{"id":19746,"date":"2022-10-11T10:45:38","date_gmt":"2022-10-11T09:45:38","guid":{"rendered":"https:\/\/www.economicsobservatory.com\/?post_type=question&p=19746"},"modified":"2022-10-11T14:28:48","modified_gmt":"2022-10-11T13:28:48","slug":"banking-crises-who-won-the-2022-nobel-prize-in-economic-sciences-and-why","status":"publish","type":"question","link":"https:\/\/www.economicsobservatory.com\/test\/banking-crises-who-won-the-2022-nobel-prize-in-economic-sciences-and-why","title":{"rendered":"Banking crises: who won the 2022 Nobel Prize in Economic Sciences and why?"},"content":{"rendered":"\n

The Nobel Prize in economics \u2013 or to use its proper title, the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel<\/a> \u2013 is awarded annually to an economist or economists who have contributed to the advancement of economics. <\/p>\n\n\n\n

The prize has not been without criticism. The 1997 award<\/a> to Myron Scholes and Robert Merton for option pricing theory was subsequently criticised when Long-Term Capital Management<\/a>, a hedge fund that implemented their theories and on whose board they sat, collapsed in 1998.<\/p>\n\n\n\n

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 S\u00f6derberg, 2016<\/a>).<\/p>\n\n\n\n

Who won the prize in 2022?<\/h3>\n\n\n\n

The winners of the 2022 prize are Ben Bernanke, Douglas Diamond and Philip Dybvig. Ben Bernanke<\/a>, 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<\/a> is a professor of finance at the University of Chicago; and Philip Dybvig<\/a> is a professor of banking and finance at Washington University in St Louis. <\/p>\n\n\n\n

The Nobel committee<\/a> awarded the 2022 prize to these three economists because they \u2018have 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.\u2019<\/p>\n\n\n\n

Why did Diamond and Dybvig win the prize?<\/h3>\n\n\n\n

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<\/a>).<\/p>\n\n\n\n

Why do banks exist? Why don\u2019t 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 \u2013 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.<\/p>\n\n\n\n

In Diamond and Dybvig\u2019s 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<\/a>).<\/p>\n\n\n\n

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\u2019 money in illiquid projects, their incentive is to get first in the queue. This results in a bank run. <\/p>\n\n\n\n

Banks are fragile because anything \u2013 and in the Diamond and Dybvig (1983<\/a>) model, it literally is anything \u2013 can spark a bank run. The policy conclusion from Diamond and Dybvig\u2019s 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.<\/p>\n\n\n\n

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.<\/p>\n\n\n\n

The UK\u2019s 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.<\/p>\n\n\n\n

The problem with the UK\u2019s deposit insurance scheme in 2007 was that only 90% of deposits up to \u00a335,000 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.<\/p>\n\n\n\n

Today, depositors in UK banks enjoy 100% protection up to \u00a385,000. So, unless they have more than \u00a385,000 in UK banks, depositors have no incentive for a run on their bank. <\/p>\n\n\n\n

The work of Diamond and Dybvig (1983<\/a>) has been criticised because it ignores the role of shareholder capital and shareholder liability in preventing banks becoming fragile (Turner, 2014<\/a>). It has also been criticised as having little basis in historical experience (White, 1999<\/a>).<\/p>\n\n\n\n

Why did Bernanke win the prize?<\/h3>\n\n\n\n

Ben Bernanke\u2019s seminal piece of work was also published in 1983 (Bernanke, 1983<\/a>). 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?<\/p>\n\n\n\n

The standard answer up until 1983 was the one given by a previous Nobel laureate, Milton Friedman<\/a>, and his co-author Anna Jacobson Schwartz in their 1963 book A Monetary History of the United States<\/a><\/em>.<\/p>\n\n\n\n

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<\/a>).<\/p>\n\n\n\n

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.<\/p>\n\n\n\n

Figure 1: Number of bank closures or suspensions in the United States, 1921-70<\/h4>\n\n\n
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