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The simple economics of panic: The 2022 Nobel Prize in perspective

The 2022 Nobel Memorial Prize in Economic Sciences went to Ben Bernanke and Douglas Diamond and Philip Dybvig, largely in honour of papers they published in 1983. This column addresses criticisms that Diamond and Dybvig did nothing but mathematically formalise something everyone already knew, or should have known, and that Bernanke was rewarded less for his research than for his later role as a policymaker.

The 2022 Nobel Memorial Prize in Economic Sciences went to Ben Bernanke, a household name, and Douglas Diamond and Philip Dybvig, who were largely unknown to the public but immensely influential within the profession. Few economists predicted the 2008 financial crisis, but when it happened, few found it baffling; in the days after the fall of Lehman, economists could in effect be found roaming the halls of their departments, muttering “Diamond-Dybvig, Diamond-Dybvig.”

This year’s prize was, in a way, unusual. Nobel prizes in the hard sciences are generally given for one important piece of research; economics Nobels are typically more like lifetime achievement awards. This time, however, the award largely honoured one seminal paper, Diamond and Dybvig’s 1983 “Bank Runs, Deposit Insurance, and Liquidity,” together with Bernanke’s paper of the same year, “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression.”

The prize has also generated some controversy, on two fronts. Heterodox economists and historians have argued that Diamond and Dybvig did nothing but mathematically formalise something everyone already knew, or should have known. At the same time, there have been some questions raised about whether Bernanke was rewarded less for his research than for his later role as a policymaker.

On the first question, I’ll argue that the critics are wrong — not just because formalisation matters, but because Diamond-Dybvig offered a quite different message from that of more discursive writers like Hyman Minsky and Charles Kindleberger. The second critique, as I’ll explain, raises subtler issues about the role of economists who become public servants.

Let’s start with what Diamond and Dybvig did.

The Diamond-Dybvig model

Diamond and Dybvig (1983) is a relatively short paper, and fairly simple compared with many papers in economic theory. Indeed, it’s arguably a paper too simple to get published these days. Where’s the sensitivity analysis, the number-crunching, etc.? But it provided a mind-opening analysis both of banking and of bank runs, with wide implications for those who got its message.

The Diamond-Dybvig analysis starts with the idea of a trade-off — a real trade-off, not something merely financial — between liquidity and returns. Individuals know that they may face unpredictable needs for current purchasing power, say, because of health emergencies; however, productive capital is often hard or impossible to sell on short notice. In the absence of financial intermediaries, the desire for liquidity would impose real costs, because a significant part of savings would have to be devoted to liquid investments with low yield.

Financial intermediaries — call them banks, although they needn’t look like conventional banks — can resolve this problem by selling liquid liabilities (bank deposits, or something like bank deposits) that can be converted into cash on short notice, while investing mostly in illiquid but high-return assets. This usually works because the need for cash, while unpredictable at the level of the individual, is much more predictable in aggregate, so that a modest amount of liquid investment — bank reserves or their equivalent — is sufficient to meet normal demands.

Unfortunately, as Diamond and Dybvig pointed out, a system in which financial intermediaries borrow liquid but invest illiquid tends to have multiple equilibria. If everyone expects the system to work, it does. But if people come to expect other people to withdraw funds en masse, they will rush to withdraw their own funds too, breaking banks that can’t easily liquidate their investments.

The possibility of a bad equilibrium creates a role for public policy. Governments and quasi-governmental entities like central banks can prevent self-fulfilling panics by acting as lenders of last resort, insuring bank deposits and more.

So Diamond-Dybvig showed, in a minimalist model, that banking is a productive activity but also one that creates systemic risk unless backed by a public safety net. And from that insight, a lot of other things follow.

What the model tells us

Despite its simplicity, Diamond-Dybvig has remarkably broad implications both for economic analysis and for economic policy. Arguably, failure to understand these implications over the course of the 1990s and 2000s helped set the stage for the 2008 financial crisis; but the quick, if belated, appreciation of these implications by policymakers, Bernanke very much among them, helped the world avoid a repetition of the Great Depression.

First, Diamond-Dybvig makes it clear that a financial intermediary needn’t be a bank in a legal or conventional sense — it needn’t be a depository institution — to be subject to the possibility of de facto bank runs. Any financial player with liquid liabilities but illiquid assets is in the position of serving a useful economic function but posing the risk of self-fulfilling panic.

We learned this lesson the hard way in 2007–08. Economists were generally sanguine about financial risks, because they believed — correctly — that depository institutions were protected by an adequate safety net. Indeed, there were hardly any runs on institutions covered by the Federal Deposit Insurance Corporation (FDIC). But there were runs on money market funds, investment banks that issued repo, and other ‘shadow banks’ — institutions that were banks in the Diamond-Dybvig sense, but didn’t have deposit insurance or traditional access to Fed lending.

Relatedly, Diamond-Dybvig makes it clear that the reason bank runs damage the economy is not, as many people have supposed, that they reduce the money multiplier and hence reduce the money supply. In fact, the Diamond-Dybvig model isn’t explicitly monetary at all; the loss from a bank run comes from real wealth destruction. And the disconnect between their analysis and concern about monetary aggregates becomes even clearer when you think about the 2008 crisis, which largely hit shadow banks whose liabilities, unlike the deposits of conventional banks, aren’t counted in the money supply.

Finally, Diamond-Dybvig makes the case for financial regulation, not just for depository institutions, but for all financial intermediaries that engage in liquidity transformation. All such institutions need access to some kind of safety net to rule out self-fulfilling panic; but provision of a safety net creates moral hazard, so it needs to go along with regulations designed to limit the exploitation of this moral hazard. This can be a tricky problem in practice: How do you know which institutions require regulation? America’s Dodd-Frank Act, introduced after the 2008 crisis,  regulates “systemically important” institutions, but how are such institutions identified? Essentially it relies on a pornography test: you (or rather a committee of government officials) know it when you see it. But in any case, Diamond-Dybvig provides the intellectual justification.

But did we need a stylised formal model to deliver these insights?

Was it all in Minsky?

The 2022 Nobel has faced some harsh criticism, notably by the historian Adam Tooze, who attacked the prize as a sort of coverup for mainstream economists’ failure “to take seriously thinkers who face the essential important of finance and its dangers for the modern world head on,” such as Hyman Minsky and Charles Kindleberger (Tooze 2022).

Is this accusation fair?

Obviously, Diamond and Dybvig didn’t discover bank runs, or their self-fulfilling nature. Indeed, you might consider their analysis a formalisation of the central theme of Walter Bagehot’s 1873 book Lombard Street. But formalisation plays an important role in economics, helping to pick out the essential points in more discursive expositions, which can often seem to be — and all too often are — word salad with no clear implications.

As for Minsky and Kindleberger, to revisit their work is to realise that they were doing something quite different from Diamond-Dybvig.

Minsky’s “financial instability” hypothesis, adopted by Kindleberger in later editions of his Manias, Panics, and Crashes, told a story of manic-depressive cycles in financial behaviour. An era of financial stability breeds overconfidence, then irrational exuberance, which leads to rising leverage and eventually to a crash; then the cycle starts again.

Diamond and Dybvig showed, however, that destructive bank runs can happen even in a fundamentally sound financial system — they don’t have to be the result of past folly and too much leverage. And the policy response should focus more on containing the risks of panic than on preventing financial excesses.

There’s a strong parallel here with business cycle theory before and after Keynes. Pre-Keynesian analysts — many of them summarised in Haberler (1937) — asked “Why do we have booms and busts?”, and offered stories of alternating periods of exuberance and fear, not that different from the Minsky account. Human nature being what it is, these analysts tended toward prurience, lavishing time on the excesses of the boom rather than on the question of why such excesses should lead not just to waste, but to mass unemployment.

Keynes, however, spent much, though not all, of The General Theory addressing a quite different question: “How can an economy remain depressed for long periods?” This placed the emphasis firmly on the slump itself, not the excesses that may or may not have preceded it.

Not incidentally, Keynes’s focus provided much more useful policy guidance. Pre-Keynesian theorists asked what should be done about the Great Depression, offered little in the way of clear proposals, and often opposed monetary and fiscal stimulus out of concern that it would encourage more excess. Keynesians said, in effect, “push this button” — i.e. provide stimulus. And they were right.

Similarly, the financial instability hypothesis may help make sense of history and serve as a useful corrective to complacency, but it doesn’t offer much guidance about what we should do. Diamond-Dybvig, with its crystal-clear case for financial safety nets plus financial regulation, is, for all the abstractness of its model, more practical than sprawling verbal discussions and flow charts showing lots of arrows connecting lots of boxes.

So, criticism that portrays Diamond-Dybvig as simply doing fancy maths on what everyone already knew, and this year’s prize as an advertisement for economists’ weaknesses, not their strengths, misses the point in several ways. Diamond-Dybvig was a major contribution that changed the way everyone thought about finance.

What about Bernanke?

Ben Bernanke’s 1983 paper on the macroeconomic effects of financial crisis was an important piece of research. If you’ll excuse my metaphor, it put empirical meat on the bones of the Diamond-Dybvig model. It provided a powerful, if implicit, rejection of the Friedman-Schwarz (1963) claim that monetary forces caused the Depression. It was, in short, a paper that mattered.

But did it matter the way Diamond-Dybvig mattered? Nobels in economics are, for the most part, given for work that dramatically changes our understanding — papers and books that, once read, permanently change how one thinks about the world. Diamond and Dybvig clearly meets that threshold. It’s not obvious that Bernanke’s work, excellent as it was, cleared that bar. So, there’s some understandable suspicion that Bernanke was to some extent rewarded for his heroic role as a policymaker as opposed to his academic research.

On the other hand, Bernanke was an important researcher before he moved to the Federal Reserve, doing more than anyone else to incorporate the role of finance into macroeconomics. So it’s not as if giving him the Nobel is in any way absurd or indefensible.

And we definitely don’t want to fall into the trap of devaluing academic research after the fact because the researchers in question had second acts in their lives, moving on to policymaking, politics, or, yes, journalism. The work should be judged on its own merits, not by what its author did later.

So adding Bernanke to the prize was a bit odd, but, as I said, defensible.

A prize for our time

What’s really striking about the 2022 Nobel is how relevant it seems, even though the seminal papers behind the prize were published almost 30 years ago. Financial panics have played a huge role in the 21st-century economy — and not just in 2008. The euro area crisis of 2011–12 seems to have strong elements of self-fulfilling panic; so did the recent turmoil in Britain’s bond market. Neither of these crises fits the Diamond-Dybvig-Bernanke analyses exactly, but in each case our understanding of what was going on was very much shaped by what we might call a Diamond-Dybvig-Bernanke frame of mind.

So this was an important and well-justified Nobel. Don’t let anyone tell you it wasn’t.


Bagehot, W (1873), Lombard Street.

Bernanke, B (1983), “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression”, American Economic Review 73(3): 257-276.

Diamond, D and D, Philip (1983), “Bank Runs, Deposit Insurance, and Liquidity,” Journal of Political Economy 91(3): 401-419.

Friedman, M and A Schwartz (1963), A Monetary History of the United States.

Haberler, G (1937), Prosperity and Depression, League of Nations.

Kindleberger, C (1978), Manias, Panics and Crashes.

Minsky, H (1986), Stabilizing an Unstable Economy.

Tooze, A (2022), “Kindleberger, Mehrling and that Nobel Prize”, Chartbook, 14 October.

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