Asset Price Cycles (Financial Economics)

This is a short study note on the nature of upswings and downswings in asset price cycles.

Credit and the Upswing of Asset Price Cycles

• When asset prices such as property prices are rising, many people will have the expectation of future asset price increases.
• This then increases the borrower demand for credit at a time when commercial banks are more willing to lend to borrowers because of the expectation of higher profits
• Expectations / sentiment become crucial in explaining asset price cycles

Big danger of upswing: Cycles of over-supply and over-demand of credit

Credit and the Downswing of Asset Price Cycles

• When asset prices start falling, lenders will tighten up their lending criteria and the supply of loans contracts
• In a systemic credit crunch, the financial markets may stop or severely limit lending to each other.
• A rise in bad debts / loan defaults hits the profits and reserves of the banks
• In a severe crisis banks may fail because of insolvency and a loss of liquidity

Big dangers of an asset price downswing: Bankruptcy, default, debt overhang

Adair Turner on Banking and Financial Crises

“Modern financial systems left to themselves inevitably create debt in excessive quantities. In particular, the type of debt that does not fund new capital investment but rather the purchase of already existing assets, above all real estate.”

“Banks do not only “take deposits from households and lend money to business,” but they also “create credit, money and purchasing power.”

“Debt can be dangerous, even if all bankers are as honest, responsible and professional as possible, and even if each individual loan seems in itself socially useful and economically sustainable.”