A Credit Crunch Is Coming | Opinion

Every three months, the Federal Reserve issues the Senior Loan Officer Opinion Survey on Bank Lending Practices, known in markets as the SLOOS report. Most of the time, the survey does not get much attention, but the most recent edition caught headlines—it showed credit standards tightening, a trend very reminiscent of what happened just prior to the 2008 financial crisis. With banks blowing up left and right this has many worried that we might be in for another credit crunch.

Credit crunches are the terminal phase of the credit cycle. While not popular topics in the teaching of mainstream economists, most practical financial analysts know that credit cycles exist and are important. The credit cycle is an approximately 10-to-15-year life cycle that the credit markets go through. In the initial phase banks are flush with cash and interest rates are low, so lending starts kicking into gear. Small businesses pop up like mushrooms after rain, larger corporations invest, and housing markets start to rise.

In the next phase, excesses start to creep in. Borrowers that banks were previously wary of start to get access to credit and companies with little prospects of success get access to debt and equity financing. The third phase is when interest rates start tightening and banks pull back on lending. The financial system starts to sway and creak—maybe a few banks fail. In the final phase—the crunch—the whole thing falls apart. Lending dries up, companies fail, investment retreats and, as the economy sinks into a recession, defaults rise and the financial system goes into meltdown.

The most recent SLOOS survey suggests that we are currently deep into the third phase and about to tip into the fourth. The survey data show credit standards tightening dramatically on everything from mortgage loans to consumer credit to loans to small firms to commercial property loans. The demand for credit is contracting too. With high interest rates and anxieties over future economic prospects, borrowers are pulling back. A perfect storm is developing, and a credit crunch looks like it's almost certainly on the horizon.

When are the chickens going to come home to roost? On this question, the markets are divided. Bond prices are rising, which suggests that bond traders believe the Fed is going to have to lower rates—presumably in the face of a credit crunch. Yet stock markets are more optimistic. After a brief lull when the SLOOS report came out, the stock market recovered. Hedge funds agree with the stock market, with many taking positions in the bond markets that suggest the credit crunch is still a few months—and maybe a few more Fed rate hikes—away.

But whether the crunch comes over the summer or during the winter, it now seems very likely to happen. The construction sector will be the one to watch, and most especially the construction sector that builds commercial real estate. When real estate investment companies start shedding workers and the unemployment rate starts to rise, you can be pretty confident that a credit crunch is imminent.

When this happens, we will have experienced three credit crunches since 2000. The first, in 2000, was relatively minor and was mainly characterized by the bursting of the dot-com equity bubble. The second, in 2008-09, was very large and resulted in long-term economic stagnation. What will the third look like? It will be much closer to the 2008-09 crisis than the 2000 crisis. The financial system is fragile, and the real estate market is running hot. There is even a chance that the coming credit crunch will be the worst yet.

This raises questions about Federal Reserve policy more generally. Fed economists make out like they use monetary policy to calibrate the economy much in the same way we use a thermostat to calibrate the temperature in our homes. If the economy is running a little too hot, the Fed economists tell us, they dial up interest rates a little and cool it off. If it is running too cold, they lower rates and the economy warms up.

Will these economists be able to maintain this fiction after yet another credit crunch? It seems unlikely. The reality is that Fed policy is not like a thermostat at all. It is much more aggressive than that, especially in its more experimental methods, like quantitative easing, that have come into fashion since the 2008-09 crisis. What the Fed actually does is stuff the banking system full of newly printed cash when the economy is sluggish and raise interest rates to punishing levels when the economy is overheated.

The fact of the matter is that the Fed steers the credit cycle. In doing so it exacerbates the credit cycle. In its attempts to steer the economy it makes the economy much more volatile and prone to credit cycles. Its loose money policies pump up asset markets—from equity markets to housing markets to debt markets—and then when it pulls back some of that loose money these asset markets collapse. Doing this has ramifications for both economic and financial stability; ironic, since central banks' primary function is to stabilize the banking system. Today the Fed's actions seem to completely destabilize the banking system.

Hopefully, after the smoke clears on the coming credit crunch we can raise questions about how the Fed and other central banks behave. Are their experimental monetary policies actually helpful? Or do they just encourage wasteful capital allocation and economic instability? Should the Fed even be attempting to steer the economy at all? Or should it just concern itself with the stability of the banking system and providing the economy with a fair rate of interest? It is time people started asking these questions. The Fed has very little oversight and has become increasingly a playground for pie-in-the-sky abstract academic theories. Someone needs to bring the institution back down to earth.

Philip Pilkington is a macroeconomist with nearly a decade of experience working in investment markets, he is the author of the book The Reformation in Economics: A Deconstruction and Reconstruction of Economic Theory.

The views expressed in this article are the writer's own.