May 9, 2023 - 1:00pm

As a slew of banks wither from the Federal Reserve’s tight money policies, the noose is finally tightening in credit markets. Monetary policy impacts the economy in two ways. First, it makes the cost of credit — the interest rate — more expensive, which discourages borrowing. Secondly, it puts stress on the financial system that results in banks becoming less and less willing to lend people money as they fear that borrowers might default.

We are now seeing a very sharp tightening in credit markets. Loans for everything from small firms and consumer credit to the automotive and construction industries are becoming harder to get hold of. Outside a very brief period at the start of the pandemic, we have not seen credit tightening like this since the 2008 financial crisis.

Economists often refer to the “credit cycle”. At the start of the cycle banks are confident and flush with money, and interest rates are low. Banks start to lend and people start to borrow. At a certain point, however, excesses creep in. Less trustworthy borrowers get access to credit. Then the central bank starts to raise rates and credit standards start to tighten up, with banks becoming increasingly conservative with their lending. Finally, the cycle breaks, lending collapses, the economy falls into recession and the bad loans start to default.

We are currently somewhere near the top of the tightening part of the cycle. The wave of defaults has yet to take place, but there is every reason to think that the dam could break at any moment. Borrowers are starting to sense this and demand for loans is drying up. In the market for loans, fewer people are buying and fewer people are selling. Meanwhile, every time a bank blows its lid other institutions get increasingly nervous.

When does it all come crashing down? On this, the markets are divided. Many institutions are now positioning themselves for a recession, assuming as they do that when banks blow up one is just around the corner. Hedge funds, though, are betting against such an outcome. They think that the economy remains too strong, despite the tightening credit standards. Yet neither banks nor hedge funds have any illusions about what the result of all this is.

The big question is whether the economy will recover from this recession. After 2008-09, stagnation set in, with central banks having to print large quantities of money to try to lift the economy from its slumber.  This time around, we are going into a recession with serious structural inflationary problems, not to mention a nascent trade war between the world’s two largest economies (China and the United States). If the post-2008 recovery was sluggish, the comeback from the approaching recession might be even more challenging.

Philip Pilkington is a macroeconomist and investment professional, and the author of The Reformation in Economics