History Replete Instances Which Seemingly Healthy Economy Plunged Difficulty, Investors Have Become Suddenly Insistent Exercising Contrac- Options to Mitigate Individual Risks,

healthy economy has plunged into difficulty, investors have become suddenly insistent on exercising contractual options to mitigate their individual risks, and financial intermediaries have consequently become unable to honor all their commitments. To design good policy to prevent or mitigate such crises, economic policymakers need to make a judgment about causality. Is financial intermediation’s structure unstable and thus causing the broader economic difficulty? Or is the observed instability amongfinancial intermediaries merely re fl cting that broader economic difficulty? Douglas Diamond and Philip Dybvig (1983; reprinted in this issue of the Quarterly Review) have provided a classic theory to formalize the first possibility, the idea that financial intermediation’s structure causes economic crises. 1 We demonstrate here that Diamond and Dybvig ’s theory is incomplete, so that the second possibility remains a live one. Further work is needed to determine what ’s missing in Diamond and Dybvig’s theory and ultimately to provide policymakers with a better understanding of financial intermediation. As Neil Wallace (1988, pp. 4, 8 –9) points out, the environment Diamond and Dybvig consider has four key ingredients of an actual banking system: uncertainty about people ’s preferences for expenditure streams, which produces demand for liquid assets; privacy of information about these preferences after they have been realized (information about people ’s types,whether they are patient or impatient to consume); a sequential service constraint,or a rule that spending by different people must occur successively; and real investment projects that are costly to restart if they are interrupted. Diamond and Dybvig argue that welfare-maximizing agents in such an environment will select a banking arrangement that resembles a demand deposit contract which can implement the efficient allocation in an equilibrium. Moreover, unless the economy also has either deposit insurance or a suspension of payments contingency such as existed until the 1930s in the United States, financial intermediation via demand deposit contracts will have a bank run equilibrium. That is the sense in which Diamond and Dybvig think that financial intermediation ’s instability can be a cause, rather than merely a side effect, of broad economic crises. Diamond and Dybvig make their fundamental point in a benchmark model which has no aggregate uncertainty about the number of agents who are impatient to consume (and thus want to withdraw their deposits early). Diamond and Dybvig then show that a suspension of payments scheme can eliminate the bank run equilibrium in the benchmark model and that, with aggregate uncertainty, when the suspension of payments scheme does not work, a deposit insurance arrangement can do the trick. The contractual arrangements considered by Diamond and Dybvig are limited to a space of feasible arrangements that, as they point out, is too narrow to implement an efficient allocation in the environment with aggregate uncertainty. Speci fically, Diamond and Dybvig assume that the banking arrangement must give all depositors who demand early withdrawals the same amount of consumption, namely, the socially efficient amount calculated based on the true parameter (the fraction of impatient depositors), no matter how many depositors actually claim to be impatient. In the Diamond and Dybvig model, although the consumption given to individual depositors varies with their own claimed types, the amount for each type does not depend on the full information communicated to the bank by all depositors collectively. Let us call this approach simple contracting. We suggest that Diamond and Dybvig ’s theory is incomplete in an important respect. In particular, we argue that the demand deposit contract considered by Diamond and Dybvig is only one of the feasible arrangements in the environment of their model. We show that a contractual arrangement exists that implements an efficient allocation in their environment with aggregate uncertainty, but without a bank run equilibrium. 2