gold dollarWhat Causes A Credit Crunch?

A credit crunch usually occurs when there has been a long period of lax and inappropriate lending. The result is borrowers in debt with loans that should never have been granted. When these 'bad loans' turn sour, the lending institutions may then reduce the availability of credit, increase the cost of borrowing by raising interest rates, or stop lending completely due to their losses from those bad loans.

Banks and other lenders may suddenly make borrowing more difficult and expensive for a number of reasons. Usually, it is due to a lack of confidence in a borrower's collateral. The lender is anticipating that there will be a decline in the value of the collateral that is being provided by the borrower to secure the loan. Sometimes it may simply be a perception of risk regarding the solvency of other banks within the system.

If the Central Bank raises interest rates or reserve requirements, the trickle down effect takes place and in an effort to comply, banks pass the costs down to the consumer and ... you guessed it, we end up in a credit crunch. The government can also create a credit crunch by imposing direct credit controls or forbidding banks from lending for a period of time.

A prime example is the soft real estate market and resulting housing bubble in many areas of the country. "Easy money" or "loose credit" paved the way for a speculative frenzy in these real estate markets. It allowed consumers who, under more controlled lending practices would not have qualified, to buy a house. With a greater demand for property than there was supply, frenzied competition and leveraged bidding resulted in hyperinflation in the real estate marketplace.

When there is a reduction in the market prices of previously "overinflated" assets, there is a financial crisis or credit crunch that results from the price collapse. Many believe the subprime mortgage crisis of 2007 - 2008 is the cause of the recent credit crunch.

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In its latest global financial stability report, the International Monetary Fund says that falling house prices and slowing economic growth are hitting credit. The US government is spending large amounts on stimulus packages to limit the severity of the economic downturn, but that extra spending will have to be largely funded by borrowing as well.

Credit risks in the US are spreading from subprime mortgages to other types of mortgages, as well as to all other major credit categories, such as car loans and credit card loans.

"Historically, societies that seek high levels of instant gratification and are willing to borrow against future incomes to achieve it have more often than not suffered inflation and stagnation.

"The economies of such societies tend to run larger government deficits financed with fiat money from a printing press . . . Eventually, the ensuing inflation leads to a recession or worse, often because central banks are forced to clamp down . . . I regret that the US may not be wholly immune to it." ~ Alan Greenspan former Fed chairman from his book: The Age of Turbulence

It appears the current credit crunch sadly, has many turning to quick payday loans as a source of credit. Mr Robert Frank, an economics professor at Cornell University, equates payday loans with "handing a suicidal person a noose". He said: "These loans lead to more bankruptcies and wipe out people’s savings, which is bad for the economy."

Others, more wisely, have begun to reassess their spending habits.

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Notable Quotes

quote open Historically, the United States has been a hard money country. Only [since 1913] has the United States operated on a fiat money system. During this period, paper money has depreciated over 87%. During the preceding 140 year period, the hard currency of the United States had actually maintained its value. Wholesale prices in 1913 ... were the same as in 1787.quote close
~ Kenneth Gerbino, former chairman of the American Economic Council

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