During the upward phase in the credit cycle, asset prices experience bouts of competitive, leveraged bidding, inducing asset price inflation in a particular asset market. This can then cause an unsustainable, speculative price "bubble" to develop. As this upswing in new debt creation also increases the money supply and stimulates economic activity, it tends to temporarily raise economic growth and employment.
When new borrowers cannot be found to purchase at inflated prices, a price collapse can occur in the market segment inflated by excess debt, along with a dramatic reduction in liquidity in that market. This can then cause insolvency, bankruptcy, and foreclosure for those borrowers who came in late to that market. If widespread, this can then damage the solvency and profitability of the private banking system itself, resulting in a dramatic reduction in new lending as lenders attempt to protect their balance sheets from further losses. This in turn results in a contraction in the growth of the money supply, often referred to as a "drying up of liquidity".
Prime examples of this "boom-bust" cycle of credit creation and destruction can be found in the United States housing bubble and the subsequent subprime mortgage crisis, the dot-com bubble and the Japanese asset price bubble.
Weathering the Credit Market Storms: A Down Credit Cycle Combined with New Credit Impairment Accounting Rules Bring Both Challenges and Opportunities
Oct 01, 2007; [ILLUSTRATION OMITTED] With volatility in the credit markets creating severe whiplash, and investors flocking to the safety of...