Empirical evidence suggests that banking panics are related to the business cycle and are not simply the result of "sunspots." Panics occur when depositors perceive that the returns on bank assets are going to be unusually low. We develop a simple model of this. In this setting, bank runs can be first-best efficient: they allow efficient risk sharing between early and late withdrawing depositors and they allow banks to hold efficient portfolios. However, if costly runs or markets for risky assets are introduced, central bank intervention of the right kind can lead to a Pareto improvement in welfare. FROM THE EARLIEST TIMES, banks have been plagued by the problem of bank runs in which many or all of the bank's depositors attempt to withdraw their funds simultaneously. Because banks issue liquid liabilities in the form of deposit contracts, but invest in illiquid assets in the form of loans, they are vulnerable to runs that can lead to closure and liquidation. A financial crisis or banking panic occurs when depositors at many or all of the banks in a region or a country attempt to withdraw their funds simultaneously. Prior to the twentieth century, banking panics occurred frequently in Europe and the United States. Panics were generally regarded as a bad thing and the development of central banks to eliminate panics and ensure financial stability has been an important feature of the history of financial systems. It has been a long and involved process. The first cerntral bank, the Bank of Sweden, was established more than 300 years ago. The Bank of England played an especially important role in the development of effective stabilization policies in the eighteenth and nineteenth centuries. By the end of the nineteenth century, banking panics had been eliminated in Europe. The last true panic in England was the Overend, Gurney & Company Crisis of 1866.

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Optimal Financial Crises

Diamond and Dybvig (1983) show that while demand‐deposit contracts let banks provide liquidity, they expose them to panic-based bank runs. However, their model does not provide tools to derive the probability of the bank-run equilibrium, and thus cannot determine whether banks increase welfare overall. We study a modified model in which the fundamentals determine which equilibrium occurs. This lets us compute the ex ante probability of panic-based bank runs and relate it to the contract. We find conditions under which banks increase welfare overall and construct a demand‐deposit contract that trades off the benefits from liquidity against the costs of runs. ONE OF THE MOST IMPORTANT ROLES PERFORMED BY banks is the creation of liquid claims on illiquid assets. This is often done by offering demand‐deposit contracts. Such contracts give investors who might have early liquidity needs the option to withdraw their deposits, and thereby enable them to participate in profitable long-term investments. Since each bank deals with many investors, it can respond to their idiosyncratic liquidity shocks and thereby provide liquidity insurance. The advantage of demand‐deposit contracts is accompanied by a considerable drawback: The maturity mismatch between assets and liabilities makes banks inherently unstable by exposing them to the possibility of panic-based bank runs. Such runs occur when investors rush to withdraw their deposits, believing that other depositors are going to do so and that the bank will fail. As a result, the bank is forced to liquidate its long-term investments at a loss and indeed

/pdf/demand-deposit-contracts-and-the-probability-of-bank-runs-3s1w3zqrva.pdf

Demand–Deposit Contracts and the Probability of Bank Runs

A complex financial system comprises both financial markets and financial intermediaries. We distinguish financial intermediaries according to whether they issue complete contingent contracts or incomplete contracts. Intermediaries such as banks that issue incomplete contracts, e.g., demand deposits, are subject to runs, but this does not imply a market failure. A sophisticated financial system a system with complete markets for aggregate risk and limited market participation is incentive-efficient, if the intermediaries issue complete contingent contracts, or else constrained-efficient, if they issue incomplete contracts. We argue that there may be a role for regulating liquidity provision in an economy in which markets for aggregate risks are incomplete.

https://papers.ssrn.com/sol3/Delivery.cfm/2451_27043.pdf?abstractid=1297793&mirid=1&type=2

Financial Intermediaries and Markets

A complex financial system comprises both financial markets and financial intermediaries. We distinguish financial intermediaries according to whether they issue complete contingent contracts or incomplete contracts. Intermediaries such as banks that issue incomplete contracts, e.g., demand deposits, are subject to runs, but this does not imply a market failure. A sophisticated financial system—a system with complete markets for aggregate risk and limited market participation—is incentive-efficient, if the intermediaries issue complete contingent contracts, or else constrained-efficient, if they issue incomplete contracts. We argue that there may be a role for regulating liquidity provision in an economy in which markets for aggregate risks are incomplete.

/pdf/financial-intermediaries-and-markets-22cwwma1nc.pdf

Modern economic growth started in the West in the early nineteenth century. This survey discusses the precise connection between the Industrial Revolution and the beginnings of growth, and connects it to the intellectual and economic factors underlying the growth of useful knowledge. The connections between science, technology and human capital are re-examined, and the role of the eighteenth century Enlightenment in bringing about modern growth is highlighted. Specifically, the paper argues that the Enlightenment changed the agenda of scientific research and deepened the connections between theory and practice.

/pdf/long-term-economic-growth-and-the-history-of-technology-qmdik18onn.pdf

Long-Term Economic Growth and the History of Technology

On avoiding bank runs

Many argue that the intrinsic uselessness of fiat money makes ``coordination'' an essential part of monetary theory: consumers could all equally well coordinate on believing that fiat money has no value. The coordination view suggests, however, that many transactions patterns are in fact possible as economic outcomes. Indeed, we do seem to observe different patterns of exchange at different times and in different places, and the relative importance of money is probably not a universal constant. The main goal of this paper is to develop a simple model of money's role as a medium of exchange when multiple transaction patterns are possible. The coordination view is conveniently analyzed in a dynamic version of Shubik's game-theoretic trading post economy. This economy allows a role for fiat money, and fiat money can coexist with barter in exchange. There are multiple decentralized equilibria, and one of these coincides with the equilibrium of a cash-in-advance economy: the model can be viewed as a generalization of the cash-in-advance framework. Other equilibria use both money and other, intrinsically valuable, objects as media of exchange. One implication of the coordination view is that the effects of monetary policy in general depend on the equilibrium transactions pattern. The paper illustrates this point by showing how estimates of the welfare costs of inflation may be biased depending on the econometrician's beliefs about the transactions patterns.

Patterns of Exchange, Fiat Money, and Coordination

Under the hypothesis that aggregate U.S. consumption is random and, more importantly, viewed as ambiguous by consumers, we examine the implications for asset prices and for how consumption fluctuations influence consumer welfare. First, considering a simple, Mehra-Prescott-style endowment economy with a representative agent facing consumption fluctuations calibrated to match U.S. data, we study to what extent ambiguity aversion can deliver asset prices that are consistent with data: a high return on equity and a low return on riskfree bonds. For some configurations of preference parameters - a discount factor, a degree of relative risk aversion, and a measure of ambiguity aversion - we find that it can. We then use these parameter configurations to investigate how much consumers would be willing to pay to reduce endowment fluctuations to zero, thus delivering a Lucas-style welfare cost of fluctuations. These costs turn out to be very large: consumers can be willing to pay over 10% of consumption in permanent terms.

https://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1088259_code461158.pdf?abstractid=986559&mirid=1

Ambiguity Aversion, Asset Prices, and the Welfare Costs of Aggregate Fluctuations

Persistent, nonfundamental exchange rate fluctuations

We examine the potential importance of heterogeneity in consumers’ ambiguity aversion for asset pricing, portfolio allocation, and the wealth distribution. A main focus is to explore a situation in which ambiguity aversion is \above normal", such as when there has been a sudden inow of market-relevant, but hard-to-interpret information: a situation like that during the onset of the recent crisis in nancial markets. During this episode, market participants appeared unsure of the values of a variety of assets, trading all but stopped. Ambiguity aversion, it appears to us, oers a tractable way of analyzing such occurrences theoretically, especially when one allows the possibility that dierent consumers/traders have dierent amounts of ambiguity aversion. By considering a model with heterogeneity on ambiguity, we explain dierences in portfolio allocation, which lead to non-participation|a drastic form of trading less|in the ambiguity-ridden market by certain agents (here we have in mind those with higher levels of ambiguity). This endogenous limited participation on the market also has implications for the relative wealth of agents in an economy. The dynamics of the wealth distribution coming out of the model is one (of several) implications we explore. We show that the equilibrium \belief" of the ambiguity-averse consumer will evolve endogenously and nontrivially over time as a result of the equilibrium interaction. Moreover, we show that the \standard agents" will dominate in the pricing of the assets in the long run (but much less so in the short run).

Irasema Alonso

Papers

On avoiding bank runs

Patterns of Exchange, Fiat Money, and Coordination

Ambiguity Aversion, Asset Prices, and the Welfare Costs of Aggregate Fluctuations

Persistent, nonfundamental exchange rate fluctuations

Equity trading under heterogeneity in ambiguity aversion