A Nobel for an economic model with real world application

Sweden’s Riksbank is sometimes accused, only half in jest, of awarding the Nobel memorial 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 prize honours — runs on financial institutions, the damage they do, and how to prevent them — remains depressingly timely.

The laureates — former Federal Reserve chair Ben Bernanke, and economics professors Douglas Diamond and Philip Dybvig — have demonstrated the fundamental role banks play in the economy and above all the role they play when things go wrong. The Diamond-Dybvig model, a staple of economics teaching since it was developed in the 1980s, clarifies how banks intermediate between depositors who want immediate access to their savings and businesses that need long-term investment funding. The model sets out how and why banks are therefore vulnerable to deposit runs and establishes the central argument for government deposit insurance.

Bernanke at around the same time analysed the devastating effect bank runs can have on economic functioning by blocking credit flows and destroying knowledge about creditworthiness. His research on the 1930s downturn showed how bank failures helped turn a run-of-the-mill recession into the Great Depression — which had until then been explained largely as the result of bad monetary policy.

The real world importance of this work is clear in the influence it has had on how economic policymakers have done their job. “[Bernanke] himself used many of these ideas in his approach” to the 2008-10 global financial crisis, says Ricardo Reis, economics professor at the London School of Economics and an expert on the area. But Reis warns against taking the prize as a comment on Bernanke’s performance at the helm of the Fed.

As Reis points out, the lesson that a lender of last resort and fiscal backstops are needed to prevent runs has been internalised across the board. In the financial crisis “you [saw] clearly how central banks all over the world . . . immediately stepped in to reassure depositors . . . This was the major difference that prevented the Great Recession [of 2009-10] from becoming another Great Depression.”

Similarly, during the pandemic, governments keen to preserve the health of the banking sector issued guarantees for crisis lending to businesses hurt by lockdowns.

Today’s award, then, should serve as a reminder that despite the blow to its reputation caused by the failure to predict financial crises, mainstream economics has much useful to say about how to tackle them. The Bank of England’s swift intervention in gilt markets last month, which faced dynamics in some ways analogous to bank runs, is just the most recent example.

It also illustrates that banks are only one side of the story. Partly because of Bernanke, Diamond and Dybvig’s influence, the risk of runs is greater in the non-bank or “shadow” financial sector than in banking. And banks that know governments will not let them fail are tempted to pile on risk if they are not prevented from doing so by regulators.

These are topics of more recent research, which some economists say would have been just as deserving of a Nobel. In that sense, at least, the joke about the prize committee being behind the times remains valid.

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