Axel Leijonhufvud over at the Center for Economic Policy Research:
The Treatise on Money contains a piece of analysis that I have found illuminating. It deals with the financial side of a business downturn. Keynes assumes an initial equilibrium disturbed by a decline in expected future revenues from present capital accumulation. Firms cut back on investment and, as activity levels decline, direct some part of cash flow to the repayment of trade credit and of bank loans. As short rates decline, banks choose not to relend all these funds but instead to improve their own reserve positions. Thus the system as a whole shows an increased demand for high-powered money and simultaneously a decrease in the volume of bank money held by the non-bank sector. Keynes’s preference for speaking of ‘liquidity preference’ rather than ‘demand for money’ becomes understandable in this context since while an increase in liquidity preference does constitute an increase in the demand for outside money it also leads to a decrease in the volume of inside money.
What makes this analysis relevant in today’s context is that it describes a process of general deleveraging as part of a business downturn. Causally, it is the decline of investment expectations and the consequent contraction of output that prompts deleveraging. Today, we are faced with the converse question of whether or not the deleveraging that the financial sector is rather desperately trying to carry through will of necessity bring about a serious recession. For many months now, we have been treated to brave protestations from all sorts of sources that the real economy is strong and will not be much affected by the credit crisis. Yet, it is quite clear that, in a closed system, it is a fallacy of composition to suppose that general deleveraging can take place with out a decline in asset prices and excess supply of goods and services in general (Leijonhufvud 2007c).
Of course, the US private sector is not a closed system. Leverage can be reduced and liquidity improved by inducing sovereign wealth funds or other foreign entities to assume an equity interest in domestic enterprises as some American banks have done. Similarly, the government can guarantee certain private sector debts and/or swap safe and liquid government debt for risky and illiquid private debt. This too has been done. But there are limits to both these safety valves and it remains a serious question whether they will suffice to stave off a serious and long-lasting recession.