The nonfinancial sector wants to hold risk-free short-term assets and issue risky long-term liabilities. To accommodate this, the financial sector does the opposite. If the financial sector suddenly contracts, the nonfinancial sector gets stuck with an asset mix that is riskier and more long-term than it wants and a liability mix that is less risky and shorter term than it wants. The reaction to this unwanted mix can cause a recession. That is how the financial sector affects the real economy.Think of an economy where investment projects consist of fruit trees. It takes time for them to mature, and they are subject to risk, such as the risk of disease.

Other things equal, consumers would rather have riskless, short-term assets than shares in fruit trees. As a consumer, you might need money in a hurry. Or, you might not be able to deal with the loss of wealth that would come from disease ravaging fruit trees in your investment portfolio. Entrepreneurs, meanwhile, need long-term capital to back their fruit tree investments.

Ultimately, the market has to resolve the conflict between what Keynes saw as the propensity to hoard of consumers and what he called the animal spirits of the entrepreneurs. In the absence of financial intermediation, the growers of fruit trees have to persuade consumers to buy shares of stock in their enterprises. If consumers require a high expected return on these shares, then only a few fruit trees will be able to satisfy them. If they were willing to accept a lower expected return, then many more fruit trees would be profitable to plant.

Let us say that, given that consumers are wary of taking risk, the supply and demand for fruit tree investments are in balance when 100 fruit trees are planted. If fewer were planted, the expected returns would be so high that consumer would be willing to buy more shares in fruit trees. If more were planted, the expected returns would be so low that consumers would not be willing to hold shares in fruit trees.

Next, along comes a financial intermediary, which we will call a bank. Somehow (we’ll explain the magic shortly), the bank holds fruit trees as assets and issues short-term, risk-free liabilities (demand deposits, also known as checking accounts). Consumers are much happier with demand deposits than fruit tree shares, so they put up a lot more wealth than they would if they had to invest in fruit trees directly. The bank invests this additional wealth in fruit trees, which causes the required return on fruit trees to go down. This results in more fruit trees being planted.

With a bank, let us say that the entrepreneurs are able to plant 500 fruit trees. Before the bank came along, there were 100 fruit trees, with the shares in the fruit trees making up the liabilities of the entrepreneurs and the assets of the consumers. With the bank, there are 500 fruit trees, with the shares in the fruit trees making up the liabilities of the entrepreneurs and the assets of the bank. Consumers’ assets are demand deposits, which are the liabilities of the bank.

If consumers “see through” the bank, they will realize that their ultimate assets consist of shares in 500 fruit trees. They were not willing to hold that many shares before there was a bank, but now indirectly that is what they do hold.

How is the bank able to pull off this sleight-of-hand? On both sides of its balance sheet, the bank is using some combination of diversification, customer selection, and behavior modification.

Diversification means that the bank is counting on risks to be imperfectly correlated. For example, as a consumer, you have a risk that you will need your money to deal with a short-term crisis in your family, such as a medical emergency. The bank knows that, on average, only a fraction of its customers will be confronting emergencies. Perhaps on a typical day, 1 percent of customers need to withdraw their funds. On a really, really bad day, 10 percent of customers need to withdraw. So the bank decides to hold 10 percent of its deposits in a cash reserve, leaving the other 90 percent to invest in shares in fruit trees.

It is as if the consumers have gotten together and formed a mutual insurance company, under which they help each other out. When one consumer needs emergency funds, the others make the money available. Sooner or later, anyone is bound to have an emergency, but the emergencies do not all happen at once.

The bank could select its customers carefully. It might not want to have depositors who live hand-to-mouth and have a lot of money emergencies.

Diversification also works on the investment side. Suppose that fruit tree risk consists of “market risk” (the chance that every tree will be struck by disease) and “idiosyncratic risk” (risk that is specific to each fruit tree). For example, market risk could be 1 percent, meaning that there is a 1 percent chance that a disease will come along that damages every tree. Idiosyncratic risk might mean that each tree has a 20 percent chance of being struck by a disease that will not affect any other trees.

If you could only invest in one tree, then the risk of a damaged tree would be 1 percent plus 20 percent equals 21 percent, adding together market risk plus idiosyncratic risk. On the other hand, if you invest in two trees, then the chances of both trees falling to idiosyncratic risk is (0.2)(0.2) = 4 percent, so your risk of being totally wiped out is 1 percent + 4 percent = 5 percent. As the bank invests in more and more trees, the idiosyncratic risk gets smaller and smaller. Thus, the bank’s assets, while not completely risk-free, get to be quite safe. Moreover, the bank can protect depositors against the nondiversifiable market risk by holding capital.

Another strategy for the bank is underwriting, which is customer selection on the asset side. Individuals find it very costly to examine the prospects for each fruit tree, so they have to take a very conservative view of investing in fruit trees. The bank has an experienced, professional staff to examine trees. (Or, if you will, think of a bank that makes mortgage loans, using a professional staff to evaluate the borrower’s ability to repay and to appraise the home.; or think of business loans, with the staff evaluating the financial prospects of the business.) The skills and experience of its underwriting staff enable the bank to obtain shares in trees that have higher returns and lower risk than the trees that the average uninformed consumer could find to invest in.

Finally, the bank can use behavior modification. If it foresees a lot of demand for liquidity by its consumers, it can try to work with entrepreneurs to improve the short-term cash flows from the trees. On the consumer side, the bank can increase the penalties for sudden cash withdrawals and increase the rewards for consumers who maintain a high minimum balance in their accounts.

With all of these tools at its disposal–diversification, underwriting, and behavior modification–the bank works pretty well most of the time. When it works well, consumers develop confidence in the bank, and it is able to get by with greater leverage, meaning lower cash reserves and less capital.

Unfortunately, stuff happens. The bank may suffer a solvency shock, because of a really bad disease outbreak. Or, the bank may suffer a liquidity shock, because of an unusually high rate of withdrawals. It is easy imagine a slight solvency shock leading to a liquidity shock, because depositors may believe that the last one to withdraw will find that the bank is out of money.

If stuff happens, then the financial sector (the bank) will contract suddenly and sharply. This means that we no longer want 500 fruit trees, owned by a bank. Instead, the market tries to get down to a lot fewer fruit trees. Tobin’s q, which is the price of a fruit tree relative to the cost of planting a fruit tree, goes way down. That tells entrepreneurs to stop planting fruit trees.

Reconfiguring the economy to plant fewer fruit trees and instead to do something else is a long, painful process. While fruit tree planters look for other jobs, they cut back on consumption, creating multiplier effects. The economy goes into recession. Eventually, after enough wage reductions and enough workers have changed occupations, the economy returns to full employment. But that can take a long time.

What can government policy do about this? That is a good topic for a later lecture.