The demand for cash increases with uncertainty - Causes a deleveraging shock

There is an optimal level of cash in every portfolio, but this allocation is dynamic and based on the environment. If there is more uncertainty and volatility, cash levels will go up to provide for liquidity needs and serve as a store of value versus other assets. As volatility and uncertainty increase, what is considered a safe asset or cash substitute also changes. Safety may move from bonds to currency.

If we are in a risk-on environment, cash levels are minimized. If the economy switches to a risk-off environment, wealth is switched to a safe asset like bonds, but there may not be a significant chance in cash levels. If we move to a recession and there is a further increase in uncertainty, cash levels increase, but it may be through increases in bank deposits or money funds. If there is a banking crisis, cash levels will further increase, but a greater portion of wealth may be held in currency and not with bank deposits. Finally, if there is a true pandemic and real economic shock, cash as well as goods will start to be hoarded and all financial assets will be avoided. 

The impact on the financial system increases as cash levels increase because there will be a financial deleveraging shock. Cash increases force a decrease in financial leverage both through the banking and non-banking financial system which leads to a deflationary feedback loop as assets are sold to raise cash levels.

Central banks and governments have to use their powers to offset the natural consumer tendencies to increase cash when faced with uncertainty and stop the threat of a deleveraging shock.