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Wednesday, April 20, 2011

Quote of the Day...

"I accuse the classical economic theory of being itself one of these pretty, polite techniques which tries to deal with the present by abstracting from the fact that we know very little about the future."
-J.M. Keynes, 1937
P.S. The paper from which the above quote was drawn can be found here.  It is a must read for any aspiring economists out there. Despite all of the advances in the last 70+ years, most economic theory is still (I think) susceptible to the above critique.

Sunday, April 17, 2011

Desirability of Market Completeness...

Have been re-reading Lord Turner's (of the FSA) recent speech on the role of banking in the economy.  Based on his speech, I would like to put forward the following proposition for discussion.
If financial markets are self-equilibrating systems, then market completeness is desirable (almost axiomatically).  However, if financial markets are not self-equilibrating systems, then the desirability of market completeness is at best ambiguous (and more likely destabilizing).
I feel like a thorough understanding of the desirability of market completeness is important from both a theoretical and practical perspective.  I think I will bring this up at the summer school in Jerusalem and see if I can get anyone interested...

Saturday, April 16, 2011

Diamond and Dybvig (1983)...

As part of my preparatory reading for my upcoming summer school in Jerusalem, I am reading some of the seminal papers in the literature on banking, financial, and credit crises.  I have chosen to start with Diamond and Dybvig (1983): Bank Runs, Deposit Insurance, and Liquidity.  The following is a short summary of the basic ideas of the paper.  I may write up my notes more formally, and will share them if I do so.

In Diamond and Dybvig (1983) banks fulfill an explicit economic function.  Banks transform illiquid assets into liquid liabilities.   

Model demonstrates three points:
  1. Banks issuing demand deposits can improve on competitive market by providing better risk sharing among people who need to consume at different random times.
  2. Demand deposit contract that provides this improvement has a "bad" equilibrium (a bank run) in which all depositors panic and withdraw funds immediately.
  3. Bank runs have real economic consequences because even "healthy" banks can fail, causing the recall of loans and the termination of productive investment.
At its core, the model is an asymmetric information story.  In a perfectly competitive set-up where agents have private and unverifiable information about their liquidity needs, Diamond and Dybvig (1983) show that the market outcome can be inefficient relative to a world where information was perfect and liquidity needs where publicly observable. 

Diamond and Dybvig (1983) argue that demand deposit contracts can help achieve the same optimal risk sharing arrangements that can be made when liquidity needs are publicly observable.  However, the ability to achieve optimal risk sharing via demand deposits comes at the cost of introducing the possibility of bank runs.   

Demand deposit contracts can be improved upon if the bank has some information about the distribution of liquidity needs amongst its depositors.  If the normal volume of withdrawals is known and not stochastic, then writing demand deposit contracts that call for the suspension of convertibility (i.e., a suspension of allowing withdrawal of deposits) in the event of a bank run can actually prevent a run from happening along the equilibrium path.  However, the situation is very different in the event that the volume of withdrawals is stochastic.  In this case, bank contracts cannot achieve optimal risk sharing (although deposit contracts with suspension are still an improvement over the basic demand deposit contracts).

Diamond and Dybvig (1983) conclude by demonstrating how government deposit insurance can provide improvements over both basic demand deposit contracts, and demand deposit contracts with suspension in the event that the volume of withdrawals is stochastic (i.e., liquidity needs are randomly distributed).  In fact, demand deposits with government deposit insurance can achieve the full-information optimum even in this most general stochastic case.

Heading to Jerusalem...

Just found out that I have been invited to attend the 22nd Summer School in Economic Theory at the Hebrew University in Jerusalem.  This year's school will focus on the financial crisis...

Never been to the Middle East before, and am definitely looking forward to it!

Thursday, April 14, 2011

On the Road...in Paris...

Once again I find myself at the Charles de Gaulle in Paris stealing 15 minutes of WiFi on my way back to the U.S.  I am currently reading Keynes: A Very Short Introduction while waiting for the boarding call.  So far it has been a very fun read, and one I would highly recommend...

Tuesday, April 12, 2011

True or False...

The following question was inspired by Larry Summers claim at the recent INET conference that microfounded, DSGE-style models played no role in informing policy making during the recent financial crisis.
Is there an important distinction to be made between the type of microfoundations used in DSGE modelling and the type of microfoundations used in the incomplete markets/contracting literature? or are they effectively the same?
(I am aware that this is not actually a True or False question...)

Larry Summers at Bretton Woods...

Entertaining interview with Larry Summers about the problems in macroeconomics from the recent INET conference in Bretton Woods, NH.



I have become sceptical of sweeping critiques of economics. Fortunately, Summers, doesn't make any such criticisms. He rightly points out that there is a vast literature, both old and modern, on bank runs, liquidity provision, the relationship between liquidity and asset price inflation, the importance of credit, and the relationship between all of the above and real macroeconomic performance.

About 22 mins into the interview Summers expounds upon topics that, from his perspective as a policy maker, have been under-developed in the academic literature. Very fruitful ground for any PhD students looking for policy-relevant topics for dissertations...

Thursday, April 7, 2011

Daydreaming...

A pint to the person that correctly guess where I was when this photo was taken...

If only...

I have been working extremely long hours trying to pin down my model for my first year PhD paper.  I am starting to feel very burnt out and in need of some physical exertion...I went looking for ideas and came across this list...which one should I attempt?  I will let the wisdom of the crowd decide (and by crowd, I mean the 3-4 people who read this blog)...