Login

Credit Crisis Versus Credit Crunch

Discussions of how to deal with the ongoing financial mess have been confusing (and, often, confused) because the problem actually has two quite distinct aspects, which keep getting mixed up with each other.

So let me try to distinguish (following my colleague Olivier Jeanne, speaking at the Johns Hopkins University’s Center for Financial Economics panel discussionof the financial crisis on Monday evening):

  • Crunch: The economy is in a credit crunch when you visit a bunch of banks to apply for a mortgage, and you find that (if your credit rating is borderline) the banks turn you down or offer you less money than you would normally have been able to borrow. A crunch is generally a slow-moving problem (it evolves over a time frame from a few months to a few years).
  • Crisis: The economy is in a credit crisis when you visit a bunch of banks, and they are all closed. And nobody knows when they will open again. (Another term for this is “the freezing up of the payments system”; think of it as being like a “bank run” on all banks at the same time). A crisis can be very fast-moving, and needs to be dealt with quickly and with massive resources.

A credit crisis is obviously a much more serious problem. This is what commentators are talking about when they invoke the spectre of the Great Depression.

The last financial crisis was in the Great Depression. But we have had plenty examples of credit crunches (e.g. the 1990 recession). And it is even possible to have a crisis without much of a crunch. For example, a credit crisis might happen as a consequence of a sudden realization that some asset that banks had thought was valuable, was actually worthless. If such a crisis were resolved with swift, massive, and effective measures to recapitalize the banking system, it need not result in a crunch.

The reason this distinction is important is that the best solution to a crisis may be different from the best solution to a crunch. So, when specific proposals are made for dealing with our current financial “mess,” it is important to try to think clearly about whether those solutions are designed to prevent the onset of a financial crisis (so far, the banks are still open, so we don’t yet have a crisis, though we might be getting close), or whether they are designed to mitigate the effects of a credit crunch (so far, we have seen signs of the beginning of a crunch, which probably will get much worse before it gets better).

An example of why this distinction is useful is provided by new proposals to expand the authority of the FDIC (and the credit line available to it) so that it can become the first line of defense against a credit crisis. (The reason it cannot do so now is that much of the crisis is taking place at institutions not regulated by the FDIC). The FDIC is an institution that was invented precisely and exclusively to deal with the “credit crisis” side of things. So it might well make sense to explore an expansion of the FDIC’s authority; at a minium it would seem wise to try to tap into the FDIC’s extensive expertise in handling bank runs, as part of the response to the credit crisis aspect of the current situation.

But I want to emphasize that even if a credit crisis can be averted (or at least delayed) by bolstering the FDIC, this would do little or nothing to solve the credit crunch. A credit crunch can really only be dealt with by some plan that ”recapitalizes” the banking sector. In a nutshell, this means that some money needs to flow into the banking sector from the government. I think there are much better ways for that to happen than the original Paulson plan, or the version that failed in the House on Monday. In particular, I would advocate a plan in which every dollar of taxpayer money is used to purchase a dollar’s worth of ownership in the financial institution receiving the taxpayer money (a ”buy-in” plan, as distinct from the Paulson ”bailout” plan). I have argued elsewhere (“A Warranted Buy-In”) that the Paulson/Frank/Dodd plan could be tweaked to turn it into a “buy-in” plan (Congress would just need to require that Paulson’s $700 billion be spent almost exclusively on warrants and only a little bit on buying subprime securities.)

false