The Upside of a Credit Crisis

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Once the “real” credit crisis started, we consistently forecast when it will be over.    However, maybe credit crisis isn’t so bad after all?    A credit crisis is a reduction in the general availability of loans (or credit) or a sudden tightening of the conditions required to obtain a loan from the bank.   Credit crisis create both positive and negative effects in the economy.

The Downside of a Credit Crisis. 

Credit crisis have several negative effects on both consumers and businesses. Some effects are felt right away, while others take time to be seen.

Consumers Cut Spending.  As a credit crisis progresses, the economy continues to slow. This creates a situation in which consumers are less optimistic about the future prospects for the economy and cut back dramatically on their spending. Since consumer spending accounts for 70% of economic activity, even a slight cutback in spending can cause the economy to slow dramatically.

Banks Fear Making Loans.  Credit shocks can create a situation in which banks are afraid to make new loans. This fear causes many businesses and consumers to cut spending dramatically, some even close their doors and it causes a ripple effect in the economy.

Businesses Lose Access to Capital.  When businesses do not have access to the capital they need to expand, pay expenses or pay bills, a liquidity squeeze can occur. This squeeze can force many businesses that have been thriving for years to shut their doors and let their employees go.

Rising Foreclosures May Bring Property Values Down.  If banks are forced to foreclose on too many borrowers, this can have dire consequences on communities.  Property values decline in communities where foreclosures are high.   Also, other consequences are significant, such as loss of property tax revenues for both state and local governments, economic blight for areas being affected by waves of foreclosures and the failure of local businesses that are dependent on the community to survive.

The Crisis May Force the Government to Take Emergency Measures.  As the credit shock spreads from Wall Street to Main Street, a cycle of economic weakness spreads throughout the country, creating rising unemployment and negative growth. This forces the government to take drastic measures to break the cycle once and for all by spending hundreds of billions of dollars to revive the economy.

A Falling Stock Market Eats Away at Wealth  The credit shock and uncertainty about future earnings cause many investors to sell their stock holdings and move into safer investments. This causes the equity market to go into a free fall that eats away the values of 401(k) plans, IRAs and pension plans. Diminished nest eggs force many who were planning on retiring to work longer.

Consumers and Businesses Start to Panic.  Credit shock can create a loss of confidence in the nation’s financial system. This causes many people to assume the worst and take drastic steps to protect what little wealth they have left.  At this point that banks runs become more common and even more financial institutions collapse.

The Upside of a Credit Crisis. 

Credit shocks can also create many lasting, positive changes. These changes can be seen in the aftermath of the crisis.

The Economy Cleans Out Excessive Debt and Spending.  During good economic times, many businesses and consumers increase their overall debt. This behavior is fuelled in part by businesses’ need to expand and in part by consumers who are feeling good about the economy to make large purchases without worrying about what will happen in the future.   However, at some point, the economy will slow down and many who overextended themselves during the good times will be forced to live within their means or may even fall behind. As businesses and consumers are forced to cut back, some will stop making payments on their debts, forcing financial institutions to write the bad loans off.   These write-offs will cleanse the financial system so that businesses can have strong balance sheet and consumers can increase their spending without being burdened by large amounts of debt.

Corporations Clean Up Their Balance Sheets.  Businesses can use debt to expand and increase their overall profits. However, the amount of overall debt that businesses took out during the last expansion can cause the company to face liquidity problems. By writing off the bad debt on their balance sheets, businesses become leaner, can weather the slowdown and can expand even more when positive growth returns to the economy.

Transparency and Regulation in the Financial Sector Improve.  A financial crisis can expose the loopholes in regulations that people were taking advantage of – loopholes that may have contributed to the crisis. The government then reacts by creating new regulations to address the situation. Over time, these laws bring confidence back to the U.S. financial system and leave investors feeling secure again.

Hard Times Force Consumers to Regain Control of Their Spending.  During times of expansion, many consumers try to keep up with the Joneses by living beyond their means and accumulating more debt than they can handle. Credit shocks force consumers to rein in their spending and lead lifestyles that are more appropriate to their incomes. People then regain control of their finances and cause the national savings rate to increase.

Declines in Stock Prices Create Great Long-Term Valuations.  During the crisis, when everyone is panicking and selling both good and bad investments, many smart investors are buying those good investments and holding them long-term. Once the crisis is over and the chaos has died down, they make tremendous profits.

Credit shocks have many negatives, but they also create opportunities. During times of economic crisis, it is important to keep a clear head and not get caught up in the fear. Left unchecked, large-scale fear can wreak havoc on the world economy. But over time, every crisis will end and the economy will begin to expand once again.

Anna Timone (195 Posts)

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