Credit Crunches and the Great Stagflation
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 theresult 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 employ-
ees. 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.