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A credit freeze or credit crunch is a situation in which the credit market grinds to a halt, essentially putting an entire economy into free-fall. While most average consumers are familiar with the basics of consumer credit in the form of credit cards, student loans, home equity lines of credit, and so forth, they may not be aware of the importance of credit in the business world. When the credit market is not functioning, a ripple effect occurs, putting considerable stress on the economy.
A typical credit freeze starts with the banks. First, banks may be reluctant to offer credit to consumers, and then businesses. People may be required to meet very strict requirements before they will be offered loans, and the interest rates and loan fees may be extremely high. For individuals, this can be frustrating, but for businesses, it is devastating. Most businesses rely on an open line of credit with their bank to meet payroll, buy supplies, and cover other overhead costs. When they cannot get this credit, they are forced to drastically downsize to cope with the issue. Government agencies also need credit, and a failure to obtain it could result in unpaid government workers from teachers to the staff at water treatment plants, as well as a freeze in government assistance in the form of grants, loans, and so forth.
As businesses slow operations to cope with a credit freeze, a trickle-down effect occurs. People may be left without jobs as a result of layoffs, and the flow of consumer goods also slows. Many shipping companies, for example, routinely use letters of credit in their business, and if they cannot get credit, their goods will rot in port, resulting in a shortage at the end-destination. Increased demand for decreased goods can lead to a rise in prices, making the credit freeze even more damaging.
Banks may also stop lending money to each other in a credit freeze. Free exchanges of cash and securities are a critical part of a functioning banking system. In a credit freeze, banks worry that they will extend a loan to a failing bank, and be unable to recover the funds. As a result, they lock down on loans, often leading other banks to fail because they cannot get credit.
As the financial market slows, a credit freeze can become self-perpetuating. Banks refuse to lend money to each other for fear of failure, causing banks to fail, while consumers start to panic, pulling out their deposited and invested funds and thereby pressuring the market even further. Often, drastic steps must be taken in order to put an end to a credit freeze, or the result may be an economic depression.