Nobel Prize in Economics 2022: The Failures of the Diamond-Dybvig Model

In my previous article, I presented, in the most unbiased way possible, the Diamond-Dybvig model that led its authors to win the Nobel Prize in economics. The article can be consulted by clicking here.

In this article, I will attempt a critique of the Diamond-Dybvig model. At the end of the previous article, I stated emphatically that the model suffered from enormous conceptual errors, so my comments will be, for better or worse, predominantly negative.

However, let us begin with a few positive and truly interesting points that the model of the 2022 Nobel Prize winners raises[1] .

The Positives of the Diamond-Dybvig Model

1. One of the main points that the model raises and that relates to reality is that the banking system can incredibly distort economic activity.

The model presented by Diamond and Dybvig summarizes correctly, albeit too simplistically, the problems faced by a banking sector when it prematurely liquidates assets. In fact, a premature sale of assets, on a sufficient scale, translates into a disorderly fire sale of assets that can have even a more devastating effect than the model itself suggests.

On this first point, even authors who could be considered champions of free markets, such as Hayek, proposed some type of intervention to prevent a so-called secondary recession, which basically consists in the overselling of assets beyond what the economic situation truly justifies. I do not necessarily agree with Hayek on this point: it is necessary to establish financial and monetary discipline in order to properly “cleanse” the productive economy and banking system from bad investments; discipline is also necessary to grow the economy in a sustainable way, besides avoiding future malpractices caused by moral hazard.

Hence, while I do not agree with Hayek on this point, it is certainly an interesting topic that can be explored further, yet one that we will leave aside for the moment.

2. Another important point that the Diamond-Dybvig model correctly points out is that maturity mismatching is inherently unstable.

At the end of the paper outlining the Diamond-Dybvig model, the authors point out that maturity mismatching could occur just as easily outside the banking sector and that it would carry the same risks to which the banking sector is exposed. Regarding this point, the Nobel Prize winners do appear to tread carefully.

Last, the authors point out, although outside of the formal model and with very little emphasis, the problems of moral hazard that could be brought about by the type of government intervention in financial markets that they themselves quite eagerly recommend. And it is precisely that indiscriminate bailouts of the banking sector by government produce the incentives for excessive risk-taking in the future, socializing potential losses and privatizing gains. In their model, it would be rational to take excessive risks. Unfortunately, the authors barely touch upon moral hazard, as it appears as a mere afterthought somewhere at the end of the article and without actually factoring it in their model. Another regret is that they remark, after briefly highlighting the problem of moral hazard, without explanation of any kind, that such problems can be solved by even more financial regulation.

Unfortunately, I think there is little else that can be salvaged from the Diamond & Dybvig model. Let us now critique the model that has been the claim to fame of the recent Nobel Prize winners.

A Critique of the Diamond-Dybvig Model

The main criticisms of the model have to do with the assumptions it makes with regard to the economy and, above all, the banking sector.

If you haven’t read the previous article explaining the Diamond-Dybvig model, now might be a good moment to do so (the critique below assumes the reader is familiar with the basic assumptions of the model).

1. Randomness of consumer types

The first critique is related to the alleged randomness of the types of consumers (that is, the impossibility of completely planning a future consumption pattern).

A world in which a consumer does not know in advance, or does not plan at all, his future consumption is completely inconceivable. I am going to use Modigliani’s very famous life cycle model to illustrate my point, which suggests that people prefer a relatively constant level of consumption throughout their lives. However, income is not constant throughout a consumer’s life. Therefore, people must accumulate and withdraw savings at different points in time. Yet, such points in time are, of course, anything but random. That is, individuals require income but are unable to earn income in the early and last years of their lives, while in their midlife they might have more income than expenses. Thus, Modigliani suggests that a typical person saves in midlife and draws down savings, or takes on debt, or uses parental resources, early as well as later in life.

Culbertson might even be more interesting than Modigliani. He wrote an excellent article on the structure of interest rates in 1957. The idea behind Culbertson’s contribution is twofold:

• On the one hand, people are capable of planning their future needs across different moments in time.

This implies that savers are not “abstract savers”, as Diamond and Dybvig assume, but savers with a specific time profile. Someone that saves for a MBA is very different from a person saving for retirement. Everyone understands that saving for a MBA involves a timeframe of a few years, whereas saving for retirement might be several decades away. Therefore, we can affirm that savers have a preferred habitat, a time preference that suits them and in which they feel more comfortable. Culbertson argues that savers can be moved out of that preferred habitat, but it is not easy to do so. And, of course, that preferred habitat does not always have to be the short term, as some banking and financial textbooks assume. The only reason to save at a very near-term maturity is when such savings are held for emergencies, unforeseen events, whereas other savings do involve a more specific timeframe.

• On the other hand, Culberton also argues that borrowers or recipients of credit for productive purposes also demand such funds with a definite timeframe in mind. In other words, borrowers also have a preferred habitat.

In general, the timeframe of borrowers is directly related to the maturity profile of the assets that borrowers purchase. Say, if the maturity period of an investment project equals 5 years, the preferred habitat of the borrower will be to demand a loan that also matures after 5 years[2]. If loanable funds are demanded to cover working capital or circulating capital, the preferred habitat will be short-term.

Therefore, the credit market is naturally segmented, and different credit markets spring up for each preferred habitat, both for the demand side and the supply side of savings.

Longer-dated credit markets imply higher levels of risk and lower levels of liquidity[3]. This is the reason why long-term interest rates are usually higher than short-term interest rates. Culbertson does not discard the possibility that both lenders and borrowers move away from their preferred habitat. Moving away from a preferred habitat, however, does carry risk, so the expected benefits should outweigh the increased risk that moving out of a preferred habitat implies (hence, this will in the margin often occur with less risk-adverse individuals).

In short, the assumption of randomness regarding the types of consumers, part of the Diamond-Dybvig model, is nothing short of an economic-financial outrage. Moreover, our Nobel laureates will be unable to blame the absence of prior academic literature for wrongly assuming randomness with regard to the moment in which a saver decides to consume.

2. Oversimplification and misrepresentation of the economy in general and of the production structure in particular

Assuming that there is an economy in which there only exists a single consumer good is an oversimplification of the functioning of a market. Furthermore, to assume that there is only one productive technology is almost a mortal sin. The assumption that all agents can be producers and consumers gives a false idea of the function of companies in an economy. Companies have a crucial function that consists in determining the productive structure that emerges in an economy, which, of course, impacts the performance of the banking sector. Worst of all, the model assumes that no risk or uncertainty exists in any production activity.

The only uncertainty about the future that is incorporated into the Diamond-Dybvig model is the type of future consumers (savers), an assumption that, as we have seen, is an inexcusable inaccuracy. Yet, where the concept of uncertainty and/or risk could be included in a completely natural way, it is precisely omitted. Therefore, there is neither risk nor uncertainty in the ability to generate value through the production process (since there exists a single production technology that is completely deterministic).

Of course, many of these assumptions that we are discussing are necessary to model and introduce apparently presumptuous mathematics in the Diamond-Dybvig model. The problem is that the many assumptions completely blur the real world in such a way that the applicability of the model is by any stretch sparse. The model is not a faithful representation of a real-world economy to which a few abstractions have been introduced so as to isolate the most important aspects for the researcher (which is what every economic model, whether formal or not, claims).

The model presented to us by Diamond and Dybvig is simply a set of assumptions that is needed for their preconceived way of seeing the world to make sense. The assumptions, in this case, do not serve to understand reality; they only serve to place the model’s conclusions in a more favorable light. This is a textbook example of the ivory tower in which many academic economists live.

At some point, on top of that, the very same economists try to show us how, presumably, the real world works, but the world that they construct is much more implausible and further away from reality than the world of Alice in Wonderland.

3. Biased assumptions about the economy conceal the true nature of banking

The third criticism has to do with the complete absence of the real functions of a banking sector.

Derived from the imaginary world that Diamond and Dybvig propose, the true functions of a bank completely disappear. We can, for analytical purposes, divide the banking sector into commercial and investment banking.

Briefly summarized, the function of commercial banking is to mediate in the money market, producing an efficient payment system made possible through clearing.

Again, briefly summarized, the function of investment banking is to mediate in the capital market. This entails directing the savings of an economy toward the productive sectors that hold the brightest future prospects. That is, investment banks allocate capital in an economy, deciding which projects are carried out and which projects are written off (or postponed).

In the current financial system, and due to maturity mismatching promoted by the moral hazard of government intervention in monetary and financial matters, both functions are intermingled: payments and capital allocation become bundled.

The important thing here is that the hypothetical bank presented to us by Diamond and Dybvig realizes absolutely none of its functions (after all, it is supposed to be a bank). The proposed bank represents neither a payment system nor does it allocate capital in their model economy. This occurs as a natural consequence of the imaginary world in which the 2022 Nobel laureates live: if there is only one productive technology, and also no risk, what capital is there left to allocate? In their model, it is completely unnecessary for anyone, absolutely anyone, to allocate capital. Capital allocation is a (very real) problem that is not given any consideration. On the payments side, in the model proposed by Diamond and Dybvig, there are no actual payments between consumers using their respective bank deposits (current accounts). The bank in the Diamond-Dybvig model does not even allow for payments. Indeed, there is no need for a payment system, since money does not even exist in the model. Yes, it’s true: the Nobel Prize committee has awarded the Nobel Prize to the authors of a banking model in which money is completely absent.

In sum, there is no trace of the principal functions of banking institutions in the model presented by the Nobel Prize winners. Curiously, they have built a model to analyze the banking system in which a banking system is not needed at all.

4. The problem of moral hazard because of government intervention

In the imaginary world created by the Nobel Prize winners, we have already concluded that there is no need for banks to allocate capital. Therefore, when both government deposit insurance and the possibility of central bank intervention to prevent bank runs are introduced, they appear exclusively beneficial. The problem is that reality, that stubborn reality, is much more complex than the Diamond-Dybvig model is willing to admit.

Once we introduce different companies, producing different goods and belonging to different industries, adding that many of them could go bankrupt, the problem of moral hazard of government intervention starts becoming an issue. Let us remember that investments in riskier sectors tend to produce higher returns. Yet, in a scheme where government is unapologetically committed to saving a banking sector, it causes, endogenously, the banking sector itself to take greater risks, since the potential costs of the riskiest investments are socialized through government intervention, whereas the potential higher returns on risky investments remain in the hands of banks.

Ultimately, the 2022 Nobel Prize winners are promoting crony capitalism.

5. In markets, mechanisms to deal with financial panics do have emerged

The fifth criticism has to do with the alleged inability of the market to produce ways of dealing with bank runs in the absence of government regulation.

The main way in which financial panics are dealt with in a free market is to simply avoid causing them, and this is achieved with rules of financial prudence not imposed by anything else than the very need to survive and avoid bankruptcy. Some of these rules even had a name of their own, such as the golden rule of banking: that is, that banking assets have a maturity that is at most equal to banking liabilities. Of course, this rule has been completely forgotten, and it is precisely forgotten because of the regulatory incentives introduced by government intervention in the financial sector, incentives such as the ones suggested by Diamond and Dybvig. As the great Melchior Palyi once said, a liquid financial system does not even come under liquidation pressures and, therefore, the big problem that the Nobels are trying to solve tends to be self-regulated without any need for outside intervention.

But it is that, moreover, financial markets, whenever they have been allowed to freely conduct their business, have produced, in a constant process of trial and error, ways to contain potentially unfounded financial panics. Proof of this has been the existence of penalty interest rates on bank notes in case they were not paid in cash at the request of the bearer, the unlimited liability or double liability of the owners of financial institutions, or the creation of private clearinghouses acting as private lenders of last resort. We will never see many other innovations because overregulated financial markets tend to stifle or even outlaw innovation compared to deregulated and truly free financial markets.

In short, this criticism, as well as the previous one, suggest that the imaginary world in which the 2022 Nobel laureates live, involves solving problems that were already solved and implies that government intervention does not create any problem when they are, in fact, the direct cause of the patent irresponsibility of today’s financial industry.

Of course, a slightly more detailed study of the world’s monetary and banking history would have saved them from producing such a poorly applicable model, and this is where we move on to our sixth criticism.

6. A model based on wrong historical interpretations

The sixth criticism is that the 2022 Nobel laureates are only modeling a type of banking system based on a false, or at least incredibly biased, historical interpretation of how the banking system works in an unregulated market.

This is not my criticism, but rather a criticism of George Selgin. Selgin tells us that Diamond and Dybvig assume that banking is inherently unstable, an assumption based on clearly distorted interpretations of historical episodes in US monetary and banking history.

With such a biased mindset about how banking works, the Nobel Prize winners set out to model how banks supposedly act. Additionally, the Diamond-Dybvig model cannot even be empirically tested: it is simply a model that claims to represent reality, a historical reality that, as Selgin correctly states, the authors have completely distorted. According to Selgin himself, the model is not even empirically testable, which would automatically leave it outside of the scope of science. In other words, the Nobel Prize has been awarded for creating an unscientific model.

7. The bank deposit contract imagined by Diamond-Dybvig is not a deposit contract at all

Let us move to the seventh and last point of criticism. This criticism is not mine either: in this case it comes from Kevin Dowd (1992). Dowd tells us that the bank in the Diamond-Dybvig model is a rather strange bank.

Namely, it is a bank that offers a more or less standardized deposit to type 1 consumers (short-term consumers) yet supplies a deposit that is not a deposit to type 2 consumers (long-term consumers). The Diamond-Dybvig bank dissolves at t=2 (another untenable assumption) and delivers the residual value of all assets to type 2 consumers. Yet, this has absolutely nothing to do with a bank deposit contract. The bank behaves as a kind of (closed-end) investment fund for type 2 consumers instead of as a bank.

Additionally, this type of bank does not have its own capital or external financing in the form of debt (beyond deposits, which are a very specific form of debt). Therefore, the design of this imaginary bank is especially prone to bank runs, much more so than any real bank. In the real world, both equity and debt act as a buffer or safety margin that prevents type 2 consumers from panicking in the first place.

Therefore, once again, the characterization that the Nobel laureates make of a bank to prove that banks are unstable is detached from reality.

Conclusions

In short, and by way of conclusion, the only reason to award a Nobel Prize for the Diamond-Dybvig model, as far as I see, is that it is a perfect excuse for government to intervene in financial markets. Government wants to get involved in the financial sector in order to control and direct the enormous pool of funds at its disposal towards, primarily, itself. Of course, to do so, you will need an excuse, and this is where some economists become very useful for the politicians in power. Economists are little more than mercenaries willing to produce a battery of arguments and abstract models that justify the plundering of citizens by an ever-hungry modern-day State.

On the other hand, the world economy is on the verge of a recession in 2022 and we are already experiencing enormous turbulence in financial markets. Therefore, it is a perfect moment to give the Nobel Prize to economists and experts who defend that financial markets are naturally unstable and that they must be intervened in order to guarantee their stability. This ensures that when the financial sector is intervened or rescued, even more than it already is, the general population is reminded of the fact that there is a supposedly academic and scientific justification for doing so.

We have known for a long time that the Nobel Prize in economics is essentially a politicized prize. It cannot be otherwise, as long as the fame it confers is of such magnitude, whereas the health of the economic discipline is not at its best. But the 2022 Nobel Prize in Economics almost borders on indecency for awarding the prize to a series of economic atrocities that lack the slightest economic sense or even the slightest common sense.

Legal disclaimer: the analysis contained in this article is the exclusive work of its author, the assertions made are not necessarily shared nor are they the official position of the Francisco Marroquín University.

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[1] The other award-winning economist, Ben Bernanke, is not the subject of analysis in this or my previous article.

[2] It would probably be more interesting to introduce the concept of financial duration here. But the purpose of this article is essentially didactic.

[3] Other things being equal, of course.