THE ECONOMIST: Nobel laureates give advice on crisis management
For the second consecutive year, the Nobel Prize in Economics has been awarded to three Americans. For 2022, the recipients are Ben S. Bernanke (former Federal Reserve Chairman now with the Brookings Institution), Douglas W. Diamond (University of Chicago), and Philip H. Dybvig (Washington University in St. Louis) “for the research on banks and financial crises.
Each year, the Royal Swedish Academy of Sciences awards the Prize (formerly the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel) in recognition of ideas and research that enhance our understanding of important issues in economics and in related fields. Although most people aren’t interested in the pure economics of this research, the findings often shape public policy or even how we think about the world, which, in turn, affects the daily lives of virtually everyone. the world.
This year’s winners focused on monetary economics and, in particular, its application to banks during financial crises. Each of these researchers has looked at information asymmetries in banking, which implies that potential borrowers know more about their creditworthiness than lenders, and how banks deal with the problem. They also looked at what happens during a financial crisis. This work provides important theoretical understanding, as well as practical application.
An important concept in Mr. Bernanke’s work was that banks can serve as an accelerator in economic cycles. The traditional approach dating back to the 1800s is for banks to continue lending during crisis situations, but only against very strong assets. However, when things start to deteriorate, banks usually stop lending due to falling asset values, which makes the situation worse. Similarly, when the economy improves, asset values increase and loans increase. Diamond and Dybvig developed a model showing how bank runs can occur early in a crisis and how policies such as deposit insurance can reduce the associated risk.
As Fed chairman during the 2007-08 financial crisis, Bernanke sought to reduce the accelerator role of banks as the economy struggled by implementing “quantitative easing,” or QE. Essentially, QE floods the system with liquidity, encouraging banks to lend. The policy was controversial, but prevented the situation from escalating. Without this massive injection, there was a real threat of global financial collapse. Some indicators (such as the “spread”, the difference between the risk-free rate and what banks charge when they lend to each other) were alarmingly high (55 times the normal spread at one point) and did not could not have been maintained.
The work of these Nobel laureates has helped us better understand how central banks should react in the event of an economic crisis. While all policies can have negative consequences, the Great Recession could have been much worse without their fundamental contributions.