14 Apr 2009

Can You Have Inflation With Low Utilization?

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For some time I have been meaning to complain about all the analysts–and not just talking heads on CNBC but even professional economists quoted in the WSJ–saying that, “The Fed’s worry right now isn’t inflationary pressures, because of the low capacity utilization rates.” In other words, they are saying that prices can’t possibly start rising until the real economy picks up steam.

But that’s the same Keynesian mistake that (I thought) was exploded with stagflation in the 1970s. Specifically, what happens is that a business will see its input prices rising, and so in reaction it ends up raising prices for its customers even though it may still be operating at less than full capacity. (Note I’m not giving a formal theory of how prices are set–obviously it is always about supply and demand–and I’m not really advancing a cost theory of price. I hope you get the short cut I’m taking here to get the point across.)

So it’s true, if my customers all of a sudden have more money (printed by the Fed) and the demand for my product starts rising, then I would respond by increasing output, i.e. capacity utilization would go up. But that will only be true in the initial stages of the inflationary “recovery.” Once that new money spills over into other sectors, you eventually end up with the same relative purchasing power of various people (generally speaking) and there is no reason for you to stay at the higher capacity.

Quick example: Disregarding the distributional issues etc., if the Fed doubles the amount of cash held by everyone, then prices roughly double. So if right now a businessman finds his profit-maximizing strategy–given current prices–is to run his factory at 40%, and to only carry half the employees he had during 2005, then why would a doubling of all prices lead him to change that? Yes yes, some businesses would, depending on their debt levels etc. But I hope it is now clicking with you that rising prices can occur amidst low capacity utilization (and high unemployment). Like I said, I thought we “learned” this lesson in the 1970s, except apparently for everyone quoted on CNBC or in the Wall Street Journal.

EPJ links to Stefan Karlsson making the same point:

…Zimbabwe has had extremely high money supply growth rate while also having extremely high unemployment (60 to 80%) and extremely low capacity utilization (20%). The result was an inflation rate of 231,000,000%.

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