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By Root 924 0

financial crises are not a new phenomenon. The history of capitalism has been marked by repeated collapses of the financial system, situations in which the “markets” for loans disappear for extensive periods of time. The eighteenth century saw some bubbles, but these might not be quite modern. But from 1819 on, there have been a succession of failures of banks and other financial institutions. These have typically been unpredicted and did not correspond in time to any particular exogenous event (e.g., wars). Economists did recognize the phenomenon; for example, John Stuart Mill’s survey of economic theory (1848) has a chapter on commercial crises (Book 3, Chapter 12) in terms that resonate with the latest news today. But the discussion on crises is not at all integrated with the general exposition of classical economics that unifies the rest of his fairly long book. This disjunction has remained in modern economics. No one could be a more vigorous advocate of unrestrained markets than economist Milton Friedman; yet, to my reading, the account that he and Anna Schwartz gave of monetary developments in the United States and particularly with regard to the Great Depression, emphasizes not prices, not even interest rates, but the supply of money and, by inference, of liquidity (Friedman and Schwartz, 1963).

I start with the neoclassical general equilibrium framework, to which I have given a good deal of attention and effort. I seek to identify a possible point at which it fails to supply a coherent theory of securities markets and so might possibly lead to some understanding of the repeated crises of the financial system underlying the development of capitalism. As my analysis will mainly build on economic theory, which might not be familiar to some of the readers, I will aim at presenting it through a natural progression.

GENERAL EQUILIBRIUM AND CREDIT INSTRUMENTS

The concept of general equilibrium was always implicit in any serious use of standard economic analysis, but it became explicit in the work of French economist Léon Walras (1874, 1877). The elements of the analysis are competitive markets in the individual commodities, each characterized by a large number of participants on both sides, all facing the same price, and by market clearing (buyers purchase the commodity from the sellers at this market price). Under these assumptions, there is no question of liquidity; any individual, taken to be small compared with the total market, can buy or sell at the unique market price. Money plays no essential role, except as a useful tool of accounting.

The markets are linked because the same individuals appear in all or at least many markets, and make choices as consumers or producers based on all prices. Hence, the price of one commodity affects market behavior on all other markets. Under these and other conditions, some remarkable theoretical results have been obtained. There will be a set of prices (possibly not unique) such that equilibrium (market clearing) can be achieved on all markets (with a suitable meaning for clearing when there is excess supply at zero price). Further, assume that individual behavior is rational, in the sense that individuals in these markets are maximizing the utility they derive from the goods they acquire. Then the allocation achieved at a competitive equilibrium is efficient in the sense that there is no other allocation in which some other individual is better off and no individual is worse off.

The bulk of the above analysis, however, was static in nature, dealing with a single time period (i.e., only today matters and tomorrow does not count). But a capitalist system is intrinsically forward-looking. Many economic decisions have implications for the future as well as the present and concern the tradeoff between the two. For instance, saving is a tradeoff between your present and future consumption. Investment is an expenditure today with a view to output in the future.

Value and Capital, which was published by British economist John Richard Hicks in 1939, brought a simple integration