Thursday, February 21, 2008

The Credit Crunch and the Business Cycle

The current credit crunch has brought renewed interest in the business cycle for economics and personal finance classes - at least I hope it has. And although the political candidates are going out of their way to let us know how they will remedy the business cycle, few are willing to explain how the business cycle impacts credit.

This brings me to an interesting article (subscriber content) on the front page of today's edition of The Wall Street Journal. The article is titled "Lending Squeeze Hits Ailing Firms." The article mentions that a number of firms, some of which are already under bankruptcy protection, are finding it harder and harder to borrow funds. This can mean that interest rates are inordinately high, or that credit is not available at all. And to understand this, we need to examine the components of an interest rate.

Interest rates are, of course, the price of money. But that price incorporates a number of risks for the lender. First of all, lenders seek a return on the funds to offset the opportunity cost of lending (they could have been spending the funds elsewhere but chose to postpone consumption). There are several risks at work here. First, is maturity risk - how long will it take for repayment. Generally, a loan with longer maturity represents higher risk, and will generate a higher interest rate. Inflation expectations usually figure in here, as well. Second is liquidity risk, how easy will it be to convert the loan to cash. Some items, like homes and businesses are not very liquid, as we've seen. Therefore they may entail a higher risk and a higher rate. And finally, there is default risk. What is the likelihood that this loan may not be repaid. A firm that is in questionable financial shape to begin with may not be able to pay off additional loans. In that case, the default risk is considered high and again, carrying a higher interest rate on a loan.

Many of the firms in the story are already in financial trouble. The current business cycle will make it more difficult for these firms to generate revenues to pay off debt. Consequently, the interest rates are high when credit is even available. This brings us to the business cycle.

One of the basic aspects of any downturn in business is that less efficient, less productive, less profitable firms are shaken out. This frees up resources, in this case capital resources, to be shifted to other areas of economic activity that are more efficient, more productive, and more profitable as determined by consumer demand. Does this mean that the process is painless? No. Does it mean it should be avoided? No. And an economic downturn provides information to all players as to which areas need to be adjusted.

Have you been using the current situation to discuss the business cycle and the related credit crunch? If so, please share your thoughts and your students' comments. If not, please share why you feel it may not fit into your curriculum.

1 comment:

Gabriel Mihalache said...

>> "One of the basic aspects of any downturn in business is that less efficient, less productive, less profitable firms are shaken out."

Do we have any reference on this? It was my impression that this claim is not well supported by the data.