With the UK experiencing self-inflicted financial market turmoil, and growing concerns about economic fragility across the world, the work of the new laureates feels particularly timely. Their research has greatly improved our understanding of the role of banks – in normal times and in crises.
The Nobel Prize in economics – or to use its proper title, the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel – is awarded annually to an economist or economists who have contributed to the advancement of economics.
The prize has not been without criticism. The 1997 award to Myron Scholes and Robert Merton for option pricing theory was subsequently criticised when Long-Term Capital Management, a hedge fund that implemented their theories and on whose board they sat, collapsed in 1998.
More recently, it has been argued that the Nobel Prize has had a malign effect on the discipline of economics in that it has legitimised free-market thinking and deregulatory economic policy (Offer and Söderberg, 2016).
Who won the prize in 2022?
The winners of the 2022 prize are Ben Bernanke, Douglas Diamond and Philip Dybvig. Ben Bernanke, currently at the Brookings Institution in Washington DC, was Chair of the Federal Reserve (the US central bank) from 2006 to 2014 and prior to that a professor of economics at Princeton University; Douglas Diamond is a professor of finance at the University of Chicago; and Philip Dybvig is a professor of banking and finance at Washington University in St Louis.
The Nobel committee awarded the 2022 prize to these three economists because they ‘have significantly improved our understanding of the role of banks in the economy, particularly during financial crises. An important finding in their research is why avoiding bank collapses is vital.’
Why did Diamond and Dybvig win the prize?
Diamond and Dybvig produced a seminal theoretical piece of work that explains what banks do, why they are vulnerable to runs, and how government provision of deposit insurance makes banking systems stable (Diamond and Dybvig, 1983).
Why do banks exist? Why don’t households lend their savings directly to firms? If they did, then their money is tied up in an illiquid project. Savers are therefore reluctant to lend to firms because they may want liquidity – that is, they want access to the money that they have lent to the firm because of future unexpected spending needs such as unemployment or the birth of a child.
In Diamond and Dybvig’s work, banks provide households with mutual insurance against shocks that affect their consumption needs. Banks collect funds from lots of savers and invest a proportion in illiquid loans and hold the remainder in a cash reserve. Those households who have consumption shocks can simply withdraw their savings early. Banks thus provide liquidity insurance (Diamond and Dybvig, 1983).
Deposits at banks are on a first-come-first-served contractual basis. Thus, when depositors fear that enough other depositors will withdraw their deposits and because banks will have invested a sizeable proportion of depositors’ money in illiquid projects, their incentive is to get first in the queue. This results in a bank run.
Banks are fragile because anything – and in the Diamond and Dybvig (1983) model, it literally is anything – can spark a bank run. The policy conclusion from Diamond and Dybvig’s work is that bank fragility can be mitigated with government-provided deposit insurance. Their work has also influenced bank regulation, which has been designed to prevent banks from becoming fragile.
As Figure 1 shows, the number of bank failures in the United States fell dramatically after the introduction of federal deposit insurance in 1934. Most economies have introduced deposit insurance schemes since 1983.
The UK’s deposit insurance scheme came into existence in 1982. But its presence did not prevent the UK banking system becoming fragile in 2007 and 2008. Most notably, it did not prevent a bank run by depositors at Northern Rock in September 2007.
The problem with the UK’s deposit insurance scheme in 2007 was that only 90% of deposits up to £35,000 were protected. In other words, depositors at Northern Rock were completely rational in their run on the bank because only 90% of their money was insured.
Today, depositors in UK banks enjoy 100% protection up to £85,000. So, unless they have more than £85,000 in UK banks, depositors have no incentive for a run on their bank.
The work of Diamond and Dybvig (1983) has been criticised because it ignores the role of shareholder capital and shareholder liability in preventing banks becoming fragile (Turner, 2014). It has also been criticised as having little basis in historical experience (White, 1999).
Why did Bernanke win the prize?
Ben Bernanke’s seminal piece of work was also published in 1983 (Bernanke, 1983). It seeks to answer a simple question in economic history: why did a mild recession in the United States in late 1929 turn into the Great Depression of the 1930s?
They argue that the failure of over 9,000 banks or 20% of the US banking system in panics between 1930 and 1933 (see Figure 1) caused the money supply to contract sharply (Friedman and Schwartz, 1963).
In addition, the collapse of banks made depositors withdraw money from banks and hold more cash. This increase in the cash/deposit ratio resulted in the money multiplier contracting, which meant that the injection of reserves of the Federal Reserve had limited effect on the money supply.
Figure 1: Number of bank closures or suspensions in the United States, 1921-70
The collapse of the money supply arising from bank failures resulted in a steep fall in GDP and in the price level. Friedman and Schwartz argue that the failure of the Federal Reserve to act as a ‘lender of last resort’ and provide liquidity support to banks facing runs was a major contributor to the depth and length of the Great Depression (Friedman and Schwartz, 1963).
Bernanke points out a major flaw with the Friedman and Schwartz (1963) story: the fall in the US money supply was too small to explain the subsequent falls in output. Something else – a non-monetary phenomenon – was at play (Bernanke, 1983).
That something else was that bank failures increased the cost of credit intermediation. In other words, bank failures made it much more costly for banks to channel funds from depositors to borrowers. This resulted in a collapse of bank credit by 50% between 1929 and 1933. This non-monetary effect was particularly acute for households, farmers and small businesses.
The policy implications of Bernanke’s work are clear. Policy-makers should not let banks collapse and they should keep lending channels open during financial crises to avoid a repeat of the Great Depression. Serendipitously, Bernanke was Chair of the Federal Reserve during the global financial crisis of 2007-09, during which his main policy objective was to prevent a collapse in credit and a steep rise in the cost of credit intermediation.
Where can I find out more?
- The laureates explained the central role of banks in financial crises: the laureates’ work explained at the Nobel Prize website.
- The political slant of the Nobel Prize in Economics: an interview with Avner Offer in The Atlantic about the Nobel Prize and the free-market turn in economics
- The Diamond and Dybvig model: a short explainer by Tyler Cowen at Marginal Revolution.
- The Nobel Prize goes to Bernanke and Diamond and Dybvig: Alex Tabarrok at Marginal Revolution on the 2022 Nobel Prize.
- Explaining the rationale for the 2022 Nobel Prize in Economics: a piece by Anil Kashyap at the University of Chicago, who is a member of the Bank of England’s Financial Policy Committee.
Who are experts on this question?
- Anil Kashyap
- Paul Krugman
- Richard Portes
- John Turner