The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for 2022 — popularly called the Nobel prize for economics — has been awarded to three US-based economists: Ben S Bernanke (former Chair of the US Federal Reserve and currently associated with the Brookings Institution in Washington DC), Douglas W Diamond (University of Chicago) and Philip H Dybvig (Washington University in St. Louis). The award carries a prize money of 10 million Swedish kronor (roughly Rs 7.31 crore), to be shared equally between the laureates. Why have they won? The Royal Swedish Academy of Sciences, which adjudicates the award, stated that this year’s laureates “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.” This research dates back to the early 1980s. Bernanke on what caused the Great Depression The work for which Bernanke is being recognised was formulated in an article in 1983, which analysed the Great Depression of the 1930s. Between January 1930 and March 1933, US industrial production fell by 46 per cent and unemployment rose to 25 per cent. The crisis spread like wildfire, resulting in a deep downturn in much of the world: from Great Britain, where unemployment increased to 25 per cent, and Germany and Australia, where almost one-third of the workforce was out of jobs, to Chile, where national income fell by 33 per cent between 1929 and 1932. “Everywhere, banks collapsed, people were forced to leave their homes and widespread starvation occurred even in relatively rich countries,” notes the Academy. Until Bernanke’s paper, bank failures were seen as a “consequence” of the financial crisis. But Bernanke’s 1983 paper proved it was exactly the opposite— bank failures were the “cause” of the financial crisis. “Using a combination of historical sources and statistical methods, his analysis showed which factors were important in the drop in GDP. He found that factors that were directly linked to failing banks accounted for the lion’s share of the downturn,” states the Academy. Bernanke zeroed in on bank runs as the key reason why a fairly normal recession spiralled into the greatest economic crisis in modern history. Bank runs happen when depositors become worried about the bank’s survival, and rush to withdraw their savings. If enough people do this simultaneously, the bank’s reserves cannot cover all the withdrawals, and it is driven to bankruptcy. Thanks to bank runs, the recession of 1929 had turned into a full-fledged banking crisis by 1930 as half the banks went bankrupt. “Bernanke demonstrated that the economy did not start to recover until the state finally implemented powerful measures to prevent additional bank panics,” remarks the Academy. The deposit insurance provisions — where a certain amount of one’s deposits in a bank are insured — is a critical tool towards building trust and preventing bank runs. Today, Bernanke’s views — letting banks fail often worsens a financial crisis — are conventional wisdom, backed empirical studies. Diamond and Dybvig’s analysis Since the Global Financial Crisis of 2008, banks have lost their sheen in the public eye. They are often seen as money-grabbing institutions that exist to profit off borrowers as well as depositors. But in a world without banks, it would be impossible to make any long-term investment. That’s because, as Diamond and Dybvig’s 1983 paper showed, there are “fundamental conflicts between the needs of savers and investors”. Savers always want access to at least some part of their savings for unexpected use; this is also called the need for liquidity. They want the ability to pull out money when they need it. The borrowers, especially those taking out a loan for building a home or building a road, need the money for a much longer time. Borrowers cannot function if the money can be demanded back at a short notice. How does society resolve this mismatch? Diamond and Dybvig showed that these mismatches can best be solved by institutions constructed exactly like banks. “In an article from 1983, Diamond and Dybvig develop a theoretical model that explains how banks create liquidity for savers, while borrowers can access long-term financing,” states the Academy. They also explained that banks are able to resolve this conflict through the process of maturity transformation. “The bank’s assets have a long maturity, because it promises borrowers that they will not need to pay back their loans early. On the other hand, the bank’s liabilities have a short maturity; depositors can access their money whenever they want. The bank is an intermediary that transforms assets with long maturity into bank accounts with short maturity. This is usually called maturity transformation,” states the Academy. Together, the work for which Bernanke, Dybvig and Diamond have been recognised has also laid the foundation for modern bank regulations. Their work has been “crucial to subsequent research that has enhanced our understanding of banks, bank regulation, banking crises and how financial crises should be managed,” states the Academy.
