Credit crunch

From Wikipedia, the free encyclopedia

A credit crunch is a sudden reduction in the availability of loans (or "credit"), which may be due to increased perception of risk, a change in monetary conditions, or even an imposition of credit controls.^[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 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 restraining their ability to lend.

A credit 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.^{[citation needed]} 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.

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.^[2] 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 may 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.^{[citation needed]}

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 in a debt-based monetary system, 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.^[3]

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.^[4]

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."^[5]

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

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 is considered by some to have caused a credit crunch.^[6]