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Current time:0:00Total duration:11:49

Inflation, deflation, and capacity utilization 2

Video transcript

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 you know 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 you know 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 high or a lot of unused capacity it's everyone's incentive to kind of try to sell that extra unit and they all lower prices so you could have an increased money supply but if the velocity slows down or if demand is slowing down because that's what's causing the de philosophie slowdown then you could still have a deflationary situation so given all of that that we talked about and actually I you know we touched on this chart where we showed that every inflationary major inflationary bout was actually was actually stimulated or is actually preceded by a pretty big upturn in capacity utilization and the inflation really started going once capacity utilization got into the 80% range and you could imagine that on average that's when 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 percent and those people who are running at 95 percent those are the people who say gee instead of trying to run at 96 97 98 percent utilization why don't I just raise price and not having to worry about producing that extra unit and obviously their inputs go into other people's their outputs go to other people's inputs and then it you get a generalized price inflation now with that said actually I want to make another point in nineteen in the early 70s all the way everyone always talks about the oil shock right in 1973 and the Yom Kippur War we resupplied Israel and then I had all the OPEC countries that essentially stopped selling oil to the US 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 just CF is right around is right around there so if you actually look at this chart we're already kind of on an inflationary spectrum prices the generalized prices were already increasing and capacity utilization had really preceded that that probably just added fuel to the flame well that said everybody know the question that everyone's wondering about is what's going to happen now so before the current financial crisis let me just we had a certain amount of capacity we had actually let me say that let's say this is everything this is the u.s. output u.s. output and in a normal environment in the nor let say this is u.s. GDP right output it GDP is just output so in a normal developed environment so if you go back into the 60s and I should probably draw get the Bloomberg chart on this too because it's pretty interesting we spent about we consumed about 60% of our sixty sixty percent of our GDP was on consumption and consumption always isn't a bad thing let me turn off my phone three consumption isn't always a bad thing it's actually what we use to have a good standard of living you know if I have a nice sofa 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 the remainder in a traditionally you know kind of responsible developed nation you save 40 percent maybe 30 to 40 percent depending on your whether you're Japan or whether you're Western Europe and what savings turns into is essentially a new investment to raise your output so this savings is what allows you to increase your output in the next year whoops my screen so if you don't do that savings your output if you don't if you don't save even a little bit your output will actually decrease because you you're no one will invest in factories and the factories will get old and the roads will stop you know being usable and all the rest whenever investment whenever someone's investing that's someone else's savings and it's very important to realize that their 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 you know the next year or the next decade and then when we consume sixty percent of this we're consuming a sixty percent of a larger number and our standard of living will go up and this is a very sustainable and good situation what happened unfortunately over the really since since the early 80s is that we had a constant expansion of credit and we started lending more and more money to to everyone and other countries started lending more and more money to us and almost of that got expressed in more and more consumption so if you look at u.s. output u.s. output actually if you this is GDP if you actually go to 2007 the average American we consumed more than we produced we had a negative saving so if I were to draw that if I were to draw that it looks like this in 2007 consumption was larger than our total output consumption so the question is how did this happen well essentially if you know let's put all you know everyone talks about money in 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 buying their we're borrowing their output right we're borrowing their Goods and 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 debtor 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 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 it was essentially being the consumption and the investment was being financed by other people's output and of course when you have consumption kind of touching up against you know your fully utilized that makes even more incentive to invest so all of these people were willing to invest in the US what happened now is you realize that a lot of this a lot of the financing or a lot of the debt that was being taken on it was you know it was being facilitated by people homes and home equity loans but people really aren't good for it and now all of a sudden the banks have 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 good a considerable amount of that investment that was being fueled by financing disappears right and you know now that we're in a global world we really should think about global output but it doesn't matter we could we could talk about just u.s. output but now that this demand has disappeared if this is US output and let's say this is output that you know we were taking it 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 prudence 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 and what we talked about in the last video then 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 and this is see this shock more recently right here as we express we've said in the last video the orange line is us capacity utilization and it dropped from let's see that was about the 80% range and if it had gone up here I would have I would have started getting worried about hyperinflation but it you see right around summer of 2007 it dropped off of a cliff and it's down here someplace and as 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 treasurer is doing and the Fed is printing money and Obama is spending a trillion dollar stimulus is that going to lead to inflation my answer is just watch the capacity utilization numbers and just so you know you know the stimulus plan the whole idea about is they didn't want us the the government doesn't want us to enter into a deflationary spiral so 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 an expectation that wages will go down that prices will go down then they all go into panic mode and they stop spending then prices and utilization you know let's say they stopped spending stop spending then utilization goes down even more than unemployment goes up even more and this also and 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 and you saw that in the during the Great Depression right here let me draw a zero point to show you where so if this is this is 0 that is 0 let me draw it further that's the the dividing line between inflation and deflation and 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 One and the Great Depression actually lasted all the way until so you entered the war and the late 30 so it's right about here to here we had a little bit of inflation kind of yet 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 percent inflation is kind of really really bad and let me draw a line there so that's kind of the 5 percent inflation mark you see we really didn't get it 5 percent above 5% inflation until you with World War one and then you have the post-war period we're under Bretton Woods and then in the 70s we had thee as I talked about before you know you get the oil shock and all of the rest and you know the rest is history but as you see the deflationary periods were just 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 take fill up the gap where the consumer is left off now the question is are they going to fill up enough of a gap and 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