All Financial Wisdom

Credit Crunch Explained

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We are now at the point where the economy has stabilized, unemployment levels have decreased, and the Fed is set to raise interest rates, clear signs of recovery. However, this was not the ease in 2008. There was a credit crisis? A Credit crunch. What’s a credit crunch? Glad you asked

A credit crunch is a financial phenomenon consisting of reducing the money available to lend – loans or credits – or a sudden increase in the cost of obtaining bank loans. This term became fashionable in the 2008 financial-banking crash.

Among the immediate consequences of credit crunch, there is a limitation of the possibilities of borrowing for consumers – which implies a reduction of consumption – and of investment for entrepreneurs – which limits economic growth.

During the period of credit crunch, lending institutions tighten the conditions for lending money, either by demanding greater guarantees, by raising the price of money, by imposing harsher conditions, etc. The credit crunch is caused by the need for Central Banks to raise interest rates. This causes banks to start seeing too much risk in the sectors where they have been lending money with too much joy. Banks and savings banks begin to select loans with loans from companies and individuals. At one point, a major restriction of credit can severely block the paths of economic growth, essentially because the money most affected is investment capital.

The economists Friedrich von Wieser, Ludwig von Mises, and Friedrich Hayek demonstrated that the creation of new and artificial money by the banking system lent to low interest, denominated credit expansion, distorted the investment patterns, allocating disproportionate losses when the credit contracted.

A clear example of credit crunch was the subprime mortgage crisis. Credit expansion is halted and prospective home buyers can no longer obtain financing to buy new properties. This reduces demand at the same time that the banks themselves are trying to get their debtors with the lowest rated loans to sell their property and pay off the debt. This increases the supply of housing at the worst time, causing prices to fall.

One of the credit crunch gurus is Nouriel Roubini, professor of economics at New York University. From interventionist postulates, Rubini warned that the subprime crisis was a systemic crisis whose problems are distributed throughout the entire system, which is why he favors nationalizing US banks before they spread their business problems to the entire financial world.

From the opposite side, the Liberals and Austrians defend that the debt must be amortized to avoid the credit crunch. This objective could only be achieved by increasing disposable income of individuals through tax cuts and reductions in public spending.

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