Was the 2007-2008 global financial crisis the cause of credit unavailability, or was it the effect? The standard story is that the financial crisis resulted in the loss of credit availability. This policy brief argues that story is reversed and examines what lessons that can teach us. Although the causal relationship between credit availability and financial decline leading to the global financial crisis was somewhat interactive, a loss of credit availability appears to have caused the financial crisis more than the reverse. The potential for credit unavailability to cause a financial crisis suggests at least three lessons: because credit availability is dependent on financial markets as well as banks, regulation should protect the viability of both credit sources; diversifying sources of credit might increase financial stability if each credit source is robust and does not create a liquidity glut or inappropriately weaken central bank control; and regulators should try to identify and correct system-wide flaws in making credit available. These system-wide flaws can include not only financial design flaws but also flaws caused by our inherent human limitations. We do not yet (and may never) understand our human limitations well enough to correct the latter flaws. To some extent, therefore, financial crises may be inevitable. Financial regulation should therefore be designed not only to try to prevent crises from occurring but also to work ex post to try to stabilize the afflicted financial system after a crisis is triggered.
The Financial Crisis and Credit Unavailability: Cause or Effect?
Policy Brief No. 98