Diamond and Dybvig and the Panic of 1907

George SelginMy last post argued that, despite whatDiamond and Dybvig ' s famous theory suggests, bank runs have seldom proven fatal to otherwise sound banks. Instead, when people run on a bank, it ' s usually because it ' s already in hot water.In response to that post, a Twitter correspondent wondered whether the Panic of 1907 —the proximate cause of the reform efforts culminating in the Fed ' s establishment —was an exception to my claim, and therefore evidence of the inherent vulnerability of fractional reserve banking. The gist of my two-tweet reply was that it wasn ' t. But since 560 characters hardly allowed me to elaborate, I do so here.A Quick ReviewBefore we look into the 1907 episode, let ' s quickly go over Diamond and Dybvig ' s theory of runs along with the alternative, " information-based " theory. If you want to know more about them, have a look at my previous post linked above, and (if that doesn ' t suffice) at an earlierpair ofposts I wrote about Diamond and Dybvig ' s work.In essence, that work treats runs as results of sheer panic: all it takes to inspire depositors to rush to withdraw their money from a bank is the fear thatother depositors might do so. It follows that sound banks are as likely to be a target of runs as unsound ones, and that a run can itself cause a bank to fail.In contrast, the theory that runs are information based holds that depositors only run on a bank when they have reason to believe that it ' s already in trouble, owing to so...
Source: Cato-at-liberty - Category: American Health Authors: Source Type: blogs