Enthusiasm alone rarely creates a dangerous bubble. People can be excited about a new technology, a booming city or a fashionable investment, but if they can only spend their own savings, prices can rise only so far. What turns enthusiasm into a bubble, and a bubble into an economic crisis, is usually credit: borrowed money.
Almost every major bubble in history has been accompanied by a significant rise in lending. Sometimes the lenders were established banks; sometimes they were new banks, finance companies, foreign lenders or novel financial products. The pattern is so consistent that a rapid rise in credit is one of the most reliable warning signs of a bubble, and one of the best predictors of how much damage it will do when it bursts.
This article explains how credit fuels bubbles, why lending tends to expand in booms, what signs to watch, why debt makes busts so much worse, and what this means for businesses that borrow and lend. It is part of GoCore’s series on bubbles; the stages of a bubble are described in The anatomy of a bubble.
How credit feeds a boom
The mechanism is a feedback loop.
- Asset prices rise. A genuine opportunity, falling interest rates or rising incomes push prices up.
- Collateral values rise. Assets that have risen in value can support larger loans. A house worth more can be borrowed against; shares worth more can secure a larger margin loan.
- Lenders lend more. With higher collateral values and recent experience of few losses, lenders become more willing to lend, and on easier terms.
- Borrowers buy more. The extra credit is spent on more assets, pushing prices higher still.
- The loop repeats. Higher prices support more lending, which supports higher prices.
As long as prices keep rising, the loop looks like a virtuous circle. Borrowers profit, lenders record few losses, and the economy grows. The problem is that the same loop runs in reverse when prices fall.
Why lending expands during booms
Several forces encourage lending to grow faster than is safe.
Recent experience looks reassuring. During a long boom, few loans go bad, because rising asset prices allow struggling borrowers to sell or refinance. Lenders’ loss records look excellent, which encourages them to lend more and to relax standards.
Competition. When one lender loosens its standards, others lose business unless they follow. Lenders that remain cautious watch their market share and profits shrink while the boom continues.
New entrants. Booms attract new lenders: new banks, finance companies, foreign lenders, online platforms or other providers who are keen to grow. New entrants often compete on looser terms to win customers.
Regulatory or structural change. Deregulation can allow lenders to lend far more freely than before. The housing bubbles in the United Kingdom and Scandinavia in the 1980s followed the liberalisation of their banking systems.
Financial innovation. New loan products, such as loans with very small deposits, interest-only repayments or low introductory rates, allow buyers to pay higher prices than their incomes would otherwise support.
Even when banks are cautious, credit finds a way. History suggests that if established banks hold back, other sources of finance tend to step in: new lenders, personal credit, foreign borrowing, or financial products that provide leverage without a traditional loan.
Minsky’s three kinds of borrower
The economist Hyman Minsky offered a useful way to understand how borrowing becomes more fragile during a long period of stability. He described three kinds of borrower:
- Hedge borrowers can meet both interest and repayments of the loan from their income. They are safe even if asset prices stop rising.
- Speculative borrowers can meet interest from their income but rely on refinancing to repay the principal. They are vulnerable if lenders stop rolling over their loans.
- Ponzi borrowers (named after a notorious fraud, though Minsky did not mean they were fraudulent) cannot meet even their interest from income. They rely on rising asset prices, so that they can sell or borrow more, to stay afloat.
Minsky argued that long periods of stability encourage a gradual shift from hedge to speculative to Ponzi borrowing, as confidence grows and lenders relax. The system becomes more fragile precisely because it has been stable. When asset prices stop rising, Ponzi and speculative borrowers are forced to sell, and their selling pushes prices down further.
Money growth, credit growth and real interest rates
Behind many bubbles lies what can be described as a relaxed monetary policy. This can show up in several ways.
Rapid money growth. Sometimes the money supply grows quickly, providing ample funds for lending and spending.
Rapid credit growth. Probably more important is the growth of credit itself: the increase in debt across households and businesses. Money growth and credit growth are related but not identical, and credit growth tends to be the more direct indicator of bubble risk.
Low real interest rates. The real interest rate is the interest rate after subtracting inflation. When real rates are unusually low, or even negative, borrowing to buy assets becomes especially attractive, because the cost of the loan is small compared with the expected gain in asset prices.
Why central banks may not react
During many bubbles, consumer price inflation remains subdued. Central banks whose main target is inflation in everyday prices may therefore see no reason to raise interest rates, even as asset prices and credit surge. Asset price inflation is not directly part of most inflation measures, so a bubble can grow while the official inflation picture looks calm.
Whether central banks should respond to asset bubbles directly has been debated for decades. Some argue that raising interest rates to deflate a bubble would harm the wider economy; others argue that waiting allows imbalances to grow until the bust causes far more damage. Since the global financial crisis of 2007–09, many countries have added macroprudential tools, such as limits on high loan-to-value or interest-only lending, which target credit risk more directly without changing interest rates for the whole economy. In Australia, the prudential regulator APRA used measures of this kind in the 2010s to slow growth in investor and interest-only housing lending.
Signs that credit is fuelling a bubble
When assessing whether a boom is credit-driven, a few indicators help:
| Indicator | What to look for |
|---|---|
| Credit growth | Lending growing much faster than incomes for several years |
| Debt levels | Household or business debt rising relative to income |
| Lending standards | Smaller deposits, longer terms, interest-only loans, looser income checks |
| New lenders | New banks, finance companies or platforms gaining market share |
| Real interest rates | Unusually low or negative |
| Savings rate | Households saving less as they borrow against rising assets |
| Leverage products | Rapid growth in margin loans, leveraged funds or similar products |
No single indicator is decisive, but several together suggest that borrowed money is driving prices.
Why credit makes the bust worse
Bubbles financed mainly with savings can still cause losses when they burst, but the damage tends to be contained to those who invested. Bubbles financed with credit spread the damage much further.
Forced selling. Borrowers who cannot meet repayments, or whose lenders demand more security as prices fall, must sell. Forced selling pushes prices down further, triggering more forced selling.
Negative equity. Borrowers whose debts exceed the value of their assets cannot easily sell or refinance. They cut spending to keep up repayments, weakening the economy.
Lender losses. As loans go bad, lenders’ capital shrinks. To protect themselves, they cut lending to everyone, including sound borrowers and businesses that had nothing to do with the bubble.
Credit crunch. A sharp reduction in the availability of credit can push healthy businesses into difficulty, because they cannot renew overdrafts or finance normal operations.
Long recovery. After a credit-fuelled bust, households and businesses often spend years paying down debt rather than spending and investing. Economists sometimes call this a balance sheet recession, a term associated with the economist Richard Koo, who used it to describe Japan’s long slump after its bubble burst around 1990.
The difference is visible in history. The bursting of the technology share bubble in 2000, which was financed largely with equity rather than debt, led to a relatively mild recession in the United States. The bursting of the US housing bubble a few years later, financed heavily with mortgage debt, led to the global financial crisis.
A worked illustration
This is an illustration with round numbers.
Two buyers each purchase an investment property for $800,000.
Buyer A pays a 40% deposit ($320,000) and borrows $480,000. Buyer B pays a 10% deposit ($80,000) and borrows $720,000.
Prices then fall 15%, and the property is worth $680,000.
| Buyer A | Buyer B | |
|---|---|---|
| Original deposit | $320,000 | $80,000 |
| Loan | $480,000 | $720,000 |
| Property value after a 15% fall | $680,000 | $680,000 |
| Equity remaining | $200,000 | −$40,000 |
| Share of deposit lost | 37.5% | 150% |
Buyer A has lost a substantial amount but retains equity and can choose when to sell. Buyer B is in negative equity, owing more than the property is worth. If Buyer B’s income falls or interest rates rise, they may be forced to sell at a loss larger than their entire deposit.
Multiply Buyer B across a whole market, and the forced selling, lender losses and reduced spending explain why credit-fuelled busts are so damaging.
What this means for businesses
Credit cycles affect every business, not just those directly involved in a bubble.
Borrowing is easiest when it is most dangerous. In a boom, lenders compete to lend, and terms are generous. That is exactly when borrowing to expand is riskiest, because asset prices and demand are most likely to be inflated.
Facilities can disappear. Overdrafts and credit lines that seemed permanent during a boom can be reduced or withdrawn when lenders retrench. Businesses that depend on them for working capital are exposed.
Customers’ credit matters too. If customers buy on credit, or depend on borrowing for their own businesses, a credit crunch will reduce their spending.
Collateral values can fall. Loans secured against property or equipment may be reviewed if the value of the security falls, even if the business is performing well.
Keep borrowing within what earnings support. The guidance in Debt as a warning light applies especially strongly during credit booms: measure borrowing capacity in years of earnings, not in what lenders will offer.
For businesses that extend credit
Many businesses lend in effect, by offering customers payment terms. During a boom, it is tempting to extend generous terms to win sales, especially to customers in booming industries. When the cycle turns, those receivables can become slow or impossible to collect.
Sensible practices include checking customers’ creditworthiness, setting credit limits, watching for customers who start paying more slowly, and being particularly careful with customers whose own business depends on a boom.
Common mistakes
Treating easy credit as a sign of a healthy economy. It may be a sign of a bubble.
Assuming lenders will always renew facilities. They may not when conditions change.
Borrowing against inflated asset values. The security may be worth much less later.
Ignoring real interest rates. Very low real rates encourage risky borrowing.
Underestimating the bust. Credit-fuelled busts are deeper and longer than equity-funded ones.
Questions to ask
- Is credit growing much faster than incomes, and for how long?
- Are lending standards loosening, and are new lenders gaining share?
- Are real interest rates unusually low?
- How much of the current demand in your market depends on borrowed money?
- For your own business: could you operate comfortably if your lender reduced your facilities by half?
Bringing it together
Credit is the fuel behind most damaging bubbles. Rising asset prices support more lending, more lending supports higher prices, and long periods of stability encourage borrowers and lenders to take more risk. Relaxed monetary policy, low real interest rates, competition between lenders, new entrants and financial innovation all add fuel.
When prices turn, the same loop runs in reverse: forced selling, negative equity, lender losses and a credit crunch that harms sound businesses along with speculators. That is why the amount of credit behind a boom is one of the best indicators of how dangerous it is, and why businesses do well to borrow from strength rather than from the generosity of a boom.
Sources: an introductory chapter on asset bubbles written in the mid-2000s, the work of Hyman Minsky, and widely documented financial history. Figures in the worked illustration are not data. This article is general information, not financial, lending or investment advice.
