Pursued Economy

CHAPTER 8Money and Banking in the Other Half of Macroeconomics

When a bubble bursts, the economy typically faces an absence of both borrowers and lenders (Case 4). The absence of borrowers causes a balance sheet recession, which is a macroeconomic phenomenon. The absence of lenders causes a credit crunch, which is a financial phenomenon. Depending on the nature and size of the bubble and the subsequent policy response, one can also happen without the other.

Lenders disappear from the scene because they lent money to participants in the bubble, many of whom became insolvent or unable to service debts after the bubble burst. The post-bubble balance sheet recession will also reduce the incomes of those who were not involved in the bubble. That, in turn, undermines their ability to service their debts. The resultant increase in nonperforming loans (NPLs) erodes banks' capital, leaving them unable to lend. Many lenders may find themselves effectively bankrupt as well.

Two Banking System Externalities

When banks are unable to function fully because of impaired balance sheets, the broader society suffers in two ways. First, banks are at the core of the payment system. Because everything from utility bills to college tuition is paid via the banking system, a breakdown here can have a devastating economic impact. Banks' second function is to ensure that saved funds are borrowed and spent, thereby keeping the economy going. A failure of this intermediation function will also lead to ...