If banks go bust and firms can't get bank loans to finance their operations, that has supply side effects too. A firm that has plenty of customers, but can't get financing to produce enough goods to meet the demand, may raise prices. And if a firm closes down because it can't get financing, its competitors may raise their prices. And if the threat of entry is diminished because new firms can't get financing, incumbent firms may raise prices.
Yes, bank failures will affect aggregate demand, unless monetary policy can and does ensure they don't. And yes, the recent recession should be understood as a fall in aggregate demand. And yes, the fall in aggregate demand may itself have caused bank failures. But that's not what this post is about. This post is about the supply side.
One of the things that has puzzled me about the recent recession has been the failure of inflation to fall more quickly. Reading some of Stephen's and my old posts from late 2008 and early 2009 (put "deflation" into the search box on the top right) reminds me of just how big a concern deflation was back then. Now the Canadian recession was less severe than previous recessions, so the failure of inflation to fall more in Canada is less of a puzzle. But if you had told me in late 2008 that many countries would still be seeing few signs of recovery in 2012, I would have predicted deflation in many countries. And I would have been wrong.
There are a number of possible explanations for the failure of inflation to fall more, despite the recession. Here are those that come to mind:
1. The Phillips Curve is flatter than it used to be in previous decades because a history of successful inflation targeting has made it flatter.
2. The Phillips Curve is flatter than it used to be in previous decades because inflation is closer to 0% than it used to be and there is absolute downward nominal wage rigidity.
3. Oil price rises, indirect tax increases, exchange rate depreciation, and other special factors have caused an upward shift in the short run Phillips Curve. (Note that some of these explanations only work for some countries. In particular, the exchange rate depreciation story cannot by definition work for all countries.)
4. Others I've forgotten.
I'm not saying those explanations are all wrong. There may be some truth to some of them. But I want to set them aside and consider a fifth explanation: the supply-side consequences of bank failures, and financial market problems more generally.
I am reasonably confident that it works theoretically. An exogenous shock that sent a rifle bullet directly to banks and financial markets would cause an adverse shift in the Phillips Curve. Any short run trade-off between inflation and unemployment would get worse. There would be more inflation for any level of unemployment, or more unemployment for any level of inflation. But, like any theory, it's not very useful if the effects aren't big enough to matter. And that's where I'm a lot less confident.
How could we test this theory, to see if the effects might be big enough to matter, and make it a useful theory?
My first thought is to look at cross-country comparisons. Did those countries that had the most bank failures and other financial market disruptions also seem to have the biggest adverse shift in their Phillips Curves (and so had higher inflation than one would have expected given the depth of their recession and their previous level of inflation)?
Doing that cross country test rigourously would not be straightforward. You would need some sort of index to measure the degree of bank failures (including banks that didn't fail but had to contract their operations to avoid failure) and other financial disruptions. Plus, since the depth of the recession would also be correlated with that index of financial stress (with causation running both ways) you would need to be able to distinguish between shifts in the Phillips Curve and movements along a given Phillips Curve, which requires some sort of judgement about the slope of the (short run) Phillips Curve.
My second thought is to look at historical comparisons. Comparing past recessions, did inflation fall more quickly, for a given depth of recession, in those recessions that were not associated with bank failures and other financial market disruptions? The Great Depression had bank failures, and deflation, but was also a very deep recession. So I'm not sure what lesson to draw there. And Canada's history isn't very useful as a test of the theory, simply because there haven't been enough bank failures.
So, does anyone have any better ideas about how to test or measure whether this effect is big enough to matter? Can it can explain (part of) the cross-country or historical experience?
My sense is that it might help explain the recent cross-country experience. For example, countries with bank problems like Greece, Spain, the UK, and the US have had much worse recessions than Canada, but they haven't had bigger falls in inflation. But I'm not sure.