Telephone interview, October 2022
“We thought … how we can use some parts of game theory to understand financial crises?”
Telephone interview with Douglas Diamond following the announcement of the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2022 on 10 October 2022. The interviewer is Adam Smith, Chief Scientific Officer of Nobel Prize Outreach.
In this interview recorded just after the public announcement, Douglas Diamond, the first of the three laureates to hear the news, speaks about his happiness at receiving the economic sciences prize together with Philip Dybvig and Ben Bernanke. He tells Adam Smith how he and Dybvig laid the groundwork for their intense working relationship, which lead to the influential Diamond-Dybvig model, while waiting outside their supervisor’s office at Yale, plentifully supplied with cookies. Fast forward to the financial crisis 15 years ago and, Diamond says, “The world was incredibly lucky to have Ben Bernanke sitting in the Federal Reserve”.
Adam Smith: Hello, am I speaking with Douglas Diamond?
Douglas Diamond: Speaking.
AS: Oh, hello. My name is Adam Smith, calling from nobelprize.org, the website of the Nobel Prize.
DD: Thank you for calling.
AS: Congratulations on the award of the prize in economic sciences.
DD: Thanks very much.
AS: I believe so far you’re the only one of the three laureates that the committee has reached?
AS: How did the news reach you?
DD: So, I was sound asleep. And my cell phone was right next to me. And the phone rang and I was wondering what it was. And then I heard a Swedish voice on the line. I was hoping I wasn’t being pranked by one of my friends and it turned out I was not. And then a couple members, three members of the actual committee spoke to me on the phone and I realized this was indeed the real thing.
AS: You have been tipped many years in the past, have you prepared for this in your thoughts?
DD: I have for a couple of reasons. One, Washington University had a conference several years ago on the paper with Phil Dybvig, so we had to think a little bit about, you know, the broader context in which this stuff, which our work and my work fit and then, you know, just from teaching both masters and PhD students about it, I’ve thought many times about, you know, why did we do things and what were we thinking when we were building certain parts of the model, so that gave me a chance to think a little more broadly rather than about the exact research project I was working on that particular day.
AS: And that Diamond-Dybvig model has been so influential. What drove you to explore the fragility of banks?
DD: So, there were two things in the background. One just from my own background, before I started speaking with Phil Dybvig about it is I had been very influenced by an amazing book by Milton Friedman and Anna Schwartz called A Monetary History of the United States and it had a very interesting chapter about the 1929 to 1933 great depression and the role of bank runs in it. And it always struck me that the verbal description they gave there of how the process worked was only part of the problem. So I felt that was very interesting but an incomplete story. But I didn’t really have a good way to think about what was the better explanation. And then Phil Dybvig, who was a classmate of mine, we were both students of Stephen A. Ross, the late Steve Ross, so we thought we need to think about the idea of how we can use some parts of game theory to understand financial crises. And sort of the simple idea is that bank runs are sort of self-fulfilling prophesies, to use the term of Robert K. Merton, the sociologist. And then the point of our model was, why does the financial system, banks as a good example, write a contract where a bank run is a self-fulfilling prophecy and not having a bank run is also a self-fulfilling prophecy. That’s sort of the natural instability we’re trying to get at. The point that we came up with was that it was not that the banks were somehow responsible for falls in the price level and deflation. Not that the banks liabilities were a means of payment like money. But just that bank liabilities, bank deposits were short term and a source of liquidity in the portfolios of their holders. So if I’m a depositor I have a short term deposit, and I think hey I can take this out whenever I want. And then that’s very valuable to me. But if everybody takes it out then we’re in trouble. So that’s how we started thinking about self-fulfilling prophesies, that’s how, and then it’s not about banks, it could be many types of other financial institutions that are sometimes, in modern times called shadow banks. It’s about contract form, it’s not about money. Clearly related to money but we had no notion of money in the way we modeled it.
AS: Interesting. And are you broadly happy with the way that policy-makers have interpreted your work, especially in the way that they’ve insured deposits in banks?
DD: Yes, so we think deposit insurance, particularly very high levels of deposit insurance, not say ten thousand euros worth of deposit insurance. High levels of deposit insurance definitely makes the financial sector as a whole, not just banks, much more stable. You know, after the 1930s, the financial sector of, you know, the developed world was quite stable basically until the 2008 crisis. And then during the 2008 crisis the policy makers around the world who were you know informed by the economics literature were thinking about ‘fear of fear itself’, self-fulfilling prophesies was something that they had to be strongly cognizant of in any of the policies they came up with. One reason the paper with Phil Dybvig is so simple, it’s not simple basically to a laymen but to an economist it’s relatively simple and not particularly detailed, it’s because Phil Dybvig said to me we’ve got to write this paper a little more carefully and simply than the average paper because we’ve got to make sure that bank regulators who are not necessarily economic theorists can read it and understand the main point. And it seems to me like they did.
AS: Yes, it’s certainly been taken up the world over.
DD: I can also say that the world was incredibly lucky to have Ben Bernanke sitting in the Federal Reserve during the crisis. He’d been thinking about this just exactly as long as Phil Dybvig and I had. You know, our papers basically appeared in the same year. The world was very lucky to have someone who had thought very carefully about it and done the best empirical work on it in the center of the policy-making world.
AS: It must be very pleasing to you to have the three of you united in this prize.
DD: Without question. There are very few people in the world I’d rather be discussing these issues with and be sitting next to when discussing these issues.
AS: Well how nice that the three of you will be brought together in Stockholm. I need to finish because I know you will have the world at your door, but I did want to just ask what was so special about the working relationship between you and Phil Dybvig that allowed you to produce this work?
DD: I mentioned that we were both students of Steve Ross at Yale Economics and Steve was an amazing advisor and stupendous mentor to both of us. But Steve used to have this policy of not making appointments but you would have to sit outside his door, waiting to see when he had some time to talk. So Phil Dybyig and I sat outside his door, you know, waiting for time to talk to him, and while out there we talked to each other quite a bit. And while we were in graduate school we sort of came up with the idea we wanted to try to work together on something related to these issues. But we didn’t actually start working closely on it until we both had essentially finished our PhDs. And then we basically spent all of our thinking hours in the period we were actually formulating this model together and trying to understand it, and simplify it, we had a more complicated idea in the beginning and we kept simplifying it. And Phil is among the clearest thinkers of anyone I know in social science. So the fact that our model is quite clear and simple would not be possible without him as a co-author.
AS: That’s absolutely fascinating. I imagine people listening to this the world over now will adopt that approach of having students wait outside the door. And talking to each other, it was obviously tremendously successful.
DD: Yes, and he had an assistant who was very nice and gave us cookies and things like that while we sat out there too. So that was also very helpful. No one starved outside of Steve Ross’s door.
AS: Combination of cookies and patience. Worked wonders. Gosh, it’s been an enormous pleasure speaking with you.
DD: And you ask very insightful questions, thanks for the good questions.
AS: Well I look forward to speaking further. We’ll have a chance to do a longer interview when things quieten down a bit. But for now I’ll let you get on with the busy and exciting day ahead.
DD: Thank you very much.
AS: Thank you so much.
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