Inflation, deflation, and capacity utilization 2

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.