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