Economic Theory and the Financial Crisis: A Reading List

We’re talking today about economic theory and the financial crisis — basically how well economic theory was positioned to predict and explain the 2008 financial crisis. Your first choice is a classic article, Bank Runs, Deposit Insurance and Liquidity, on banks and bank runs from 1983 by Diamond and Dybvig. Like most economic theory, it is probably too technical for non-economists, so do you want to start by explaining what it says? And, also, why you chose it, given that, with the exception of Northern Rock, this crisis hasn’t been particularly characterised by bank runs?

Diamond and Dybvig lay out their vision of the role of banks and the notion of liquidity. Even though the current financial crisis isn’t mainly about old-fashioned bank runs, it certainly is about banks and also about liquidity. Liquidity is the thing that enables a consumer to cover her immediate spending needs when her wealth is tied up in a long-term project, or that allows a producer to finance a project today even though it won’t pay off until tomorrow.

And providing liquidity is where banks come in. Banks, according to Diamond and Dybvig, are in the business of transforming illiquid assets – assets that pay off in the future – into liquid assets, so that people can undertake the spending and productive projects they want now. Banks accomplish this by pooling the risks of many individual people. It may be difficult to predict whether an individual person will choose action A rather than B, but it is relatively easy to predict what proportion of a large group of people will choose action A. This is the same principle that insurance companies rely on.

So, let’s say it’s Thursday and there’s a large population of people. Each person has some wealth but doesn’t know when she will need to spend it – that is, whether her spending needs will occur on Friday or on Saturday. There is also a productive project. Each dollar invested in this project on Thursday yields $1.50 of output on Saturday. If a person doesn’t have to spend until Saturday, then she can benefit handsomely from the project. On Thursday she can invest her wealth in it, and on Saturday end up with 50 per cent more than she started with. But what if, instead, her spending needs turn out to occur on Friday? In that case, she has to take her money out of the project then, losing the 50 per cent return she would have received had she been able to wait until Saturday.

So, here’s what a bank does. Lots of people deposit their wealth in the bank on Thursday and it then invests these deposits in the productive project. Even though the bank doesn’t know for sure whether any given person will want to withdraw her money on Friday, it knows accurately what proportion of people will do that. So it can, in effect, give those people insurance. Rather than just giving them their deposits back – which is what these people would get if they were on their own without a bank – it can pay them interest, in exchange for reducing the interest rate for the Saturday withdrawers below 50 per cent. In other words, the Saturday people subsidise the Friday people (in the same way that, with health insurance, people who remain healthy are subsidising those who get sick). And the bank makes this possible.

That seems straightforward enough.

But there’s a problem with this arrangement. Suppose that on Friday people get worried that the bank may not have enough money to pay off all the depositors. Then everybody – not just the people who need to spend on Friday, but also those who would otherwise have waited until Saturday – will try to withdraw their deposits on Friday. That’s a bank run. And if it occurs, the bank actually won’t have enough money to pay everyone off.

So it’s a self-fulfilling prophecy.

Yes. This is an important feature of banking: at any given time, a bank doesn’t have enough money – shouldn’t have enough money, if it’s doing its job well – to repay all its depositors then and there. The money has been invested in some productive project; it’s illiquid. Having all its assets in liquid form would be unproductive, inefficient for the bank. But, nevertheless, if everyone decides to withdraw at the same time, the bank is stuck. And furthermore, if a bank run takes place at one bank, then the same thing may well happen at other banks, because their depositors get worried too – and we soon have a financial crisis. So there’s an important role for government here. Government can promise depositors that it will repay them if the bank cannot – it can offer deposit insurance. The government can make this pledge credibly because it has the power to tax: it can get the money to repay depositors by taxing other people. And once the government has made the pledge, the threat of bank runs vanishes: depositors will no longer all try to withdraw their money on Friday.

Now what is the relevance of all this for the current financial crisis? Well, deposit insurance has pretty much eliminated traditional bank runs. But many financial institutions have experienced the equivalent of a bank run. Bear Stearns was brought to the brink of collapse because investors had lost confidence in it and had therefore withdrawn their financial support. The government bail-out of Bear Stearns was something akin to paying off on deposit insurance.

And all economists seem to agree that not bailing out Lehman Brothers was a big mistake. Which seems counter-intuitive, because it incentivises banks to take bigger risks, to get bigger rewards and get big bonuses. There’s no downside, because when it all goes wrong, the government picks up the bill. In short, what about moral hazard?

That’s one way in which the Diamond and Dybvig framework is incomplete: it ignores the fact that if banks know their deposits are insured – or that they are going to be bailed out – they may change their behaviour. Diamond and Dybvig is certainly a good starting point, and a great deal of the subsequent work on banks and on liquidity follows in their footsteps. But they don’t take account of moral hazard.

So is this the first article where economists really tried to model bank runs?

There had been previous models of bank runs – after all, bank runs are a very old phenomenon – but this particular explanation is new to Diamond and Dybvig. As Diamond-Dybvig show, it would be very damaging for the government to refrain from insuring deposits or bailing out banks. Bank runs are not only scary for depositors, but interfere with production. If all depositors try to withdraw on Friday, the bank has to take its entire investment out of the productive project. So there’s no output on Saturday. Deposit insurance and bail-outs are essential to prevent an economy’s production from grinding to a halt, but they create a moral hazard problem. And moral hazard is something that Holmstrom and Tirole explicitly take into account in their paper, which can be thought of as an extension of Diamond and Dybvig.

Do they come up with a solution in their paper, Private and Public Supply of Liquidity?

Holmstrom and Tirole make two points that are relevant to our conversation.

First, how do you get around the moral hazard problem, or at least reduce the severity of that problem? In Holmstrom-Tirole, this is done by seeing that the owners of a bank investing in risky projects bear some of the risk themselves. The bank is in the business of investing its depositors’ money in such projects. But unless its owners – the equity holders – also put up a stake, the bank won’t have the incentive to invest the deposits wisely.

Second, Holmstrom and Tirole identify a role for government beyond providing deposit insurance. In their model, the risky projects that banks invest in may turn out to require a further infusion of capital later on. If some projects need more capital, but others don’t, then banks can work out an insurance arrangement: they can all put a little additional capital aside and this capital can then go to the banks whose projects need it. But let’s imagine that all the projects need liquidity at the same time. This can set off a financial crisis – everyone demanding liquidity simultaneously. Holmstrom-Tirole show how the government can step in to provide the extra financing and stop all these projects from grinding to a halt.

So how does that relate to the financial crisis?

The current crisis started with a sudden drop in liquidity in financial markets (we’ll talk about the reasons for that drop later). And to prevent the projects sustained by financial markets from shutting down, someone had to come up with the missing liquidity. In the US, that someone was the government. So, the US government acted in the way that Holmstrom and Tirole said it should.

There’s been lots of criticism, for example from Paul Krugman, that the economics profession did not foresee the crisis. But from the way you’re talking, it seems there are existing models that predict that these crises will happen, and it’s a question of how you respond.

I don’t accept the criticism that economic theory failed to provide a framework for understanding this crisis. Indeed, the papers we’re discussing today show pretty clearly why the crisis occurred and what we can do about it. The sort of economics that deserves attack is Alan Greenspan’s idealised world, in which financial markets work perfectly well on their own and don’t require government action. There are, of course, still economists – probably fewer than before – who believe in that world. But it is an extreme position and not one likely to be held by those who understand the papers we’re talking about

So shall we go on to the book by Mathias Dewatripont and Jean Tirole, The Prudential Regulation of Banks?

The Dewatripont-Tirole book makes an important point about moral hazard. They note that depositors are not in a position to monitor their bank to make sure it is investing their money in a responsible way. So there’s also a moral hazard problem between the depositors and the bank, which generates a role for regulation. The regulator is a stand-in for the depositors. And its job is to place restrictions on what the banks can do. One vital restriction is to require the bank to be adequately capitalised. As we talked about before, bank owners should be putting up enough of their own money to prevent the bank from taking excessive risks. In other words, the bank’s leverage ratio – how much debt it takes on relative to its equity – shouldn’t be too high. Unfortunately, in the run-up to the current crisis, the leverage ratios of many financial institutions reached extraordinary levels. I view this as a failure of government regulation.

So were economists like Dewatripont and Tirole warning people in government, saying: ‘You’re crazy to allow this much leverage!’ If it’s clear what’s going to happen, how do you, as an academic economist, get the message across?

The theory indeed makes the danger quite clear. I really don’t know why the message failed to get through to policymakers. Perhaps theorists deserve some blame here.

So is that something that is going to improve going forward? Firstly, focusing on the leverage ratios – presumably people have learned their lesson in that regard. But also, generally, in terms of the dialogue between people who are studying this theoretically and what’s actually happening on Wall Street.

Yes. I suspect that theorists of finance will want to keep a closer eye on the practice of finance in the future. A major task now is to devise regulations that will help prevent this kind of crisis from happening again. Theory will inform this undertaking, but translating the theory into simple, effective, enforceable rules is not a trivial undertaking. And there’s a danger of overdoing the regulation. You don’t want government micromanaging financial institutions. Government is not particularly good at that, and it’s likely to stifle good investment that would otherwise occur. So we’ll have to strike a balance, which government is not always good at doing.

Are you optimistic based on what you’ve seen so far? Or are you concerned?

Well, I believe that the economists in the Obama administration probably have a pretty good grasp of the principles we’ve been discussing. So I think that in the US there is a reasonable chance good regulation will be formulated. What I’m not so sure about is what will happen when Congress gets into the act. As with healthcare, the administration can propose lots of good, theoretically sound ideas about financial regulation, but whether Congress will pay much attention to these is not clear. We’ll see. I guess I’m cautiously optimistic.

What about Wall Street bonuses? You were talking about the moral hazard issue with regards to the equity holders, and most of these bankers do hold equity in their bank so have a stake in it. But separately they also get bonuses, which may reward them for risky behaviour. Do any of the articles touch on that? What’s your view on that?

Yes, the articles we’ve talked about are certainly relevant here. They suggest that it’s fine to reward bankers with bonuses if things go well, as long as they are correspondingly punished for failure. It’s the absence of punishment on Wall Street, rather than bonuses per se, that has been the problem. That’s why I feel the populist urge to limit bankers’ compensation is somewhat misplaced. Yes, it is satisfying and tempting to put a cap on what bankers can earn. But I don’t see that as getting at the heart of the issue, which is ensuring that bankers’ compensation schemes strike a proper balance between reward and punishment.

Let’s go on to the last two papers, which give some insight into the causes of the crisis.

I mentioned, when discussing the Holmstrom-Tirole paper, that government may have to step in when the financial system suddenly loses liquidity. Now, how can that sudden loss of liquidity occur? Well, the Kiyotaki and Moore paper, Credit Cycles, provides a possible scenario. Typically, if a firm or bank borrows money for a project, it will have to provide some security – some collateral – for that loan. The Kiyotaki-Moore model assumes, with some justification, that borrowers can be induced to repay loans only if those loans are backed up by collateral of at least equal value: only the threat of losing the collateral provides the borrower with the incentive to repay.

The project itself can constitute the collateral, but so can real estate or any other asset. Let’s take the case of real estate and imagine that its market value goes down a bit – perhaps because demand for housing turns out not to be as strong as people thought it would be. This decline in value can have a domino effect. Because the real estate is worth less, less lending is possible – since lending needs to be backed up by an equivalent amount of collateral. But if fewer loans can be made, there’s less production. And if there’s less production then people are poorer and therefore buy less real estate, causing a further fall in real estate prices, and you have a downward spiral. Like the others we’ve discussed, this model says a lot about the present financial crisis. What began as a problem in the real estate market – in fact, just the subprime part of the real estate market – grew through something like the Kiyotaki-Moore domino mechanism to envelop the entire financial sector, and, because the financial sector is critical for most production, to the real economy as well

So tell me about your last pick, the Fostel and Geanakoplos article, Leverage Cycles and the Anxious Economy.

This article is again about leverage. The relevant point it makes is that, just as there’s a business cycle with booms and recessions, so there is a leverage cycle. And the two are intimately connected. So, in boom times, leverage tends to be high, and in fact may become too high. By too high I mean that it becomes too easy for banks or other financial institutions to be wiped out by relatively small declines in asset values. Now, high leverage is a calculated risk that an individual bank may be willing to take on. If I’m highly leveraged, I stand to profit greatly if my bet pays off, and so some probability of collapse may be tolerable. But the problem is that my collapse doesn’t stop with me. If I go down, then other banks could well go down too. The Fostel-Geanakoplos paper describes a mechanism by which that happens. In their model, some banks are especially optimistic about assets and so take on high leverage. If assets turn out to be worth less than they thought, they get wiped out. But now – with them gone – there is lower demand for assets, causing a further fall in their value, which then wipes out banks with somewhat lower leverage, and so we have the same kind of downward spiral as in the Kiyotaki-Moore paper. So, these papers are related. They both give explanations for how a relatively small piece of bad news can give rise to a big deterioration – in liquidity, lending, and production. In both cases, the remedy, once such a decline begins, is for the government to step in and provide liquidity. In Fostel-Geanakoplos, furthermore, the government can act beforehand to limit crises (downward spirals) by constraining leverage in the first place.

You do that by regulating?

Yes, you do that by regulating leverage or equivalently by limiting liquidity. If leverage is restricted, then the bank’s capital requirements are higher, and so it can’t lend as much. In other words, the bank’s liquidity – how much it can finance productive projects – is reduced. Another way of accomplishing the same thing is for the central bank to raise interest rates. So, monetary policy and leverage/capital requirements are closely linked. Unfortunately, in the time leading up to the current crisis, not only was leverage high, but interest rates were low, both of which encouraged overly risky behaviour.

The paper is dated 2008, which presumably means it was written before the crisis?

Yes, it was. In fact, Geanakoplos made much the same set of points in a sequence of earlier papers going back to the late 1990s.

So policymakers, especially people in Congress, need to read these papers.

Yes, or at least understand what’s in them. I think most of the pieces for understanding the current financial mess were in place well before the crisis occurred. If only they hadn’t been ignored. We’re not going to eliminate financial crises altogether, but we can certainly do a better job of preventing and containing them.

This interview took place in September 2009, in the midst of the financial crisis.