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Credit crunch

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A "credit crunch" is a recessionary period in a debt-based monetary system where growth in debt money (or "credit") has slowed and subsequently causes a drying up of liquidity in an economy.[1]

It is often caused by lax and inappropriate lending, which results in losses for lending institutions and investors in debt when the loans turn sour and the full extent of bad debts becomes known. These institutions may then reduce the availability and ease of obtaining credit, and increase the cost of accessing credit by raising interest rates for fear of further losses. In some cases lenders may be unable to lend further, even if they wish, as a result of earlier losses restraining their ability to lend.

A credit crunch is generally caused by an irreversible reduction in the market prices of previously "overinflated" assets and refers to the financial crisis that results from the denouement of this price collapse. In contrast, a liquidity crisis is triggered when an otherwise sound business finds itself temporarily incapable of accessing the bridging finance it needs to expand its business or smooth its cash flow payments. In this case, accessing additional credit lines and "trading through" the crisis can allow the business to navigate its way through the problem and ensure its continued solvency and viability. It is often difficult to know, in the midst of a crisis, whether distressed businesses are experiencing a prolonged and intractable credit crunch caused by mistaken and unsustainable valuations and lending practices, or whether these businesses are experiencing a temporary liquidity crisis which can be traded through and survived.

In the case of a credit crunch, the best response is generally to "mark to market" - and if necessary, sell or go into liquidation if the capital of the business affected is insufficient to allow continued trading through the "barren" post-boom phase of the credit cycle. In the case of a liquidity crisis on the other hand, it is often preferable to aggressively trade through the crisis and attempt to access additional lines of credit, as opportunities still exist for growth once the liquidity crisis is overcome. Given that the appropriate responses to each crisis are in fundamental conflict, stakeholders' rapid and accurate assessment of any financial crisis is crucial for the preservation of investors' remaining capital.

A prolonged credit crunch is the opposite of cheap, easy and plentiful lending practices (sometimes referred to as "easy money" or "loose credit"), the likes of which have been seen around the world, particularly between 2002 and 2007. During this upward phase in the credit cycle in a debt-based monetary system, asset prices experience bouts of frenzied competitive, leveraged bidding, inducing hyperinflation in a particular asset market. This can then cause a speculative price "bubble" to develop. As this upswing in new debt creation also increases the money supply and stimulates economic activity, this also tends to temporarily raise economic growth and employment.[2]

Despite the obvious self-destructive recklessness of "loose" bank lending practices prior to a credit crunch, game theory dynamics can provide insights into the subtle incentives behind the banks' apparent lemming-like herd behavior. Often it is only in retrospect that participants in an economic bubble realize that the point of collapse was obvious. In this respect, economic bubbles can have dynamic characteristics not unlike Ponzi schemes or Pyramid schemes.

As prominent Cambridge economist John Maynard Keynes observed in 1931 during the Great Depression: "A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him."

Sudden precipitous price collapse rather than steady slow decline is usually associated with the end of any economic bubble and the credit crunch aftermath.

When new gullible borrowers cannot be found to purchase at inflated prices, a price collapse occurs in the market segment inflated by excess debt due to the inability to find any counterparty willing to purchase at the low yields being offered (this concept is captured by the money market expression "there are no more fools on the buy side", in reference to the analogous greater fool theory of market behavior). This complete absence of willing buyers then triggers a dramatic reduction of liquidity in that market. This can then cause insolvency, bankruptcy, and foreclosure for those borrowers who came in late to that market. If widespread, this can then damage the solvency and profitability of the private banking system itself, resulting in a dramatic reduction in new lending as lenders attempt to protect their balance sheets from further losses. This in turn results in a contraction in the growth of the money supply, often referred to as a "drying up of liquidity."

A reduction in the growth of the money supply caused by a credit crunch can bankrupt marginal borrowers and threaten the solvency of marginal lenders, as the liquidity in the economy dries up due to a shortage of new debt money. This reduction in the money supply and the sharp drop in previously inflated asset prices stifles economic growth and employment, thereby triggering an economic recession or in severe cases, a depression.

The 2007 Subprime mortgage financial crisis may have brought about a credit crunch.[3]


References

  1. ^ Definition of credit crunch
  2. ^ Rowbotham, Michael. The Grip of Death, Jon Carpenter Publishing, 1998
  3. ^ Dollar tumbles as huge credit crunch looms




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