Credit crunch, effective supply failure and stagflation

Much of contemporary economics does not view capital as dated labour inputs – a view popular with the Austrian School of Mises and Hayek, with clear antecedents in Marx (Karl, not Groucho).  Instead it has just two kinds of inputs – instantaneously variable inputs, like labour and raw materials, and fixed inputs like capital goods. Instantaneously variable inputs are hired and immediately produce output which is sold on the market without any lags.  Fixed input decisions are taken one year, the capital equipment is installed the next year and starts producing output for which is available for sale the year after that.

This view of the production process means that the cost of capital, interest rates and credit conditions, including credit rationing, don’t have any impact on potential output (supply) over horizons relevant for cyclical stabilisation policy.  Their effect on demand, through fixed investment, inventory investment, consumption and net exports, is recognised of course, so the impact of tighter credit conditions, including credit rationing because of a credit crunch, is always assumed to be a lower output gap – demand falls but supply remains unchanged or, equivalently, actual output declines but potential output is unaffected in the short and medium term.

Once we recognise that all production takes time, credit conditions can influence effective supply (effective potential output) even in the short run.  Labour is hired this month, produces output next month which is sold at the end of the month after that.  Assuming labour is paid no later than the end of the month in which it is performed, the employer has to find enough credit to pay for one month’s worth of wages and one month worth of inventory of finished goods if he is to produce at all, even if the fixed capital is installed and ready to go.

While the effect of higher interest rates on short-run supply may not be very significant as long as credit is freely available at whatever the level of interest rates happens to be, credit rationing – unsatisfied demand for credit at the rates prevailing in the markets – can have a brutal effect on effective supply, even in the short run.

We are currently going through the most severe credit crunch affecting industrial countries for three generations.  If such a credit crunch hits the economy, it is quite likely that there are sectors or industries for which effective supply is held back by more than the effective demand for their products or services.  These need not be the capital intensitive industries – just the working capital-intensive industries.  In the first instance, SMEs are likely to be worst affected, as their sources of external finance are limited and often just consists of banks.  When banks ration credit, or impose too onerous conditions on would-be SME borrowers, profitable production may not be possible and businesses may cut back or shut down, at least temporarily.

And when commercial paper markets also dry up, as has been the case in the current credit crisis, not only SMEs may run short of working capital.  Large enterprises, which typically fund themselves through the commercial paper market, are also likely to find themselves off their notional output supply curves because credit is simply not available at any price.

If effective supply falls by more than effective demand in a sector or industry, there will be growing inflationary pressure in that sector or industry.  It is even possible that a credit crunch would, in the short run, hit aggregate effective supply more than aggregate effective demand, so domestically generated inflationary pressures in the economy could rise initially as a result of a credit crunch.  In any case, downward inflationary pressures will be weaker in the presence of credit-induced effective supply failures than if such effects are not present.

This potential short-run inflationary effect of a credit crunch was central to the structuralist economic perspective on the transmission mechanism of monetary and credit policy.  This originated with the work of the Economic Commission for Latin America (ECLA or CEPAL) and is associated with such names as Raul Prebisch and Celso Furtado.

Much of the structuralist approach suffered from the problem that the analysis was half-right and the policy recommendations therefore almost always wholly wrong.  The key difference between a one-off change in the price level, or a relative price change, and a sustained rise in the general price level (i.e. inflation) generally escaped the structuralist.  Some of these shortcomings were corrected in the neo-structuralist approaches of economists like Harvard’s Lance Taylor.  This neo-structuralist perspective can be found back in the work of a later generation of South American economists, including Domingo Cavallo, the former Governor of the Central Bank of Argentian and finance minister of Argentina, who wrote his Ph.D. thesis on the subject (Cavallo, Domingo F., “Stagflationary Effects of Monetarist Stabilization Policies,” unpublished Ph.D. dissertation, Harvard University, 1977.)

An elegant modern restatement of the theory of effective supply failures can be found in a paper by my former Princeton Colleague and former Deputy Chairman of the Federal Reserve, Alan Blinder (Blinder, Alan S, 1987. “Credit Rationing and Effective Supply Failures,” Economic Journal, Royal Economic Society, vol. 97(386), pages 327-52, June, obtainable with a subscription from JSTOR).

It is likely that, with commodity prices falling globally (relatively and absolutely in most currencies), and with demand getting hammered, especially from the consumer demand side and increasingly from the fixed investment side also, inflation will be dropping sharply globally.  Where the working capital channel of monetary and credit transmission via the supply side are important, however, effective supply failures may, in the short run, reduce or even reverse the domestic inflationary effect of the credit crunch.  Monetary policy makers should, in my view, ‘see through’ this reduction in domestic disinflationary pressures caused by effective supply (constrained by credit availability) being below notional supply (what supply would be if credit markets were not subject to rationing but functioned normally).  It is the task of credit policy (and banking sector solvency restoring or solvency-boosting measures by the fiscal authorities) to eliminate the gap between effective supply and notional supply.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website