Presenter: Itamar Drechsler
Affiliation: University of Pennsylvania, Wharton School
Date: December 13, 2022
Time: 13:00 GMT (15:00 Israel Time)
Abstract: We show that severe credit crunches contributed to the four successive stagflationary cycles that characterize the Great Stagflation of 1965–1982. The crunches were the result of large outflows of deposits from the banking system that intensified whenever inflation increased. These deposit outflows were due to the Fed’s policy of imposing a low ceiling on bank deposit rates, which eliminated the passthrough of the Fed funds rate to deposits and caused real deposit rates to become increasingly negative as inflation rose. Since credit is an input to firms’ production, the high cost of credit during the crunches forced firms to raise prices and cut output and employment, i.e., they led to stagflation. Consistent with this theory, we find a tight relationship between declines in deposits and bank credit, the buildup of unfilled manufacturing orders and inflation, and declines in GDP growth, employment and inflation. We then test the theory in the cross-section of manufacturing industries sorted by their dependence on bank financing and find that during the credit crunches, more finance-dependent firms raised prices and cut output more, held less inventory, and hired fewer employees. We similarly find these results for firms financed by banks located in areas that were more exposed to deposit outflows. Our findings imply that the supply shocks generated by the credit crunches were an important driver of the Great Stagflation.