Falling Credit: Unless Lending Can Increase, Crisis Will Continue

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The crisis of 2008 was marked by low access to credit for companies and individuals. The reduction in credit was led by losses on the real estate loans made by banks, which closed their doors on the best of businesses and individuals. Credit/loans are the lifeblood of the economy and facilitate commerce by letting businesses take out loans for the production of goods and services. A reduction in credit disrupts the continuum needed to preserve the flow of economic activity. As a result, businesses reduced production and laid off millions of employees. The stock market fell from September 2007 until March 2009. Since March, the market has risen more than 50% and still rising. However, the increase in stock prices has not reflected upon an increase in credit. The total credit in the country continues to fall, and until the trend reverses, the economy will continue to recede.

The graph below depicts an important indicator of economic activity, the total bank credit issued by all commercial banks in the country. As the graph shows, credit had never fallen so precipitously in the last 40 years of account keeping. Even in the severe recessions of 1981-82 and 2001-02, both marked by grey lines, the credit grew, although at a slower pace. A reduction in credit is the most important indicator of how the economy would perform in the medium term.

The decrease in credit has been caused by a reduction in both supply and demand. The demand has fallen from both the companies and the individuals, as the two begin to hoard money in view of the excessive leverage they already hold. As a result, the savings rate, which states the amount of money not spent by the consumers, has risen from a low of 1% in 2008 to a multi year high of 5% in the 2nd quarter of 2009.

A further increase in the savings rate would cause the hoarding of money to have serious consequences upon the price levels in the country. As spending falls, the businesses will recover less than the cost of production and hence default on their loans to the banks. The prices will fall to reflect the wastage in the system caused by a decline in spending.

Also, the banks have reduced credit, as is shown in the graph below. The credit is currently waning at an annual rate of 7%.

According to a survey conducted by the Federal Reserve, 15% of the commercial banks restricted credit in the three months up to October, while 16% of the banks lowered credit availability to the smaller companies. In addition, more than a quarter of the total banks reduced residential real estate loans during the same period.

The commercial banks, despite their ubiquitous nature only extend about a third of the total credit available in the economy. The other major lenders are private financial companies, credit unions, savings institutions, and securitized assets. Each of the above has lowered credit in the last 2 years by 5-10%. Below are graphs that depict the total decrease in consumer credit as well as the decline in that held by private financial companies.


Even though credit is not a leading indicator of the future economic prospects, it provides a clear view of the near term opportunities for growth. Many economic watchers mistakenly attribute importance to the total money supply, as a forerunner of consumption and prices. However, most consumption is a function of the total income generated or consumer credit issued. The only way to offset the decline in consumption is through massive deficit spending. A massive deficit of $1.4 trillion has somewhat been able to prevent falling prices, but has been unable to motivate the lenders to increase lending. Unless the lending can increase in the economy, the production and employment will continue to fall, thus lengthening the crisis.