The way out of the credit crunch

By Minyanville

Hopes that the credit crunch is nearly over continue to be dashed with regularity.

Where we're really at is stage two, the Main Street impact from the collapse of the Wall Street debt bubble. Here's how to decipher the mess -- and a way out of it.

1. What is a credit crunch?

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 slows the growth of 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 or, in extreme cases, even go lower.

This risk aversion on the part of lenders makes it more difficult for even the most creditworthy 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 -- a vicious cycle of economic pain.

2. Why does credit growth matter?

Because in our fiat-based monetary system, economic growth is dependent upon credit expansion.

What does that mean? And why is it a problem?

First, a fiat-based monetary system is simply the name economists give to a system in which money is created through fractional reserve banking, the practice of issuing more money than a bank holds in cash reserves.

In a fiat-based monetary system, if risk appetites are supportive -- that is, if borrowers are willing to take on debt -- then credit expansion can feed into normal risk-seeking behavior. But credit expansion, if excessive, can foster unsustainable booms, as we saw with dot-coms and with housing.

As long as credit expansion and demand for credit continue at an accelerating pace, the appearance of prosperity continues as asset prices increase.

The "accelerating pace" aspect is critical. It is the key to maintaining the boom.

As Michael Darda, the chief economist for MKM Partners, told The New York Times: "Access to capital and credit is essential to growth. If that access is restrained or blocked, the economic system takes a hit."

3. What do we mean by credit expansion?

First, credit is not in and of itself necessarily a bad thing. Capitalism thrives on the productive use of credit. But what has transpired over the past decade is that credit has increasingly been used to mask weak economic growth.

Since the early 1990s, new money was created by the banking system and offered at artificially low interest rates and, later, to borrowers with increasingly low credit quality. By offering willing borrowers money at artificially low rates, this encouraged increased time preferences among economic actors, which is to say that investment horizons were lengthened and risk tolerances were widened.

This is how debt was pyramided to such an extent that one small setback -- in subprime borrowing, for example -- can result in a widespread problem that quickly spreads to other, supposedly safe credit risks.

Offering willing borrowers money at artificially low rates encouraged increased time preferences among economic actors, which is to say that investment horizons were lengthened and risk tolerances were widened. This money was then over-invested and misallocated by investors into dot-com ventures and houses.

Continued: From expansion to crunch

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