[This is the last half of a two-part critique of Douglas Diamond and Philip Dybvig’s highly influential paper purporting to show that fractional reserve banking systems are inherently unstable. Part I can be found here.]
Sauce for the Goose…
Half a century after the fact, the “aggregate uncertainty” version of the Diamond-Dybvig model appeared at long last to offer solid proof of the inherent instability of ordinary banks, together with an equally solid foundation for government deposit insurance. But no sooner had the inspectors started poking their flashlights around that supposedly solid structure than its serious weaknesses became evident.
The first casualty of that inspection was Diamond and Dybvig’s case for deposit insurance. That case depends on their model’s “sequential service” constraint, which calls upon their bank to meet its depositors’ demands on a first-come-first-served basis. The constraint matters because, if it could instead delay paying its customers until it has received all of their requests, a Diamond-Dybvig (“D‑D”) type bank could make its period‑1 payments contingent on total period 1 withdrawals, thereby ruling-out runs despite aggregate uncertainly, by achieving the same structure of expected returns it might achieve using the threat of suspension in the aggregate certainly-sequential service case.
The problem with Diamond and Dybvig’s case for deposit insurance is that it implicitly and illogically exempts government authorities from the sequential service constraint imposed on the D‑D bank. In order for the deposit insurance solution to work, the government must itself accumulate all period‑1 payment requests, and then present those making such requests with their (optimal) tax bills before they actually withdraw funds, lest unwanted withdrawals should cut into period‑2 returns by interrupting the production process. There must, in other words, be no “first-come-first-taxed” constraint on the government corresponding to the bank’s “first-come-first-served” constraint. Although Diamond and Dybvig recognize that their case for deposit insurance rests upon this “asymmetry” in their treatment of the sequential service constraint, they never bother to justify it. They therefore opened themselves to the charge, leveled at them by Neil Wallace, of not taking their model’s sequential service constraint “seriously.”
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