The 2022 Nobel Foundation Prizes for “Economic Science” to former Fed Chairman Ben Bernanke and economists Douglas Diamond and Philip Dybvig are deserved and welcome.
All three are good scholars who made scholarly contributions to economics that also had beneficial practical consequences in real economies—pocket problems you and I feel today. And, unlike some years, none of the three winners is an arrogant jerk.
However, the circumstances are incongruous. The prizes were awarded for research in the field of money and banking amid near-global inflation, widespread disruption in foreign exchange markets and fears of dramatic falls in financial markets. The real world economy indeed.
The three new laureates studied how and why banking systems can collapse – and the effects when they do. What causes sudden seizures? How do they turn into widespread financial panics, with myriad banks and investment firms on the brink of default? What are the societal costs of a banking system collapse? How can all of this be avoided?
Ironically, in our country, we have followed the prescriptions of these academics on banking and economic solvency for 21 years – yet the financial systems seem fragile. Which give?
Before answering, another question in this year’s awards needs to be addressed: weren’t the ideas for which they get money and medals already known? Knowledge shared not only by economists and historians, but also by people like my Depression survivor uncle who quit school after eighth grade? Recalling the bank run scene in the Hollywood movie “It’s a Wonderful Life”, a former student emailed me: “So why didn’t (director) Frank Capra not also got a Nobel Prize?” Is she way out in left field?
Certainly, if one reads only the Nobel press release and media reports, it seems that these economists have produced little new. If nothing else, the Great Depression taught us that when, for whatever reason, people lose faith in a bank and rush to withdraw their deposits, it can become a contagion, engendering fear in others. banks, motivating an ever-increasing panic that leaves depositors and even solvent banks bankrupt and entire economies in a harsh long-term recession. Without any entity, such as a central bank, having the authority and ability to intervene, won’t the meltdowns happen again? Yes, this was well known long before these economists started their work.
About 230 years ago, Alexander Hamilton, framer of the US Constitution and first US Treasury Secretary, called for the creation of a Bank of the United States for this and other reasons. Nor was the idea original to Hamilton. It simply reflected common views in the British banking industry where the Bank of England had already been operating for a century. Yet the US Federal Reserve was not created until 1913.
Then there’s British journalist Walter Bagehot’s classic, “Lombard Street: A Description of the Money Market.” Written in 1873, it covers most of the issues described in this week’s Nobel press releases and reports.
Moreover, in this 1946 Frank Capra film, Jimmy Stewart’s character George Bailey gives an impassioned and pleading explanation of banking to its frightened depositors – three decades before these economists began writing scientific papers.
Finally, economists Milton and Rose Friedman released their videos and their book “Free To Choose” in 1980. The third episode, “Anatomy of A Crisis”, lays out the fundamental issues addressed by Bernanke, Diamond and Dybvig.
So their rewards are not for seeing a new phenomenon, but rather for analyzing the problems we all knew in formal mathematical models and testing those models with real-world data.
Bank runs hurt depositors who are impoverished and also hurt bank owners. The fate of both can ruin the economy and harm citizens as a whole. Bernanke’s research looked at the dynamics of both sides – banker and depositor. By examining the Great Depression, he demonstrated that Milton Friedman and historian Anna Schwartz exaggerated the failure of the Federal Reserve at the time. Friedman and Schwartz pointed out how the Fed let the money supply implode. Bernanke noted that the monetary base, the narrowest measure currently controlled by the Fed, fell much less than expected. Based on his theory and his tests with real data, he then prescribed the actions that central banks should take in the face of further crises.
Diamond and Dybvig have done similar work, emphasizing intermediation. Banks are intermediaries between savers and borrowers, but they also “transform” maturity and size or denomination. In the Capra movie, the local town’s Bailey Building and Loan compiled small demand deposits to issue large, longer-term mortgages. Today, my retirement plan can take hundreds of millions and lend them out in the form of “commercial paper” or “repurchase agreements” for just a few weeks.
Diamond and Dybvig also noted that when banks are allowed to fail, the blow to the general economy is not just the sudden lack of credit. There is also a loss of information which forms the basis of the most productive distribution of capital. Banks have in-depth knowledge of customer creditworthiness. They can thus distinguish between proposed investments that would be productive and those that would not. But when a bank is liquidated, all of this valuable information, much of it embedded in the experience and expertise of its loan officers, simply disappears. Capital would again become available and business owners wanting loans would appear. But the information needed to know which loan applicants were a good use of the money and which were not would no longer be available.
The search for the three new winners was therefore productive. Which brings us back to today and the original question. The irony, thankfully not tragic, is that we may have taken their advice too far. The 1990s saw stable prices and strong production growth. But the September 11 attacks threatened a deep recession. The Fed has acted – making borrowable funds plentiful for households and businesses. Then, six years later, we witnessed the collapse of a financial bubble generated by guaranteed mortgage bonds and other “derivatives”.
Then-Fed Chairman Bernanke expected the damage “to be well contained.” It was not. It was the worst debacle in 70 years. Following his research into the Great Depression, Bernanke’s Fed pushed interest rates to near zero and kept them there longer than ever in recorded history. This led to a huge expansion of the monetary base and the money supply. Eventually, it seemed time to tighten, which Fed Chairman Jerome Powell tried to do, meeting the wrath of then-Chairman Donald Trump. But then COVID emerged, spurring a reactive increase in the money supply around the world. Now that Russia is invading Ukraine, Powell is balancing the risk of recession with the dangers of runaway inflation. He chooses to tighten up.
So here we are. The monetary base is still 9.4 times larger than at the dawn of this millennium. Money supply M2, which measures all currency in circulation plus that of banks plus some investment, increased by a factor of 4.4. The actual output is only 1.5 times greater. This disparity between money growth rates and economic output is not sustainable. The 2022 Nobels have helped us understand why, from time to time, it is vital to blow air into the balloon. Unfortunately, no one seems to know exactly how to let him out without a deafening noise.
St. Paul economist and writer Edward Lotterman can be reached at [email protected]
