To understand how a “credit crunch” or “liquidity trap” can threaten an entire economy and how a bank can be “too big to fail,” it is necessary to have a better understanding of what the “products” are in financial markets. Financial markets theoretically exist for two reasons: to provide liquidity for investments and to facilitate risk management. 

The main consideration in an individual’s risk management strategy may be the liquidity of his investments. When the market seems to be going to hell, he can cash out and wait for things to settle down – if his investments are sufficiently liquid. Liquidity requires an active market for the “securities.” If you lend your brother-in-law money to start a restaurant and the restaurant flops, you are not likely to be able to sell your share of the ownership in the restaurant. If you invest it in blue chip stocks, you can probably always sell the shares even if the economy starts to tank. The stock market can, of course, be subject to something comparable to a run on a bank. If everyone starts to fear the economy is tanking and pulls out of the stock market, share prices will go into free fall and you will get a “recession.” 

Keynes used the phrase “fetish of liquidity” to emphasize the fact that ultimately from a macro-economic point of view there can be no liquidity. Investment requires commitment and involves risk. In the current system the needs of the individual investor contradict the needs of the economy as a whole. Economic health requires long-term investments, not just trading of financial “instruments” with an eye towards short-term profit and liquidity. 

Pundits and politicians in the U.S. have commented on the focus on the short term harms the economy and contributes to the great disparity of wealth, but few have gone so far as to advocate closing the stock market. Even Keynes, who saw that financial markets encourage a pursuit of short term gains and liquidity, thought that regulation and taxes could suffice to restrain investors and encourage long term investing. 

If investment financing came from money creation or the extension of credit by banks, there would be no need to be concerned with “liquidity.” The only risk would be the possibility of having too much money in circulation relative to overall productivity, which is generally cited as a major cause of inflation. (see Inflation) The creation of money and the extension of credit would have to be regulated to prevent an oversupply of money.

Note that even if financial markets were eliminated and the main source of financing was bank credit or money creation, there would still be the possibility that an individual or partnership could use existing cash reserves to finance a new enterprise.  These investors would simply be committed to the long haul since there would be no ready market for shares in the enterprise.  There could perhaps be regulations allowing a partner to sell his share back to the company or even to someone else based not on a price determined by a market, but on some standardized accounting method for evaluating the value of the share in the ownership.

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