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10 19 2015 | by Victor Xing | Central Banks

Are central banks responsible for credit cycles and credit crises?

Short answer: central banks are responsible for creating credit cycles, and the inevitable credit tightening have often resulted in financial downturn or even credit crises.

More nuanced answer:

Central banks adjust money supply in order to stimulate economies with more plentiful credit, or to cool growth by tightening the credit supply.

Central banks’ “money supply lever”

One lever to influence the money supply is short-term interest rates.  By lowering rates, the central banks increase credit demand by incentivising borrowers, and banks would in turn keep less deposit as reserves.  Money supply would grow to fuel consumption and investment.

Eventually, prolonged easy credit availability would make the economy run hot, and inflation (as well as distortions) would start to materialize.  In response, the central banks would tighten credit supply by raising rates.  Credit become less plentiful with higher borrowing costs, and economic growth slows.

Using the money supply lever, central banks create credit cycles.

Illustration credit: “How The Economic Machine Works by Ray Dalio,” Bridgewater Associates 

Central bank policy tightening can cool economic growth and may even lead to credit crises
Central bank policy tightening can cool economic growth and may even lead to credit crises

Putting central bank’s monetary transmission mechanism in perspective, many recent crises were essentially credit crises – our central banks would try to counter one economic crisis by lowering interest rates and induce the financial sector to flood the system with cheap credit, laying the foundation for future credit bubbles.

One good example was the dot-com bubble.  The Greenspan Federal Reserve kept rates low to soften the blow of dot-com bubble burst and the negative shocks of 9/11.  Yet, it kept rates low for too long, and the housing bubble ensued.  The Federal Reserve then tried to deflate the bubble, but monetary transmission mechanism was broken.  Raising rates had failed to affect long term borrowing costs, and the FED ended up keeping rates too high for too long, and the housing bubble popped instead of deflating.

Following 08, ultra-accommodation monetary policy had prevented the system from fully deleveraging (for better or worse), and many are again seeing signs of bubble in various asset markets.

Thus, some investors have argued that our central banks are in-fact doing more harm than good, as creating credit cycles in complex economies have led to multiple hard-to-manage boom – bust cycles with severe consequences.

Next article10 17 2015 | by Victor Xing | Central Banks

How did Federal Reserve’s QE expand its balance sheet?