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A "credit crunch" is a recessionary period in a debt-based monetary system where growth in debt has slowed and subsequently causes a drying up of liquidity in an economy. It is often caused by lax and innapropriate 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. These institutions may then reduce the availability and ease of obtaining credit, and increase the cost of accessing credit by raising interest rates for fear of further losses. In some cases lenders may be unable to lend further, even if they wish, as a result of earlier losses restraining their ability to lend.
A credit crunch is the opposite of cheap, easy and plentiful lending practices (sometimes referred to as "easy money" or "loose credit"), the likes of which have been seen around the world, particularly between 2002 and 2007. During this upward phase in the credit cycle in a debt-based monetary system, asset prices experience bouts of frenzied competitive, leveraged bidding, inducing hyperinflation in a particular asset market. This can then cause a speculative price "bubble" to develop. As this upswing in new debt creation also increases the money supply and stimulates economic activity, this also 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."
A reduction in the growth of the money supply caused by a credit crunch can bankrupt marginal borrowers and threaten the solvency of marginal lenders, as the liquidity in the economy dries up due to a shortage of new debt money. This reduction in the money supply and the sharp drop in previously inflated asset prices stifles economic growth and employment, thereby triggering an economic recession or in severe cases, a depression.
The 2007 subprime mortgage financial crisis may have brought about a credit crunch.