Last week, the economic science prize awarded by the Swedish Central Bank (Sveriges Riksbank) in memory of Alfred Nobel was awarded to Ben Bernanke (former Fed Chairman, PhD in economics from MIT and currently a researcher at the Brookings Institute), Douglas Diamond (doctor of economics from Yale and professor and researcher at the University of Chicago) and Philip Dybvig (doctor of economics from Yale and professor at George Washington University).
The recognition is for his contributions to the study of the importance of the banking sector in the economy and in particular during times of crisis.
The Riksbank explicitly recognized Bernanke for his studies on the Great Depression of the 1930s and the exponential impact of the collapse of the banking sector on the rest of the economy.
Specifically, Bernanke’s studies showed how the panic induced by the stock market crash led to a crisis of confidence and a run on the banks and how the inaction of the financial authorities contributed to deepening and prolonging the economic crisis. in the decade from 1929 to 1939.
In plain terms, a run against the banks happens when the saving public suddenly and massively comes to withdraw money from their bank accounts. The bull run of 1929 began with the stock market crash and after a cycle that began when banks began to make speculative loans to companies, individuals and governments and to invest heavily in the stock market.
When companies, individuals and governments began to have difficulties paying their loans, savers began to lose confidence in banks and flocked indiscriminately to withdraw their savings.
This situation generated a liquidity crisis in the banks, which simply did not have the resources to deliver their money to savers.
Given that a bank is by nature a leveraged institution –its liabilities generally represent between five and six times its capital– no bank can withstand massive withdrawals of its deposits no matter how healthy and well managed it is.
The failure and closure of a large number of banks resulted in a sharp contraction of credit and the money supply. Although not all banks failed, this contraction in the money supply deepened because savers, having lost all confidence in banks, kept their money under the mattress.
This decrease in the money supply – imagine a massive withdrawal of liquidity – intensified deflationary pressures and deepened the unemployment crisis.
In the case of Diamond and Dybvig, their work includes the development of the Diamond-Dybvig model that poses the fundamental paradox that exists between banks and savers.
Banks receive money from savers largely as demand deposits – meaning that the saver can withdraw at any time. However, banks use that money to make loans that are generally longer term and illiquid.
Under normal conditions, this paradox is part of the credit granting system and plays a fundamental role in the proper functioning of the economy and the creation of wealth. However, in times of crisis, this paradox contributes to exacerbating the loss of confidence and reinforcing a vicious cycle for the economy.
The recognition of these three economists was not only for their historical research work and the development of a reference framework for the analysis of the role of the banking sector in the economy, but also for their practical recommendations regarding the regulation of the financial sector and the design of economic policy.
These recommendations were put to the test during the Great Recession of 2008-09 and their implementation contributed decisively to avoiding the collapse of the banking system and freeing up a lost decade for the global economy like the one that occurred in the Great Depression of the last century.
The deep understanding of the role of the banking sector and financial institutions in financial crises led the financial authorities of the world’s main economies, including central banks, to intervene as lenders of last resort for the banking sector and providers of unlimited liquidity. for the markets, tackling the crisis of confidence, saving millions of jobs and containing the damage to assets for millions of savers.
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The Nobel Prize in Economics 2022