Last time we talked about Walras's Law--how excess demands and excess supplies across all the markets in the economy have to add up to zero. We learned that a depression--large excess supply in the markets for goods and services accompanied by low capacity utilization and high unemployment--is accompanied by an equal amount of excess demand somewhere in financial markets. And we learned that to eliminate one is to eliminate the other: boost demand for goods and services and you will find financial markets coming back into full-employment balance; boost supply in financial markets and you will find your depression in demand for goods and services, in capacity utilization, and in unemployment melting away like the Arctic ice cap.
Once you understand Walras's Law, it is impossible to make the kind of elementary mistakes in economic reasoning that we saw Luigi Zingales making in the Economist--claiming that because the proble arose in the banking sector it had to have a banking-sector cure, and that no alternative roads back to full employment were conceivable.
So far, however, we have just said "excess demand in financial markets." But what kind of excess demand? And where in financial markets? It is time to probe deeper.
One school of thought focuses on the so-called "money market": the demand and supply for those assets that are regularly used as means of payment, that are generally accepted in all markets as worth their face value--coin, currency, reserve deposits at the branches of the central bank, checking-account deposits at reputable banks, et cetera. These monetarists--so-called because they think that the key to understanding depressions and other goods-and-services-and-labor-and-capacity-utilization phenomena is to be found in the demand-and-supply for those liquid assets used as mean of payment that we generally call "money"--focus on how the market, the government, and the banking system affect the supply of money and thus induce depressions. A market-induced drain of reserves and currency--either abroad as exports fall or into people's mattresses as they panic--that diminishes the supply of the "circulating medium" will create an excess demand for money and an excess supply of goods, services, capacity, and labor. Government policies that shrink the money stock--open-market sales of bonds for cash that is then unspent or changes in reserve requirements--will cause depressions. And so will private banking-sector disturbances that cause banks to raise their deposit-reserves ratios. Keep the money supply on an even keel, monetarists say, (and avoid a collapse in confidence that causes an internal drain of the circulating medium to the mattresses,) and you will have no depressions. This is the economics of Irving Fisher and Milton Friedman.
A second school of thought focuses on the bond market: the supply and demand for long-term assets that finance the purchases of the economy's debtors. A depression, these economists say, tends to come about when savings are in excess of investment--when the market interest rate that prevails in the economy is in excess of the natural interest rate at which savers' demand for new bonds to hold would be equal to businesses' (and the government's) supply of new bonds to finance business investment and the government's deficit. The cure here is for something to happen to drive the natural interest rate up to the market rate--for the government to increase its supply of bonds by spending more or taxing less, for private businesses to raise up their animal spirits and seek to spend more on adding to their capacity and so for them to borrow more, or for households to decide that they should save less. This savings-investment-warranted-natural rate of interest school has its roots in late nineteenth-century Swedish economist Knut Wicksell.
Yet a third school of thought looks for the financial disequilibrium that causes depression not in the money market for liquid assets generally accepted as means-of-payment or in the flow-of-funds through the bond market as savers seeking to postpone spending look for businesses seeking finance to expand their capacity, but instead in the market for safe, high-quality assets--not cash, currency, and means of payment (although such are safe, high-quality assets) but a broader spectrum of places where you can put your money and be sure that it will still be there whenever in the future you happen to need it. Call this the Bagehot school, after nineteenth-century economist Walter Bagehot.
Which of these three schools is correct? All of them--that is, any one of these three financial-market excess demand configurations can trigger a depression. In general, asset market prices and interest rates will react differently depending on which disequilibrium is active. A depression caused by an excess supply of money will be one that sees high interest rates on government debt and on all other assets, as economic agents who regard themselves as short of liquid cash means-of-payment find themselves dumping their other assets, including government bonds, at fire-sale prices to try to build up their money balances. Call this a high-value-of-liquidity (high-price-of-cash) depression. A depression caused by an excess demand for safe, high-quality assets will usually see very low rates of interest on and very high prices for government bonds (for governments with reputable finances, at least) because government bonds are high-quality assets; it will, however, see high interest rates on and low prices for the debt of risky private enterprises. Call this a high-price-of-risk (high-value-of-quality) depression. A depression caused by a savings-investment mismatch will tend to see an unusually flat term structure of returns: the excess demand if for long-term financial savings vehicles that is not matched by a corresponding supply of capital investment projects promising long-term returns. Call this a high-value-of-futurity (low-price-of-duration) depression.
And, of course, the ideal types mix...