Explain how credit bubbles manifest in different ways in an economy.
Introduction
According to Joseph (2013) creation of credit that is disproportionate leads to too much money chasing few goods and services, and thus resulting in problems like inflation and asset value inflation. Joseph went on and said that this reckless creation of credit, will end in credit bubbles, and among the various causes of credit bubbles include, excessive consumption, real estate and property speculation, financial speculation, overzealous expansion, and inflationary pressures. These causes of the credit bubble are further explained below.
Excessive consumption
The cheap and easy availability of debit or credit tends to fuel consumption in the economy, which to a larger extent creates debt traps towards individual economic participants. Having a high debt to income shows that individuals in the economy are or will be in severe debt traps. Having said this, it is important to note that, debt/income ratio can be used as a good indicator of an over-leveraged household or company, which in long term is unsustainable. Among other things that worsen the debt/income ratio of individuals is loss of employment which leads to loss of income and thus negatively affects the ability of the individual to service their debt.
Real Estate and property speculation
Affordable and cheap credit increases speculation in real estate and has greater potential to cause asset price inflation. “Many households, corporate and even semi-government agencies invest in property markets, due to the availability of easy credit driving up prices. Demand for properties drives a construction sector boom, unleashing demand in several other industries such as cement, steel, construction, chemicals, paints, and a host of other business segments. A unit increase in construction expenditure has a multiplier effect and capacity to generate income multiple times (estimated to be as high as five times). Whilst this translates into strong economic growth, once the credit flow is interrupted, demand vanishes, the backlog of unsold properties accumulates and construction activity drops sharply, “Joseph: 2013)”.
Financial speculation
According to Joseph (2013), credit creation can cause excessive financial speculative deals, just as cheap credit does in relation to real estate prices. The stock and bond market boom. With this in mind, the prices of equity and equity issues will rise aggressively, which to some extent is normal in a growing economy, but there are situations where the increase in the equity prices and equity issues will be unsustainable. On these unsustainable increases in the price level, the credit bubble will have arrived. The Price-earnings ratio is another indicator that can be used to ascertain and give assurance that the economy or financial assets are approaching a bubble.
Overzealous Expansion
Lack of due diligence due to the booming part of the economy can lead to excessive expansion that will be fueled by credit. Different sectors of the economy will seek to expand their production facilities which to a larger extent will be faced with lower demand in the future, as the level of credit will dry up, and borrowers fail to service their debt. As a result credit bubble will arise from this and lead to the financial collapse of the economy.
Inflationary pressures
From the economic perspective of aggregate demand management, an increase in the availability of credit is an expansionary monetary policy that leads to an increase in demand. To a larger extent, this is what has been described above as too much money chasing few goods and services, which does fuel demand inflation. Joseph (2013) suggested that easy availability of credit increases the purchasing power of the economic agents, which puts more inflationary pressures on the economy and thus leads to a credit bubble. As inflation erodes the purchasing power later, the value of money will drop, and makes the creditor worse off, and thus cutting the availability of credit in the market.