A Nobel for an economic model with real-world application

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Sweden’s Riksbank is sometimes accused, half-jokingly, of awarding the Nobel Prize for economic research decades after the research in question actually made a difference. One could be forgiven for wishing the accusation were true today. The work that the 2022 award honors – works on financial institutions, the damage they cause and how to prevent them – remains depressingly topical.

The winners – former Federal Reserve Chairman Ben Bernanke and economics professors Douglas Diamond and Philip Dybvig – demonstrated the fundamental role banks play in the economy and especially the role they play when things turn around wrong. The Diamond-Dybvig model, a staple of economics education since its development in the 1980s, clarifies how banks mediate between depositors who want immediate access to their savings and businesses that have need long-term investment financing. The model explains how and why banks are therefore vulnerable to deposit runs and establishes the central argument for government deposit insurance.

Bernanke analyzed around the same time the devastating effect that bank runs can have on economic functioning by blocking credit flows and destroying knowledge about creditworthiness. His research on the recession of the 1930s showed how bank failures helped turn a mundane recession into the Great Depression – which until then had been largely explained by poor monetary policy.

The real importance of this work in the world is evident in the influence it has had on the way economic decision-makers have done their work. “[Bernanke] he himself used many of these ideas in his approach to the global financial crisis of 2008-2010, says Ricardo Reis, professor of economics at the London School of Economics and expert in the field. But Reis cautions against taking the price as commentary on Bernanke’s performance as Fed chairman.

As Reis points out, the lesson that a lender of last resort and fiscal safety nets are needed to prevent leaks has been internalized at all levels. In the financial crisis “you [saw] clearly how central banks around the world. . . immediately intervened to reassure depositors. . . This was the major difference that prevented the Great Recession [of 2009-10] to become another Great Depression.

Similarly, during the pandemic, governments keen to safeguard the health of the banking sector have issued guarantees for crisis loans to businesses affected by the shutdowns.

Today’s award should therefore serve as a reminder that despite the reputational blow to its failure to predict financial crises, mainstream economics has a lot to say about how to deal with them. The Bank of England’s rapid intervention in gilt markets last month, which faced dynamics in some ways analogous to bank runs, is just the most recent example.

It also shows that banks are only one side of the story. Partly because of the influence of Bernanke, Diamond and Dybvig, the risk of panic is greater in the non-bank or “shadow” financial sector than in the banking sector. And banks that know governments won’t let them fail are tempted to take risks if they aren’t prevented from doing so by regulators.

These are subjects of more recent research, which, according to some economists, would have deserved a Nobel Prize as well. In that sense, at least, the joke about the lateness of the awards committee still stands.

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