A credit crunch, also called a credit crisis or credit squeeze, occurs when the general availability of credit (loans) declines considerably, or the conditions required to get a loan from banks suddenly tighten.
The decline in the availability of credit occurs regardless of whether interest rates rise or stay the same.
Banks and other creditors become reluctant to lend money to individuals and companies during a credit crunch because of the greater risk of defaults, due to either political problems or adverse economic conditions.
During a credit crunch, lenders become much more selective about who they lend to, i.e. the focus shifts to quality rather than quantity. When this occurs, lower-income and middle-class individuals, as well as small to medium size enterprises lose out. Banks only lend money to people and businesses that do not really need to borrow.
During a credit crunch, people and businesses that really need help find it much harder to get loans – banks focus on lending to those who least need to borrow.
Central banks attempt to counter this risk-aversion by reducing interest rates in order to stimulate money markets.
According to Collins Dictionary, a credit crunch is:
“A period during which there is a sudden reduction in the availability of credit from banks and other lenders.”
This reduction in the availability of credit either prolongs an economic recession or slows down a recovery. This occurred in the Great Depression, America’s central bank (Federal Reserve) reduced money supply after the 1929 Crash – it refused to liquefy markets, and thus created deflation.
A ‘credit squeeze’ is a milder version of a full-blown credit crunch, and many economists say that was what occurred in 2007/2008. However, as you can see in the quote below, the US Federal Reserve saw it as a credit crunch.
“The 2007-08 credit crunch has been far more complex than earlier crunches because financial innovation has allowed new ways of packaging and reselling assets. It is intertwined with the growth of the subprime mortgage market in the United States – which offered nonstandard mortgages to individuals with nonstandard income or credit profiles – but it is really a crisis that occurred because of the mispricing of the risk of these products.”
Credit crunch frequency
Since the middle of the last century, credit crunches have struck more frequently.
Although most economists say it is virtually impossible to predict when a severe lending contraction will occur, they have all been associated with house-price boom-bust cycles.
Professor Richard Rumelt, from UCLA Anderson School of Management, wrote in ‘Good Strategy – Bad Strategy‘:
“In fact, during the past fifty years there have been 28 severe house-price boom-bust cycles and 28 credit crunches in 21 advanced Organization for Economic Co-operation and Development (OECD) economies.”
Video – Credit crunch explained
In this video, the speaker explains what a credit crunch is, and why the last one (2007/8) occurred.