What are the consequences of credit bubbles?
Introduction
There are various consequences that arise from the bursting of credit bubbles, among others including the weakened banking sector, increase in the risk-averse behaviour, deleveraging, deflation, the decline in the business confidence and decline or slow in economic growth. These consequences of the credit bubble are going to be explained further in the following paragraphs.
Post bubble it is hard for asset prices to recover to the historic highs of the bubble
According to Joseph (2013) after the credit bubble, it will take a very long time if not impossible for the asset price to recover from the fall. The reason is that many investors will be afraid and very cautious towards the specific asset class that faced the bubble.
Weakened Banking Sector
Credit bubbles expose the banks that will be weak in their management of credit or those banks which will have non-performing assets or loans which will be written-off. As a result, some banks will be forced to merge with other banks and some will be liquidated, thus leading to fewer players in the market. Few players in the banking sector create monopolies or oligopolies who will have too much power to control the activities of the economy and manipulate activities in the financial market.
Increase in risk-averse behaviour and cutting of lending
The bursting of the credit bubble changes the risk behaviour of the banking institutions and increase the unwillingness of the banking institutions to offer credit to the clients in the market. The reduction in the availability of credit in the market will reduce economic growth.
De-leveraging
De-leveraging leads to cutting in the levels of consumption in the economy. Since consumption is the greatest component of most economies, the decline in consumption will lead to a decline in the aggregate demand, which will lead to a decline in the economic activities and shut downing of the economies and higher unemployment. All these problems will be consequences of the credit bubble bursting.
Deflation
As experienced in Japan sometimes ago, deflation refers to the decline in the prices in the economy, which have a major problem of reducing the incentives in the economy and the power to propel economic activities. Deflation can result from declining demand for goods and services, which leads to cutting down of the levels of employment and shutdown of production activities as well as loss in the business confidence.
Low-level of business confidence
The decline in aggregate demand leads to the collapse of the business confidence and thus send a wrong and negative signal to the market. Financial institutions like banks will be very reluctant to offer more credit to their clients for the fear that, the clients might be able to pay the money back. The moral hazard and adverse selection increase the risk of lending money in these difficult periods.
Fear of another banking collapse
History is the best teacher, as more and more people will be afraid of bank collapse, more people will invest in physical gold, instead of depositing their funds, which will reduce the availability of funds available to the banking institutions in order to create more money. A reduction in the availability of funds will slow down the economy due to less credit.
Slower credit growth
As stated above, bursting in the credit bubble will lead to change in the moral hazard and adverse selection in the credit market, which will reduce the willingness of the financial institutions to offer credit to their clients. According to Joseph (2013), slower growth in credit will lead to a reduction in economic growth, as many individuals and companies will be also de-leveraging and cutting down on credit.