If I were any good at writing book reviews, this post would tell you all about Morgan Ricks' new book "The Money Problem", and would explain why I think it's a very good book. [Disclaimer: I was paid to fly down to Nashville for a couple of days to help Morgan with his first draft.]
But I'm really bad at writing book reviews, so I'm going to write this post instead. Maybe "reflection" would be the right word?
Stag Hunt is a two-person symmetric game with two Nash Equilibria: a bad equilibrium (hunt hare); and a good equilibrium (hunt stag). Each can catch a hare by himself, but it takes both players to catch a stag. Half a stag is better than a whole hare. If he expects the other player to hunt hare, it will be individually rational for each to hunt hare too. And if he expects the other to hunt stag, it will be individually rational to join him in hunting stag. [I'm self-plagiarising off my old post.]
We can easily generalise Stag Hunt into a multiplayer symmetric game with a continuous strategy space. The representative agent chooses his own action Y as a function of his expectation Ye of others' actions. In Stag Hunt, his reaction function has strong strategic complementarity (a slope greater than one) over some range between the two Nash Equilibria. Like this:
The equilibrium in the middle is an "unstable" equilibrium (in the old-fashioned sense), and so deserves to be ignored. It's not a "learnable" equilibrium, for any reasonable learning mechanism. People can learn the other two equilibria, even if they don't know exactly where they are.
If you are a macroeconomist, who wants to explain why bad things (recessions) happen, without any obvious cause, Stag Hunt is immediately attractive. Because if you have a game with two equilibria, anything whatsoever that causes people to change their expectations can cause the economy to flip from one equilibrium to the other. And it is not irrational (though it may be non-rational) for people to change their expectations, precisely because those changes in expectations can be self-fulfilling. (Roger Farmer's macroeconomics is sorta like Stag Hunt, except Roger likes to build models with a continuum of equilibria, not just two.)
But Stag Hunt applies in particular to liquidity.
The amount I am willing to pay for an asset depends on my expectation of how quickly and easily I can sell it again for a price close to what I paid. I would immediately buy your used car for anything up to $1,000 if I expected that everyone else would do the same. Because I could immediately sell it again and get my money back if I decided I didn't want to keep it. In the extreme case, if it's more liquid than any other asset, and I can store it fairly easily and know it won't depreciate too much, I might buy your car even if I couldn't drive and knew I had no use for it at all. Just like the $20 notes I hold in my pocket. And everyone else might do the same.
Morgan tells us that sociologist Robert Merton used bank runs as an example of a self-fulfilling prophecy back in 1948. And the same idea is in Bagehot. It goes back before the Diamond Dybvig model.
Now when I define "bank", I mean a financial intermediary whose liabilities are used as media of exchange. And the Stag Hunt game certainly applies to banks defined in my narrow sense. If I expect others to do the same, I will run to convert my chequing account balance into currency, because even if I know for certain that the bank is 100% solvent and will eventually let me do so, the $1,000 in my chequing account is a lot less liquid if the bank suspends convertibility even temporarily.
But the exact same argument applies to any financial intermediary that borrows short and lends long, even if it is not a "bank" in my strict sense.
And there doesn't even need to be any intermediary at all. The same argument can apply to a financial market, if liquidity begets liquidity to a big enough extent, it can become a Stag Hunt game where changes in market liquidity are a self-fulfilling prophecy.
A "panic" is when we flip from the good equilibrium to the bad equilibrium in the Stag Hunt game, so assets that used to be liquid become less liquid.
I'm a monetarist, in a fundamentalist sort of sense. I see recessions as declines in the volume of monetary exchange caused by an excess demand for the medium of exchange. But there are two ways we can get an excess demand: a fall in supply; an increase in demand. And one way we can get an increased demand for the medium of exchange is if the supply of close substitutes falls (or if assets that used to be close substitutes suddenly become less close substitutes). Morgan possibly won't want to follow me in this bit, because unlike me he does not see the salience of the medium of exchange, and wants a broader definition of "money" to include things that I would call "substitutes for money". But this is how I would fit his perspective into my perspective:
A Stag Hunt panic caused the assets that are highly liquid and close substitutes for the medium of exchange to become a less liquid and less close substitutes for the medium of exchange. It also reduced the supply of those assets. That in turn increased the demand for the medium of exchange. (If the supply of Pepsi falls, or if they change the recipe so it tastes worse and less like Coke, the demand for Coke increases). The central bank and the commercial banks that produce the medium of exchange failed to increase the supply of medium of exchange sufficiently to compensate. That caused an excess demand for the medium of exchange. That caused a reduction in the volume of monetary exchange for all goods. We call that a "recession".
But a lot of Morgan's book is about how to panic-proof the financial system. The old policy was to try to "panic-proof" banks in my narrow sense of "banks". Morgan says that's not enough. He wants to cast his net a lot wider, and panic-proof all short-term (less than 12 months?) financial assets that correspond to his very broad definition of "money". I'm not sure I want to follow him there, but that's another story.
And I take back all the nasty things I have ever said about lawyers and economics. Morgan is a lawyer who has actually read economics and actually talked to economists and has gotten his head around it as least as well as economists have. And he's worked both sides of the financial regulation fence. So he's worth listening to.