The 5 Minute Guide to the "Credit Crunch"

So, "credit crunch" is a phrase that has been tossed around way too much in the last few years. I find it tremendously cheesy and I'm not ashamed to say that it makes me cringe a bit when I read it. But, it seems to have reached that stage where it is now a socially acceptable term (ugh!) and therefore we have to roll with it. I'm taking a wild stab in the dark here assuming that a lot of people know what the "credit crunch" is but don't know how it came about, or how we ended up slap bang in the middle of it! Fear not, I am here to talk you through it in 5 minutes (don't hold me to that).

So, we roll back the clock to the early to mid 2000's. We are in America and looking at the US mortgage market. Around this time most things economical are going well, generally the world is in a stable position and growing well - meaning confidence is high. What is important to note is that, due to this, property prices in the USA were on the rise. High confidence and rising house prices put the mortgage lenders in a fairly arrogant position. We saw an expansion of what is known as the 'sub prime' mortgage market. These are essentially risky mortgages - mortgages given out to people who may have trouble meeting the repayment schedule. Why do this? Well, the banks felt safe because the rising house prices meant if the recipient of the mortgage couldn't make the payment then the bank would inherit an asset that was rising in value - increasing their profit.

Everything was all well and good until we reach 2007. Towards the end of the year inflation in the USA rises and this forces interest rates up (higher interest rates are a method of bringing prices/inflation down). The mortgage default rate begins to rise now because the low introductory interest rate of the mortgages start to come to an end. The mortgage recipients now have to pay the higher national interest rate on their repayments and many could not do this and were forced to default.

Coinciding with this, the housing boom collapses and house prices plummet. Now the banks are left with a defaulted mortgage and a worthless house - they have entered a very sticky situation and their balance sheets are severely hit. A key part of the finance sector is banks lending to each other when needed, they do this at special rates and it is the cheapest way of generating short term funds. This stops. Banks stop lending to one another because their balance sheets were hit by the defaulting mortgages and worthless properties.

This essentially is the problem. Some banks cannot afford to keep going due to the losses they've made and with no access to short term funding from other banks they have no option but to declare bankruptcy - Lehman Bros for example. It becomes a global crisis because of the integration of the world economy. Countries are so intertwined now due to trading, international agreements that something like this can spread around the world in a matter of months. It took roughly 3 months from when the USA entered recession for the UK to enter recession. In the space of a few months a crisis in one country has become a global financial crisis.

That's it. Sub-prime mortgages increase -> inflation causes interest rates to rise -> housing market collapses -> default rates increases -> banks stop lending to one another -> recession -> spreads around the world.
This is a very simple look at the credit crunch, of course there is a lot more to it. For the normal person, this is as much detail as you need to understand, essentially, what went on and why we are where we are now.
Cheers guys,
Sam.

The Economy During Interwar Britain

We've seen how the economy functioned prior to war and during the First World War in the last few blog posts, now we'll move on to the economy between the two world wars. Instability is the major recurring theme in this period. We see two major recessions, one between 1920 and 1922 and another from 1929 to 1932. There's also a slight one between 1937 and 1938, but this wasn't as sever. If you look at this in context with the rest of the world, Britain's economy is actually relatively stable yet still under-performing comparatively to the other large economies. If we look at growth statistics we can see that in the latter half of the interwar era the economy was growing at a respectable 2.2%, however before this the economy actually shrunk and therefore the growth average for the whole interwar period (1913-1937) isn't at all impressive.

There were many weaknesses to the interwar economy, as you'd expect. Firstly, international trade was falling. We'd relied so heavily on it in the 1870-1914 period but now it was dwindling rapidly. In 1913, international trade and services was at 30% of GDP. In 1938 it was only 15%. The levels of trade did not exceed the 1913 levels until after the Second World War. One of the causes for this fall in trade is that world output grew faster than world trade. Essentially this meant that demand for Britain's goods would fall because the market was getting more competitive as supply was increasing. Here are some statistics to back that point up:

• 1929 - There is 80% higher production of manufactured goods than in 1913.
• Britain's market share for manufactured goods fell from 30% in 1913 to 22% in 1937.

An example of this downturn in trade can be seen in the cotton industry. In 1914, Britain was a net exporter of cotton, with 80% of what was produced being shipped abroad. Other markets around the world, such as India, began to become self-sufficient behind tariff walls and therefore didn't import as many. Other countries such as Japan began to produce cotton too at a lower cost because of the low-wages. Because of this British cotton exports halved over the period 1913 to 1936.

Another issue with the economy is the mass unemployment. In the good years it's still at 8%, in the worse years it could reach as high as 17%. However, the issue was mostly geographical, or regional. The north of England, Wales, Scotland and Northern Island were the worst affected. These ares tended to rely a lot on the older Victorian industries such as coal and cotton. In the South and the Midlands, new developing industries were adopted, such as cars and chemicals and therefore unemployment here was at a reasonable level. Old industries were failing and not enough new jobs were being created to keep the unemployment down. 

Some economists began to argue that the problem with the economy was an inflexible labour market after 1914. Why was this? Well, trade unions had gained a lot more power, there were generous unemployment benefits giving no incentive to find work and institutions could set their own minimum wage rates. This made wages pretty stuck and unable to change much to changes in prices. However, it isn't crystal clear that wage flexibility was that much greater than before 19144. Benefits only got better as time went on. Keynes got involved and argued that government monetary and fiscal policy was the problem... debate ensues!

Thanks for reading!

Sam. 

The Trade Cycle (Macroeconomics)

In the economy, there are times in which people spend more and manufacturers produce more. There are also periods in which the opposite occurs.. telling us that the amount of economic activity fluctuates over time. Economic activity refers to the level of spending, production and employment in the economy at any given time. More economic activity normally means increased economic growth.

Economic activity is measured by GDP, which stands for Gross Domestic Product - the value of all goods and services produced within the economy in a given time period. The trade cycle describes the fluctuation in economic activity over time.

Here we have a diagram that maps out the fluctuation in economic activity. At the peak of the trade cycle there is high levels of demand and investment, pay increases, profits are high, increased house prices and strong inflationary pressures. 

In the recession period there is negative growth, meaning GDP is falling.. for two successful quarters (6 months). In this time there is normally falling demand, low investment, rising unemployment and a fall in profits and confidence. 

The slump is when the economy has hit the bottom of the trade cycle.. The only way is up after that (hopefully!). Here we have high unemployment, very low levels of demand and investment and low inflation. 

Finally, the recovery period. This is when the economy starts growing again - GDP rises again. We'd expect a rise in incomes, output and employment here. Also, there should be increases in demand and investment as the economy starts to grow again. 

One of the government macroeconomic goals is to achieve stable economic growth - meaning these fluctuations aren't desirable. Therefore the government takes measures to try and avoid the worst effects of the trade cycle - these are called counter-cyclical policies. They are: 

• Changes in the tax levels.
• Changes in public spending.
• Interest rate changes. 

That is the lowdown on the trade cycle, hope it helps. Thanks for reading.