The difference between credit crunch and recession mainly depends on the causes that result in the beginning of each. Credit crunch is a result of financial institutions reducing the lending limit of funds to individuals and firms while recession can result from diminishing economic activity caused by factors such as inflation and unemployment.
Recessions caused by war and natural disasters are almost unavoidable and it may take many years to recover from such negative conditions. For example, the world’s most severe economic recession to date lasted from 1929 to 1939 which is named as the ‘great depression’. Credit crunch and recession are two major aspects of macroeconomics, meaning that they affect the economy as a whole – not specifically a group of individuals or businesses. Both result in negative consequences by slowing down investor and consumer confidence.
The key difference between credit crunch and recession is that credit crunch is a situation where the burrowing ability weakens due to the lack of funds available in the financial market whereas recession is the reduction in the level of business activity in the economy.
The relationship between the two is that a recession is often followed by a credit crunch. So What is a Credit Crunch? A credit crunch (also known as a credit squeeze or credit crisis) is a sudden reduction in the general availability of loans (or credit) or a sudden tightening of the conditions required to obtain a loan from banks. A credit crunch generally involves a reduction in the availability of credit independent of a rise in official interest rates. In such situations, the relationship between credit availability and interest rates changes.
Credit becomes less available at any given official interest rate, or there ceases to be a clear relationship between interest rates and credit availability (i.e. credit rationing occurs). Many times, a credit crunch is accompanied by a flight to quality by lenders and investors, as they seek less risky investments (often at the expense of small to medium size enterprises). A credit crunch is a situation where the borrowing ability weakens due to the lack of funds available in the financial market.
This happens when lenders have limited funds available to lend or are unwilling to lend additional funds. Another reason that can cause the same is that the cost of borrowing may be too high, making it unaffordable to many borrowers. Following are the main causes of a credit crunch. Unwillingness of commercial banks to lend funds due to high default rates When financial institutions have suffered losses from previous loans, they are generally unwilling or unable to lend. In most cases, mortgages are kept as loan collaterals and in the case of defaults, banks attempt to sell the properties in order to recover the funds. If home prices fall, the bank is unable to cover the value of the loan, thus it incurs a loss.
A credit crunch is often caused by a sustained period of careless and inappropriate lending which results in losses for lending institutions and investors in debt when the loans turn sour and the full extent of bad debts becomes known. There are a number of reasons why banks might suddenly stop or slow lending activity. For example, inadequate information about the financial condition of borrowers can lead to a boom in lending when financial institutions overestimate creditworthiness, while the sudden revelation of information suggesting that borrowers are or were less creditworthy can lead to a sudden contraction of credit.
Other causes can include an anticipated decline in the value of the collateral used by the banks to secure the loans; an exogenous change in monetary conditions (for example, where the central bank suddenly and unexpectedly raises reserve requirements or imposes new regulatory constraints on lending); the central government imposing direct credit controls on the banking system; or even an increased perception of risk regarding the solvency of other banks within the banking system The commercial banks have a minimum reserve amount of funds they have to maintain and when the bank reaches this minimal threshold level, they borrow from the central bank.
This is usually done in the form of short-term loans. Determining the bank rate is usually done quarterly to control the money supply in the economy. A credit crunch can do severe damage to the economy by diminishing economic growth through decreased capital liquidity. E.g. The most recent credit crunch started in 2007, also known as the ‘global financial crisis’, is considered to be the worst economic downturn in recent times. It began in the mortgage market in the USA and continued to affect a large number of developed as well as developing nations.
And What is a Recession?
Recession is defined as the reduction in the level of business activity in the economy. If an economy experiences a negative economic growth rate as per country’s Gross Domestic Product (GDP) for two consecutive quarters; then the economy is said to be a recession.
And what Causes for Recession ?
A recession is caused by the following factors.
#1 . Inflation . Inflation can be mentioned as the most significant contributor for recession .
#2 . War, Natural Disasters and Similar Forms of Destruction . Resources of an economy are eradicated and wasted due to war and natural disasters and the GDP can be severely affected in case of significant scale of destruction.
#3 .Government Policies . Governments implement different policies such as wage and price controls in order to control the money supply in the economy. These may be regarded as unfavorable for investors and businesses, thus the economic activity will diminish.
#4. Unemployment . Due to high inflation and increase in the cost of production, corporations have to lay off employees. This causes a reduction in the amount of goods and services produced.
Recession is a part of the business cycle, any economy cannot grow continuously without experiencing any negative effects at all. Therefore, recessions are somewhat inevitable. However, the negative effects of the recession can be controlled to reduce its destructive effects by controlling the causes of recession such as inflation and unemployment. The government has a significant role to play in such economic situations since recession affects the economy.
E.g. the major recession followed by the credit crunch in 2007 is named as the ‘great recession’ and many countries in the world were affected by the same in various degrees. In summary : A Credit crunch is a situation where the borrowing ability weakens due to the lack of funds available in the financial market. while a Recession is defined as the reduction in the level of business activity economy. A Credit crunch often results in the reduction in the borrowing ability.
While a Recession can be caused by many factors, primary one been inflation. There are no distinct criteria to conclude whether an economy is experiencing a credit crunch, it is an outcome of many factors.whereas If an economy experiences a negative economic growth rate as per country’s Gross Domestic Product (GDP) for two consecutive quarters; then the economy is said to be a recession.
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