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A credit crunch (also known as a credit squeeze or credit crisis) is a sudden reduction in the general availability of loans (or credit); the reduction in credit availability may bear little relation to the level of interest rates.

A credit crunch implies changes in the relationship between credit availability and interest rates. There are a number of reasons why banks may suddenly increase the costs of borrowing or make borrowing more difficult, none of which may necessarily affect the relationship. It may be due to an anticipated decline in value of the collateral used by the banks when issuing loans, or even an increased perception of risk regarding the solvency of other banks within the banking system. It may be due to a change in monetary conditions (for example, where the central bank suddenly and unexpectedly raises interest rates or reserve requirements) or even may be due to the central government imposing direct credit controls or instructing the banks not to engage in further lending activity.

Examples where there is a change in the interest rate - supply relationship include the phenomonem of “flight to quality” whereby banks cherry-pick customers who either post more collateral or are ex ante more credit-worthy.

Background and causes

A credit crunch is often caused by a sustained period of careless 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 of credit, and increase the cost of accessing credit by raising interest rates. In some cases lenders may be unable to lend further, even if they wish, as a result of earlier losses.

The crunch is generally caused by a reduction in the market prices of previously "overinflated" assets and refers to the financial crisis that results from the price collapse. In contrast, a liquidity crisis is triggered when an otherwise sound business finds itself temporarily incapable of accessing the bridge 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 crisis of solvency or a temporary liquidity crisis.

This can result in widespread foreclosure or bankruptcy for those investors and entrepeneurs who came in late to the market, as the prices of previously inflated assets generally drop precipitously.

In the case of a credit crunch, it may be preferable to "mark to market" - and if necessary, sell or go into liquidation if the capital of the business affected is insufficient to survive the post-boom phase of the credit cycle. In the case of a liquidity crisis on the other hand, it may be preferable to attempt to access additional lines of credit, as opportunities for growth may exist once the liquidity crisis is overcome.

A prolonged credit crunch is the opposite of cheap, easy and plentiful lending practices (sometimes referred to as "easy money" or "loose credit"). During the upward phase in the credit cycle, asset prices may 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.

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."

See also

• Austrian Business Cycle Theory
• Financial crisis
• Minsky moment

Bibliography

• George Cooper, The Origin of Financial Crises (2008: London, Harriman House) ISBN 1905641850
• Graham Turner, The Credit Crunch: Housing Bubbles, Globalisation and the Worldwide Economic Crisis (2008: London, Pluto Press), ISBN 9780745328102
• Larry Elliott, The Gods That Failed: How Blind Faith in Markets Has Cost Us Our Future, (2008: The Bodley Head), ISBN 9781847920300
• Gerry Gold & Paul Feldman, A House of Cards - from fantasy finance to global crash. (2007: London, Lupus Books), ISBN 9780952345435

References

1. ^ Is There A Credit Crunch in East Asia? Wei Ding, Ilker Domac & Giovanni Ferri (World Bank)
2. Why economic theory is out of whack, Mark Buchanan, New Scientist, 19 July 2008
3. How the French invented subprime
4. Rowbotham, Michael (1998). The Grip of Death: A Study of Modern Money, Debt Slavery and Destructive Economics. Jon Carpenter Publishing. ISBN 9781897766408.
5. Cooper, George (2008). The Origin of Financial Crises. Harriman House. ISBN 1905641850.
6. Ponzi Nation, Edward Chancellor, Institutional Investor, 7 February 2007
7. Securitisation: life after death

• Credit
• Debt
• Economic problems
• Financial crises
• Terms and concepts of the 2000s United States housing bubble