Credit cycle
Encyclopedia
The credit cycle is the expansion and contraction of access to credit
over the course of the business cycle
. Some economists, including Barry Eichengreen
, Hyman Minsky
, and other Post-Keynesian economists
, and some members of the Austrian school, regard credit cycles as the fundamental process driving the business cycle. However, mainstream economists
believe that the credit cycle can only partially explain the phenomenon of business cycles.
During the upward phase in the credit cycle, asset prices experience bouts of competitive, leveraged
bidding, inducing asset price inflation
. This can then cause an unsustainable, speculative price "bubble" to develop. As this upswing in new debt creation also increases the money supply
and stimulates economic activity, it tends to temporarily raise economic growth
and employment
.
When new borrowers cannot be found to purchase at inflated prices, a price collapse can occur in the market segment inflated by excess debt
, along with a dramatic reduction in 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 bank
ing 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 "credit squeeze" or a "drying up of liquidity".
In the Kiyotaki-Moore model
of the business cycle, collateral constraints amplify the effects of shocks to the real economy.
Prime examples of this "boom-bust" cycle of credit creation and destruction can be found in the United States housing bubble
and the subsequent subprime mortgage crisis
, the dot-com bubble
and the Japanese asset price bubble
.
Credit (finance)
Credit is the trust which allows one party to provide resources to another party where that second party does not reimburse the first party immediately , but instead arranges either to repay or return those resources at a later date. The resources provided may be financial Credit is the trust...
over the course of the business cycle
Business cycle
The term business cycle refers to economy-wide fluctuations in production or economic activity over several months or years...
. Some economists, including Barry Eichengreen
Barry Eichengreen
Barry Eichengreen is an American economist who holds the title of George C. Pardee and Helen N. Pardee Professor of Economics and Political Science at the University of California, Berkeley, where he has taught since 1987...
, Hyman Minsky
Hyman Minsky
Hyman Philip Minsky was an American economist and professor of economics at Washington University in St. Louis. His research attempted to provide an understanding and explanation of the characteristics of financial crises...
, and other Post-Keynesian economists
Post-Keynesian economics
Post Keynesian economics is a school of economic thought with its origins in The General Theory of John Maynard Keynes, although its subsequent development was influenced to a large degree by Michał Kalecki, Joan Robinson, Nicholas Kaldor and Paul Davidson...
, and some members of the Austrian school, regard credit cycles as the fundamental process driving the business cycle. However, mainstream economists
Mainstream economics
Mainstream economics is a loose term used to refer to widely-accepted economics as taught in prominent universities and in contrast to heterodox economics...
believe that the credit cycle can only partially explain the phenomenon of business cycles.
During the upward phase in the credit cycle, asset prices experience bouts of competitive, leveraged
Leverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
bidding, inducing asset price inflation
Asset price inflation
Asset price inflation is an economic phenomenon denoting a rise in price of assets, as opposed to ordinary goods and services. Typical assets are financial instruments such as bonds, shares, and their derivatives, as well as real estate and other capital goods.-Price inflation and assets...
. This can then cause an unsustainable, speculative price "bubble" to develop. As this upswing in new debt creation also increases the money supply
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...
and stimulates economic activity, it tends to temporarily raise economic growth
Economic growth
In economics, economic growth is defined as the increasing capacity of the economy to satisfy the wants of goods and services of the members of society. Economic growth is enabled by increases in productivity, which lowers the inputs for a given amount of output. Lowered costs increase demand...
and employment
Employment
Employment is a contract between two parties, one being the employer and the other being the employee. An employee may be defined as:- Employee :...
.
When new borrowers cannot be found to purchase at inflated prices, a price collapse can occur in the market segment inflated by excess debt
Debt
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
, along with a dramatic reduction in liquidity in that market. This can then cause insolvency
Insolvency
Insolvency means the inability to pay one's debts as they fall due. Usually used to refer to a business, insolvency refers to the inability of a company to pay off its debts.Business insolvency is defined in two different ways:...
, bankruptcy
Bankruptcy
Bankruptcy is a legal status of an insolvent person or an organisation, that is, one that cannot repay the debts owed to creditors. In most jurisdictions bankruptcy is imposed by a court order, often initiated by the debtor....
, and foreclosure
Foreclosure
Foreclosure is the legal process by which a mortgage lender , or other lien holder, obtains a termination of a mortgage borrower 's equitable right of redemption, either by court order or by operation of law...
for those borrowers who came in late to that market. If widespread, this can then damage the solvency
Solvency
Solvency, in finance or business, is the degree to which the current assets of an individual or entity exceed the current liabilities of that individual or entity. Solvency can also be described as the ability of a corporation to meet its long-term fixed expenses and to accomplish long-term...
and profitability
Profit (accounting)
In accounting, profit can be considered to be the difference between the purchase price and the costs of bringing to market whatever it is that is accounted as an enterprise in terms of the component costs of delivered goods and/or services and any operating or other expenses.-Definition:There are...
of the private bank
Private bank
Private banks are banks that are not incorporated. A private bank is owned by either an individual or a general partner with limited partner...
ing 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
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...
, often referred to as a "credit squeeze" or a "drying up of liquidity".
In the Kiyotaki-Moore model
Kiyotaki-Moore model
The Kiyotaki–Moore model of credit cycles is an economic model developed by Nobuhiro Kiyotaki and John H. Moore that shows how small shocks to the economy might be amplified by credit restrictions, giving rise to large output fluctuations. The model assumes that borrowers cannot be forced to repay...
of the business cycle, collateral constraints amplify the effects of shocks to the real economy.
Prime examples of this "boom-bust" cycle of credit creation and destruction can be found in the United States housing bubble
United States housing bubble
The United States housing bubble is an economic bubble affecting many parts of the United States housing market in over half of American states. Housing prices peaked in early 2006, started to decline in 2006 and 2007, and may not yet have hit bottom as of 2011. On December 30, 2008 the...
and the subsequent subprime mortgage crisis
Subprime mortgage crisis
The U.S. subprime mortgage crisis was one of the first indicators of the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages....
, the dot-com bubble
Dot-com bubble
The dot-com bubble was a speculative bubble covering roughly 1995–2000 during which stock markets in industrialized nations saw their equity value rise rapidly from growth in the more...
and the Japanese asset price bubble
Japanese asset price bubble
The was an economic bubble in Japan from 1986 to 1991, in which real estate and stock prices were greatly inflated. The bubble's collapse lasted for more than a decade with stock prices initially bottoming in 2003, although they would descend even further amidst the global crisis in 2008. The...
.