What is a Credit Cycle?

A credit cycle is a period during which the availability of credit in a market, country or the entire world expands and then contracts. Many economic theories link this to business cycles, which affect commerce as a whole. Some economists even point to the credit cycle as the main driving factor of a business cycle.

The theory of business cycles works on the idea that fluctuations between economic growth and economic slowdown are inevitable. The general idea is that growth becomes self-perpetuating: the more money people have to spend, the higher demand is; the higher demand is, the more people are needed to work; the more people are needed to work, the more money people have to spend. At some point, the supply of goods or services outweighs the demand. This causes the process to work in reverse, with falling demand leading to falling employment and wages, in turn lowering demand further.

The general theory of the credit cycle works in a similar way. In effect, the demand for goods and services from the business cycle is replaced by the demand for credit. When an economy is growing, there is more demand for credit as firms expand, which drives interest rates higher. At some point these interest rates, which are the price of credit, are too high for those who still want to borrow further. This means the interest rates begin falling, making it less profitable to lend money and less profitable to invest money in credit-based markets. This results in less money being available for lending, which winds up with credit being harder to come by.

The precise relationship between the business cycle and the credit cycle is disputed among economists. One theory, known as the Kiyotaki-Moore model, argues that the credit cycle amplifies the effects of the business cycle. This is based on the way that in many cases the amount of on-paper money which is dealt with by credit markets is much bigger than the actual amount of cash which passes back and forth between business and consumers in "real life." This magnifies the effects of any variations caused by the business cycle.

Another model is known as Minsky's Financial Instability Hypothesis. This says that the credit cycle means that as an economy grows, businesses find it easy and cheap to borrow. Eventually they accumulate such large amounts of debt into proportion to their profits that they can no longer take the risk of investing any further in capital expenditure. This causes a drop in demand for relevant services and products, such as construction, which can help cause the business cycle to go into a downswing.