Credit cycles
A credit cycle is the rise and fall in how easy and how cheap it is to borrow. Lenders loosen when the economy is strong and tighten when it weakens, which amplifies booms and busts, especially in property. Credit cycles run longer and deeper than business cycles, and big credit booms often end in banking crises.
Before this: The business cycle and its four phases
On the exam
- Describe credit cycles
Describe credit cycles. Expect true/false style statements on how credit and business cycles relate, which sector they affect most, and why analysts watch the availability of credit.
How deeply to learn each part
- Know the idea
- Understand it in general. It frames other topics, but you will not calculate with it.
- Use it
- Understand it well enough to solve a question with it. Recognize when it applies.
- Memorize
- Learn it by heart. The exam will not give it to you.
You know this one. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still do.
You tested strong here. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still know it.
What is a credit cycle?
A credit cycle is the rise and fall in the availability and price of credit. Business cycles are measured with gross domestic product (GDP), while credit cycles are measured with financial variables: the growth of private-sector credit, credit relative to GDP, and often house prices. Credit matters because it finances business investment and household purchases of property, so credit cycles are tied to real activity.
Credit cycles are one member of a wider family of financial cycles , in which credit, the credit-to-GDP ratio and house prices tend to move together.
- The credit boom builds through two expansions. Lenders ease terms while the economy is strong, so credit grows faster than output for about a decade, right through a mild downturn.
- House prices peak with credit. Easier loans push up property prices, higher prices raise collateral values, and that supports still more lending. Both turn together.
- The downturn that meets the credit bust is deep. When lenders tighten and property prices fall at the same time, defaults rise and spending is cut harder. Output falls 4.5% below trend here.
- A downturn while credit still expands is mild. Credit keeps flowing, so the dip is short and shallow: 1.2% below trend.
Read the diagram as text
Two stacked charts over 16 years. Top: the business cycle, the output gap moving between +2.5% and −4.5% of trend in two short cycles. Bottom: the credit cycle, the credit-to-GDP gap rising from −2 to +9 points over 11 years and falling to −5 by year 15, with house prices peaking alongside it. A mild downturn from year 5.4 to 8.2 (output 1.2% below trend) happens while credit is still rising. A deep downturn from year 11.7 (output 4.5% below trend) coincides with the credit bust.
Shaded bands mark the two stretches when output is below trend; the darker band is the deep one. Stylized numbers, not real data.
How does the credit loop work?
- Strong economy Use it lenders extend more credit on easier terms
- More building and property buying
- Asset prices and collateral values rise
- Still more lending
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- Weak economy Use it lenders tighten: less credit, higher cost
- Property prices fall
- Defaults rise
- Further weakness
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When the economy is strong or improving, lenders are willing to extend credit, and on favorable terms. More building and property buying lifts asset prices. Higher prices raise the value of the collateral lenders hold, which encourages still more lending.
The loop works in reverse in a weak economy. Lenders tighten, so credit is scarcer and costlier. Property prices fall, defaults rise and the economy weakens further.
Construction and real estate feel this most, because they run on borrowed money.
How do credit cycles differ from business cycles?
- Business cycle Memorize measures output (GDP); about 1 to 10 years; smaller swings
- Credit cycle Memorize measures availability and price of credit, often with house prices; longer, deeper and sharper
| Business cycle | Credit cycle | |
|---|---|---|
| Measures | Output (GDP) | Availability and price of credit, often with house prices |
| Typical length | 1 to about 10 years | Longer |
| Amplitude | Smaller | Deeper and sharper |
| Link | Credit amplifies the business cycle, but the two are not always in sync |
Exam tip Related, not identical. Never pick “unrelated” and never pick “same length”.
Why does the credit cycle matter?
Three reasons make it a standing item for investors:
- The size of recessions and recoveries. Recessions that coincide with a credit bust, with falls in house and equity prices, tend to be longer and deeper. Recoveries with fast credit growth, risk-taking and rising house prices tend to be stronger.
- Crises. Strong credit peaks are closely associated with later systemic banking crises . Loose private-sector credit contributed to several of them, from Latin America in the 1980s to Asia in 1997 and the global crisis of 2008.
- Policy. Monetary and fiscal policy traditionally aim to smooth the business cycle. Macroprudential policy aims at the financial system, damping credit booms with tools such as limits on loan-to-value ratios.
Analysts also use the credit cycle to understand housing and construction markets and to anticipate what policy makers will do.
Go deeper Why credit amplifies the cycle (financial frictions)
Borrowers usually pledge assets as collateral, and the amount a lender will advance depends on the collateral’s value. When asset prices rise, borrowing capacity rises with them, so spending and prices rise further. When prices fall, capacity shrinks, forced sales push prices down more, and the squeeze deepens. This feedback is why access to outside financing makes both booms and busts larger than they would otherwise be.
Go deeper Credit-fuelled crises on one line
The Latin American debt crisis of the 1980s, the Mexican, Brazilian and Russian crises of the 1990s, the Asian crisis of 1997 and 1998, and the global financial crisis of 2008 and 2009 all followed periods of loose private-sector credit. Expect the exam to ask only for the pattern: easy credit, asset price bubble, bust.
Memorize this
MemorizeCredit cycle against business cycle
| Business cycle | Credit cycle | |
|---|---|---|
| Measures | Output (GDP) | Availability and price of credit; often with house prices |
| Length | 1 to about 10 years | Longer |
| Size of swings | Smaller | Deeper and sharper |
| Link | Related; credit amplifies the business cycle | Not always synchronized |
Memory hook Credit is the amplifier, not the metronome: it is slower, but when it turns with the economy the swing is bigger.
Know it cold Hit hardest: construction and property. Credit busts make recessions longer and deeper; fast credit growth makes recoveries stronger. Strong credit peaks are closely associated with later systemic banking crises.
MemorizeWhy investors watch the credit cycle
Know it cold (1) Understand housing and construction. (2) Gauge the size of expansions and the severity of recessions. (3) Anticipate policy makers, including macroprudential tools.
- Business cycle Memorize measures output (GDP); about 1 to 10 years; smaller swings
- Credit cycle Memorize measures availability and price of credit, often with house prices; longer, deeper and sharper
- Strong economy Use it lenders extend more credit on easier terms
- More building and property buying
- Asset prices and collateral values rise
- Still more lending
-
- Weak economy Use it lenders tighten: less credit, higher cost
- Property prices fall
- Defaults rise
- Further weakness
-
How it is asked
-
Statements on the link
"Credit cycles run on their own clock, so they say nothing about how deep a recession will be." Agree?
Disagree. A recession that meets a credit bust tends to be longer and deeper. "Unrelated" is the trap; "not always in step" is right.
-
Which business is most exposed?
Lending tightens and property prices slide. Most exposed: a homebuilder, a pharmacy chain or a music-streaming service?
The homebuilder: construction and property run on borrowed money.
-
Why track credit conditions?
A strategist follows bank lending standards and credit relative to GDP. What does that tell the strategist?
Whether easy credit is inflating property and asset prices that could end in a crisis, and how hard the next downturn may hit. "Loose credit damps bubbles" is the trap.
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Length and depth
Compared with business cycles, credit cycles are shorter and shallower, the same, or longer and deeper?
Longer and deeper.
Exam traps
- Saying credit and business cycles are unrelated. They are linked, though not always synchronized.
- Saying loose credit reduces asset bubbles. Loose credit feeds them.
- Assuming credit cycles have the same length as business cycles. They are longer, deeper and sharper.
Checkpoint
3 exam-style questions. About 90 seconds each.
1A sharp tightening of bank lending and a fall in property prices would hurt first and hardest:
2Compared with business cycles, credit cycles are most likely:
3An analyst says: (1) credit cycles are usually shorter than business cycles; (2) very strong credit booms are often followed by banking crises. Which is correct?
Key takeaways
- A credit cycle is easy credit in good times and tight credit in bad times.
- It amplifies booms and busts, especially in construction and property.
- Credit cycles are longer, deeper and sharper than business cycles.
- Credit booms are a warning sign for banking crises, and macroprudential policy targets them.
All Economics formulas, every lesson
Practice exam-style questions on Understanding Business Cycles
Questions about this lesson?
Where this comes back
- Employment, capital spending, inventories, housing and trade over the cycle Understanding Business Cycles
- Monetary Policy Economics
- Credit Risk Fixed Income
Questions candidates ask
What is a credit cycle in economics?
A credit cycle is the changing availability and price of credit over time, usually tracked by growth in private-sector credit, credit relative to GDP and often house prices. Lenders extend credit freely when the economy is strong and tighten when it weakens.
How are credit cycles related to business cycles?
Credit finances investment and property purchases, so credit cycles feed into real activity. They tend to be longer, deeper and sharper, and they are not always in step. When a credit bust coincides with a recession, the recession is usually longer and deeper.
Why do credit booms lead to financial crises?
Easy credit pushes up property and asset prices, which raises collateral values and encourages more lending. When fundamentals weaken, prices fall, defaults rise and lenders pull back. Strong credit peaks are closely associated with later systemic banking crises.
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