. But in other areas, where you used to have demand, but the stimulus plan doesn't touch, like $50 spatulas from Williams Sonoma or granite countertops, that area is going to continue to see deflation. And I would say net-net, since this thing this is actually so small, even though we're talking about trillion dollars relative to the amount of demand destroyed per year, we'll probably still have deflation. And, for anyone who's paying close attention to it, and I am because I care about these things, the best thing to keep a lookout for, to know when to start running to gold maybe or being super-worried about inflation, is if you see this utilization number creeping back up into the 80% range. At least over the last 40 years, that's been the best leading indicator to say when are we going to have inflation. And for all those goldbugs out there, who insist that all of the hyperinflation or the potential hyperinflation is caused by our not being on the gold standard, I just want to point out that you can very easily have-- we went off of Bretton Woods and completely went to a fiat currency in '73, that right around here. But our worst inflation bouts were actually while we were on the gold standard. And that's because we had very high capacity utilization. This is the war period. What happens during a war? You run your factories all-out. You run your farms all-out to feed the troops. The factories, instead of building cars, build planes. Everyone was working. Wages go up. Everything goes up and you have inflation. A lot of people say, oh, the war was the solution to the Great Depression. And it is true in that it got us out of that negative deflationary spiral that I talked about in the last video. And it did it by creating an unbelievable amount of inflation. And then after the war, you could argue what allowed-- I don't have GDP here, but the U.S. GDP really did do well in the postwar period-- it wasn't the war per se, although the war kind of did take us out of the deflationary spiral. So after the war, you had all of this capacity, after World War II. So you had all this capacity that was being used up by the war, and then, all of the sudden, the war ends. And you're like, well, we don't have to build planes anymore, we don't have to feed the troops anymore, and now we have all these unemployed troops who come back home. What are we going to do with them? You'd say maybe, capacity utilization would come back down there. But what a lot of people don't talk about is, the rest of the industrial world's capacity was blown to smithereens. At that point in time, the U.S. was a smaller part of GDP and the other major players were Germany, Western Europe and Japan. In the U.S., we didn't have any factories bombed. The entire war took place in these areas. And whenever people go on bombing raids, the ideal thing that they want to bomb is factories. So what you had in the postwar period, is you had all of these countries that had their capacity blown to smithereens. The U.S. was essentially the only person left with any capacity, and so all the demand from the rest of the world picked up the slack in the U.S. capacity. And that's why, even though there was a demand shock in the U.S. after that, you also had a supply shock from the war where you had all of this capacity that was blown to smithereens. In this situation that we are in now, we have a major demand shock. Financing just disappears and the savings rate's going to skyrocket because people can't borrow anymore. But there's no counteracting supply shock. Supply of factories making widgets and all the rest is staying the same. So the Obama administration is trying to create a stimulus to sop some of this up, but it's not going to be enough. And my only fear is, with all the printing money and all that goes, once we do get back to the 80% capacity utilization, once we do go back here, how quickly they can unwind all of this printing press money and all of the stimulus plan. Because that's going to be the key. Because, if we do get to 80% capacity utilization or we start pushing up there, and we continue to run the printing press-- because that's what, essentially, government's incentive is to do, because they always feel better when we're flush with money-- then, and only then, you might see a hyperinflation scenario. But I don't see that at least for the next few years.