ChainWhat it assumes · how to break it
Start
Banks suffer large losses on mortgage-related loans and securities as house prices fall, as in the 2007–08 global financial crisis, and begin to doubt each other's solvency.
1
As a result, banks stop lending to each other in the interbank market because they cannot tell which banks hold the bad assets, so funding costs rise and credit dries up.
credit crunch · asymmetric information
credit crunch · asymmetric information
Assumes: Banks cannot judge each other's exposure to bad loans.
But: If the central bank acts as lender of last resort and supplies liquidity freely, banks can fund themselves without relying on each other.
2
This means banks with depleted capital tighten lending to firms and households, charging higher rates and demanding larger deposits on mortgages.
credit rationing · capital adequacy
credit rationing · capital adequacy
Assumes: Banks rebuild capital by shrinking their lending.
But: If the government injects capital, as the UK did with RBS and Lloyds in 2008, banks need not cut lending as much to restore their capital ratios.
3
Consequently, investment falls because firms cannot finance projects, and consumption falls as households lose access to credit and house prices fall.
investment · consumption · negative wealth effect
investment · consumption · negative wealth effect
Best link to attack
Assumes: Firms and households depend on bank credit to spend.
Assumes: Firms and households depend on bank credit to spend.
But: Large firms can borrow directly through bond markets or use retained profits, and many households have little debt, so much spending does not depend on bank credit.
4
Therefore, aggregate demand falls and, through the negative multiplier, real GDP falls, pushing the economy into recession.
AD · multiplier · recession
AD · multiplier · recession
Assumes: Policy does not offset the fall in AD.
But: The Bank of England cut Bank Rate to 0.5% in March 2009 and began QE, and automatic stabilisers supported demand, which limited the fall in output.
5
In addition, the trend rate of growth may fall, because years of weak investment slow the growth of the capital stock and productivity.
hysteresis · productive potential
hysteresis · productive potential
Assumes: Lost investment is not made up later.
But: Spare capacity left idle by a recession can be brought back into use when credit recovers, so the long-run effect may be small.
End
Lending collapses, investment and consumption fall, real GDP falls and the economy enters recession, with possible lasting damage to trend growth.
Evaluation chain
- E1However, how far spending falls depends on how dependent firms and households are on bank credit.
- E2If large firms can issue bonds or use retained profits, and many households hold little debt, their spending is less affected by the credit crunch.
- E3As a result, the fall in investment and consumption is concentrated among small firms and borrowers who rely on banks, such as first-time buyers.
- E4So the fall in growth is smaller in economies where firms use capital markets more, and larger in bank-dependent economies with high household debt.
Another way to attack it: The size of the recession depends on how quickly the central bank and government respond. Rapid interest rate cuts, QE and bank rescues can limit the credit crunch, although rescues create moral hazard for the future.
Credit conditions can take years to return to normal after a banking crisis, so the drag on growth often outlasts the recession itself.
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Questions this answers
- Assess the likely impact of a banking crisis on economic growth.
- Evaluate the reasons why the 2007–08 financial crisis led to recession in many developed economies.
- Discuss the extent to which a credit crunch reduces investment.
Diagram
AD/AS: AD shifts left, real GDP falls and a negative output gap opens. If weak investment persists, show LRAS shifting right more slowly than before.
Reverse and related
Recovery of the banking system → lending resumes, investment and consumption recover and growth returns.