he 2022 Nobel Prize in Economic Sciences has been awarded to three American economists: Ben Bernanke, Douglas Diamond and Philip Dybvig, for their research on banks and financial crises. The Nobel laureates say bank failures led to the emergence of the global financial crisis in 2008 and defied a rapid recovery as major economies lined up and entered deep recessions.
The 2008 global financial crisis bore many similarities to the Great Depression of the 1930s. The Great Depression crippled global economies for many years and had lasting negative social consequences. The global financial crisis of 2008 was arguably the worst after the Great Depression of the 1930s. The research of the 2022 Nobel laureates, according to the Swedish Academy Prize Committee, was effective in managing subsequent financial crises.
Despite the professional stature of Nobel laureates, their prognosis and proposed solutions do not easily gain popularity. It is no secret that the greed of the big investment banks was primarily responsible for creating and precipitating the crisis. Governments around the world bailed out banks in 2008 and 2009, while ordinary people suffered. Some of them lost their homes. Nobel laureates, however, have argued that society as a whole has benefited from the bailouts.
Bernanke was the chairman of the Federal Reserve when Lehman Brothers collapsed in 2008. Bernanke says that if Lehman Brothers had been rescued in time, the crisis could have been much less severe. He maintains that there was no legal way to save his bank. So the second best thing for the government to do was to let the banks fail and use the resources to prevent system-wide failures. The Fed introduced ultra-low interest rates and bought massive assets to pull the economy out of recession. The stance was reversed recently after inflation hit one of the highest levels in the US and other parts of the world.
Bernanke believes that economic contractions lead to bank failures, but it was large-scale bank failures that prolonged the crisis. When banks are unable to channel loans into productive activities, more severe economic crises result. Only banks are strategically positioned to know the economic health of companies; when banks fail, knowledge is lost. As the banking system took a long time to recover, the economy performed poorly throughout the period.
Unlike Bernanke, who explained the consequences of bank failures, Diamond and Dybvig explained why banks failed. Banks failed when there was a run on the banks by depositors. Diamond explained that when people began to lose faith in the stability of the financial system, bank runs became a real possibility. What can banks do in such a situation? According to Diamond, banks must ensure that the banking sector is healthy and respond in a calculated and transparent manner to any change in the political regime, including monetary policy.
In Diamond and Dybvig’s model, banks are intermediaries overseeing the transfer of funds from depositors to borrowers. Deposits are for short periods but loans are granted for long years. It is within this framework that the banks ensure the function of maturity transformation. The banks coordinate the meeting between savers and investors and channel the credits towards the right projects. It helps the economy grow. Diamond and Dybvig suggested that bank failures could be avoided through deposit insurance. This implies a greater role in the market for governments.
No one knows if the ideas of this year’s noble winners will mitigate the risk of falling into other depressions like those of the 1930s and 2008 and make the global economy less vulnerable. They will be best judged by history.
Bernanke’s legacy as a policymaker during the 2008 global financial crisis is mixed. While he is widely praised for steering the US economy through the financial crisis, many people say he played a significant role in precipitating the crisis. Before the crisis, Bernanke was part of the team that kept interest rates low. This fueled the housing bubble. During the crisis, he developed a monetary stimulus to avoid bank failures which continued to create financial bubbles.
Diamond and Dybvig are also no strangers to controversy. Like them, Swedish economists at Sveriges Riksbank also believe that deposits lead to loans. However, there is considerable controversy here. Bank of England researchers have found that it is after banks grant loans from which the money returns in the form of deposits. In this model, the banks are not the intermediaries; they create money. The Reserve Bank of Australia and the Bundesbank of Germany also believe that bank loans precede savings deposits.
No one knows whether the ideas of this year’s three Nobel laureates will lessen the risk of falling into further depressions and make the global economy less vulnerable. They will be best judged by history.
The Great Depression of the 1930s is often referred to as a five sigma event. In terms of the probability distribution, the probability of such an event is close to 0. So no one could have predicted that such a massive depression was imminent. Looking back, we can identify a series of events that led up to it. Thus, the failure on the part of economists to predict it was seen as a general failure of the discipline of economics.
A major contributing factor to the Great Depression was Germany’s instability. Following the Treaty of Versailles, Germany had to pay considerable reparations. This made him unstable. One of the main takeaways is that since the world is much more integrated today than it was 90 years ago, it is much more important to monitor the weakest links, because the problems in one country can create problems in other countries. More recently, the war between Ukraine and Russia has led to great volatility in oil prices, a massive increase in inflation rates and volatility in the value of major currencies around the world.
Several oddities in the history of the Nobel Prize make one less inclined to see too much political value in the ideas of Nobel laureates. In the past, individuals have received Nobel Prizes for conflicting approaches, sometimes in the same year. The controversy between 2013 Noble winners Robert Shiller and Eugene Fama is a case in point. Schiller believed that as human beings, investors were likely to be influenced by several psychological factors, while Fama argued that markets were always efficient and consumers incorporated all available information into the price mechanism. The disagreement reached a point where Schiller publicly stated that Fama may be suffering from “cognitive dissonance.”
The work of 2018 Nobel Laureates Nordhaus and Romer has integrated climate change and technological innovation into macroeconomic analysis. 2019 Nobel laureates Banerjee, Duflo and Kremer have popularized experimental approaches to reducing global poverty. The works of these five Nobel laureates had direct relevance to Pakistan. Does the work of Bernanke, Diamond and Dybvig have similar relevance for her?
Much of the Pakistani population refuses to approach banks for loans due to the ban on interest in Islam. Many place their savings only reluctantly in checking accounts. Financial literacy is generally low and most people have limited skill levels to take advantage of the opportunities offered by new technologies. Without an effective regulatory and judicial system, the chances of generating a reliable revenue stream by investing in sharia-compliant peer-to-peer instruments like Musharika and Modaraba are also very low. The public is largely skeptical of the operation of banks that identify as “Islamic”. The banking system must address lingering doubts in the minds of the public to realize its potential.
The writer is a Associate Professor in Department of Economics, COMSATS University Islamabad, Lahore Campus