Credit cycles go back at least as far as any economic history that I have seen. Certainly back to the American colonial period. For a long time, credit cycles were mostly regional. Prior to the Great Depression, different regions of the country would be at different phases of the credit cycle, so there wasn’t a major country-wide problem. Instead there would be one region at a time where nobody could get loans, which led to local depressions.
In order to understand credit cycles, it is important to understand how money is created. The way a bank works is that they have some deposits which they can then loan out. But once they have loaned the money out, it will be deposited in another bank. That bank will also loan the money out. This cycle continues until a large number of people all simultaneously claim to have the exact same money. As long as they don’t try to simultaneously withdraw it from the bank, this doesn’t cause any problems.
When banks were unregulated, nobody stopped them from loaning out as much money as they wanted to. Since the banks make a profit on every loan, many banks would try to loan out as much as they could. But if people start to default on their loans at a higher than expected rate, then the bank stops making loans as freely. Prior to the industrial revolution, this would normally happen when agriculture failed, which happens to also be the worst possible time for the bank to be withdrawing credit from the economy.
In a modern economy, countries have a central bank that regulates how much a bank can loan out relative to how much it has in deposits. This allows the central bank to control the availability of money in the economy. This is called fractional reserve banking, because only a fraction of the reserves have to be held by the bank (the rest can be loaned out). The central banks also have other means of controlling the money supply. These other tools are used more often because changing the reserve requirements on banks is a very drastic measure that would cause severe disruptions to the economy if it isn’t handled very carefully.
Somehow, the entire US financial system became synchronized sometime around World War I. The roaring twenties were a byproduct of a nationwide credit expansion. Anyone could get a loan to buy anything, so people did. People were buying stocks and bonds, allowing companies to grow faster through cheaper financing.
But then the credit expansion went as far as it could. Around 1929-1930, the banks weren’t able to make more loans. With the stock market crashing, people were no longer interested in investing, which meant that companies could no longer get the financing they need for expansion. As credit markets tightened, companies couldn’t even get the financing they needed just to handle cash flow smoothing (paying for things during slow periods with profits from the better periods).
Financial leverage is used by investors to make speculative bets that are larger then they can afford on their own. There are many ways to produce leverage in a modern financial market, although most of them involve derivatives. The benefit of leverage is that it increases the effective size of a bet without requiring more money initially. For example, with 10x leverage, you make a 10% profit on a 1% increase. Of course the downside is that you lose 10% on a 1% decrease.
Prior to 1929, investors could buy stocks with substantial amounts of leverage. I don’t think the SEC regulated leverage until sometime in the 1930’s, so it was basically up to your broker to decide if you were investing too aggressively. Many people were buying stocks with 5x to 10x leverage, so when the market declined 10% and more, they had nothing left and had to sell. The forced selling was a major contributor to the stock market crash.
With the introduction of MBS’s and similar instruments, investment banks found a way to create money out of nowhere. Investors could buy MBS’s, which would go towards buying mortgages. With the mortgages sold off their books, the local banks could lend the money again and again. The Fed no longer had control over the money supply, because the investment banks were free to loan out as much money as they wanted to. In other words, the regulation of the money supply was circumvented.
