What is Credit Squeeze?

A credit squeeze happens when a country’s central bank makes it harder for people and businesses to borrow money. The central bank does this on purpose to control how much money moves around in the economy. They use different tools like making loans more expensive or telling regular banks to keep more money in their vaults instead of lending it out.

How Credit Squeezes Work

The main goal of a credit squeeze is to slow down spending in the economy. People and businesses need to borrow money to buy things or grow their operations. Making it harder to get loans means they’ll think twice before taking on new debt. The central bank watches the economy carefully and decides when to tighten or loosen the rules about lending money.

Main Tools Used in Credit Squeezes

Interest rates play a huge role in credit squeezes. The central bank sets a basic rate that affects all other loan rates in the country. Higher rates mean bigger monthly payments on loans, which makes people less eager to borrow. Banks also become pickier about who they lend to when rates go up.

Reserve requirements tell banks how much money they must keep on hand compared to what they lend out. A bank with $100 million in deposits might normally need to keep $10 million in reserve. During a credit squeeze, they might have to keep $15 million or more, leaving less money available for loans.

Credit controls give the central bank direct power over lending. They might tell banks to cut back on certain types of loans, like mortgages or business expansion loans. The central bank can also make rules about down payments or proof of income needed for loans.

Effects on the Economy

Credit squeezes impact different parts of the economy in different ways. Small businesses often feel the pinch first because they rely heavily on bank loans for day-to-day operations. Many have to delay buying new equipment or hiring workers when loans become harder to get.

Housing markets usually slow down during credit squeezes. Higher mortgage rates mean buyers can afford less expensive homes. Construction companies build fewer houses because fewer people want to buy them at higher interest rates.

Large companies might cope better with credit squeezes because they have other ways to raise money, like selling bonds or shares of stock. However, they might still cut back on expansion plans or new projects when borrowing costs rise.

Impact on Prices and Inflation

One main reason central banks use credit squeezes is to fight rising prices. Making loans more expensive reduces spending, which helps keep prices stable. When people and businesses spend less money, stores have a harder time raising prices without losing customers.

The effects don’t show up right away. It often takes months before higher interest rates lead to lower inflation. During this time, some parts of the economy might struggle more than others. Real estate and construction typically slow down first, followed by manufacturing and retail sales.

Historical Examples

Countries around the world have used credit squeezes to manage their economies. The United States Federal Reserve under Paul Volcker famously squeezed credit in the early 1980s to fight very high inflation. Interest rates reached over 20%, causing a deep recession but eventually bringing inflation under control.

The Bank of England used credit squeezes several times in the 1950s and 1960s to protect the value of the British pound. They restricted how much money banks could lend and raised interest rates sharply. These measures helped defend the currency but sometimes led to slower economic growth.

Japan experienced the opposite problem in the 1990s and 2000s. Their central bank tried to make credit easier to get, but banks remained cautious about lending. This showed that while central banks can make credit harder to get, they sometimes struggle to make banks lend more when confidence is low.

Modern Credit Squeeze Techniques

Today’s central banks have more sophisticated tools for managing credit. They can buy or sell government bonds to influence long-term interest rates. This technique, called quantitative easing when used to increase credit, can be reversed to create a credit squeeze.

Digital banking has changed how credit squeezes work. Central banks can track lending patterns in real-time and adjust their policies quickly. They also need to watch how online lenders and financial technology companies affect the supply of credit.

International Aspects

Credit squeezes in one country often affect others through global financial markets. When major central banks like the Federal Reserve or European Central Bank squeeze credit, it can make borrowing more expensive worldwide. This especially impacts developing countries that depend on foreign investment.

Exchange rates shift during credit squeezes. Higher interest rates typically make a country’s currency stronger because international investors want to earn those higher rates. This can hurt exports but make imported goods cheaper.

Challenges and Criticisms

Some economists argue that credit squeezes hurt ordinary people more than wealthy individuals or large corporations. Small businesses and workers might lose jobs or income while those with substantial savings benefit from higher interest rates on their investments.

Timing creates another challenge. Central banks must decide when to start and stop credit squeezes. Acting too early might unnecessarily slow economic growth, but waiting too long could let inflation get out of control.

Politicians sometimes pressure central banks not to squeeze credit, especially before elections. This highlights the importance of central bank independence in making tough economic decisions based on long-term stability rather than short-term popularity.