What Is A Credit Crunch?

With all the talk about the Subprime crisis and the resulting credit debacle, you may have been wondering as to what exactly the definition of a “credit crunch” is.

Minyanville’s Kevin Depew defines is as follows:

“The simple answer is that a “credit crunch” is a general decline in the supply of, and demand for, credit.

Under ordinary circumstances, the market (and sometimes the Federal Reserve) can induce a decline in the supply of credit by raising interest rates. This makes money more expensive for borrowers, and as a result slows the growth and demand for available credit.

But a “credit crunch” occurs when banks become more risk averse – less willing to lend – even though interest rates may remain the same, and in extreme cases, even though interest rates may go lower.

This risk aversion on the part of lenders makes it more difficult for even the most credit-worthy borrowers to obtain money at reasonable terms. In effect, interest rates – the cost of money – can become infinitely high for many borrowers. As a result, it becomes difficult to fund projects and investments, which can slow economic growth, which can make lenders even more unwilling to lend.”

OK, now we know what it is, how do we get out of it? Kevin explains:

“The Fed can make even more credit available; a monetary response. This may temporarily relieve tight credit conditions among financial institutions.

Also, the government can step in and create any number of mechanisms to essentially bailout borrowers; a fiscal response. Is that appropriate?

On the one hand we’re a compassionate society that sees people being foreclosed upon in record numbers, and our first instinct is to “do something.” But we have to ask what the ramifications of that are? The unintended consequence of helping people avoid foreclosure is removing the market’s penalty for unsuccessful speculation, and that changes the function of markets as we know it.

Most likely we will see a combination of the two – a combined monetary and fiscal response. That will most likely delay a deflationary credit collapse, but it won’t address two key issues; consumer time preference and risk aversion.

If consumer risk aversion becomes entrenched then we will see a long-term shift in market leadership away from financials and consumer discretionary-dependent sectors, and toward consumer staples and sectors with less exposure to consumer purchasing decisions.

And what about time preferences? Markets are too large for any central bank or group of central banks to control for long. And ironically, the more they act to try and prop up or even slow the decline in asset prices, the larger the market becomes. Think about it. If people begin to suspect that asset prices won’t really be allowed to go down, what is the rational response to that? It’s to increase the size of the bet.

So by targeting asset prices and attempting to “manage the economy” the Fed ironically creates the conditions for a market that is too large for it to control. As a result, crashes, unwinding of speculative bubbles, become more devastating, and affect far more people in the real economy.”

Being a non-economist, I like his explanation; short, sweet and to the point. As the credit bubble continues to unwind with potentially far reaching effects, it’s important that you know how it was created in the first place and what can be done to get out of it.”

While it does not have a direct effect on the decision making part of our trend tracking methodology, it will help you understand where we are when looking at the big picture. If a major trend, such as we’ve been having in domestic equities for 14 months, comes to an end all of a sudden, there is a good chance nowadays, that the Subprime/credit/housing debacle is one of the main culprits.

About Ulli Niemann

Ulli Niemann is the publisher of "The ETF Bully" and is a Registered Investment Advisor. Learn more
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