The committee that awards the Nobel Prize in economics announced Monday it has chosen three U.S. economists for the 2022 prize: former Federal Reserve Chairman Ben S. Bernanke, Douglas W. Diamond of the University of Chicago and Philip H. Dybvig of Washington University in St. Louis. The award is for “research on banks and financial crises.” The committee praised the winners for doing work “of great practical importance in regulating financial markets and dealing with financial crises.” Many monetary economists would disagree.
This is the opening paragraph of David R. Henderson, “An Economics Nobel for and by Central Bankers,” Wall Street Journal, October 10, 2022 (October 11 print edition.)
I rarely prefer an editor’s title to the one I choose, but this time I do. The editor clearly picked up on my closing paragraph:
The Nobel Prize in economics is funded not by the Nobel Foundation but by Sweden’s central bank. I don’t usually think that matters, but in this case I wonder if it does. The 2022 award seems to be an affirmation by central bankers of the value of central banking.
I’ll publish the whole thing on EconLog in 30 days.
I woke up at 2:45 a.m. PDT and turned on my computer to see who won. Once I learned, I knew right away that I knew enough to write the piece. (Sometimes I have to research for about an hour to make sure.) The main reason is that we covered all of these issues in detail in Jeff Hummel’s Masters course in Monetary Theory at San Jose State in early 2021. Larry White’s analysis of the Diamond/Dybvig model of “banking” was invaluable, and Jeff had walked us through it very carefully.
READER COMMENTS
Thomas Lee Hutcheson
Oct 10 2022 at 7:56pm
I’m troubled that approval of Bernanke’s research will be construed as approval for the disaterous policies the Fed followed under his and Yellen’s Chairpersonship.
Roger McKinney
Oct 10 2022 at 11:09pm
Here is a link to George Selgin’s analysis of the Diamond/Dybvig famous paper: https://www.google.com/url?sa=t&source=web&rct=j&url=https://www.alt-m.org/2020/12/17/modeling-the-legend-or-the-trouble-with-diamond-and-dybvig-part-1/&ved=2ahUKEwilsoGTmdf6AhVIomoFHc6aAlEQFnoECAcQAQ&usg=AOvVaw23gzkdfp5_liDUIkVKzefA
Knut P. Heen
Oct 11 2022 at 5:51am
I think the Diamond-Dybvig model is interesting from an academic perspective and that is what they won the price for. It is a partial equilibrium model and leaves out the relationship to the real economy. I am therefore skeptical about its practical value. In particular, I would love to see a model which relates deposit insurance to the real economy.
My fear is that if investments become too long-term, the short-term variance will be harder to handle. That is, if you use too many apples to plant new apple trees, a bad apple year may be harder to cope with than if you have stored some apples instead. There seems to be a trade-off between long-term growth and short-term variance which deposit insurance pushes in the direction of long-term growth. The purpose of deposit insurance is to facilitate long-term investments with short-term savings.
Roger McKinney
Oct 11 2022 at 9:29am
I have no problem with deposit insurance, but the mistake was having the state do it. That creates the greatest moral hazard possible. If private companies sold deposit insurance and charged premiums based on the riskiness of the bank’s lending, then depositors would pay attention to the solvency of the bank.
Knut P. Heen
Oct 12 2022 at 10:47am
I think deposit insurance is treating the symptom (bank run) rather than the disease (lending out deposits). The problem is that the bank has given me the right to withdraw my dollar and given someone else the right to invest my dollar. Two people cannot use the very same dollar at the same time. Lending out deposits works during times when new deposits are greater or equal to withdrawals, but fails whenever the withdrawals are much larger than the new deposits (typically during recessions). The bank may be solvent but still not able to find the cash to satisfy the withdrawals during a recession. The purpose of deposits is to have cash reserves for difficult times, hence the system fails at its main purpose.
Compare it to a bond and it is easy to see the difference. I buy a bond from a corporation and I thus give the corporation the right to invest my money. If I want my money back before we agreed, I must sell the bond to someone else who is willing to wait until maturity. You cannot have a run on the bond market because someone must wait until maturity. If corporations issued bonds with a put option for the bondholder, we would have something called “corporation runs” too.
Brian Kantor
Oct 11 2022 at 10:11am
Dear Professor Henderson,
I have read your WSJ piece with great interest and share your sentiments – particularly about the usefulness of models of banks that neither supply deposits or make loans that can go sour. i offer these comments
It takes more than a central bank to create money. (m2) Banks are also necessary to the purpose. The money supply grew slowly after the GFC (and inflation was subdued) because banks increased their demand for cash reserves so dramatically – for risk aversion reasons. And interest income on their vas excess cash reserves also encouraged them. Reactions after the Covid crisis were very different.
I wrote about this for the most recent Journal of Applied Corporate Finance. 82
Recent Monetary History: A Monetarist Perspective
Brian Kantor
The Fed knew how to deal with a financial crisis- for which there was precedent and a literature as you point out. They have had a very poor idea about how to react to Covid lockdowns and the monetary growth associated with it. For perhaps want of precedent. And wealth owners are suffering for it. Though war time economics might have been valuable as a guide. It is ironic that Nobel prizes are being awarded to central banks when they are so obviously out of their depth and confusing the financial markets and destroying wealth on a large scale doing so.
Thomas Strenge
Oct 11 2022 at 2:26pm
David, I read your WSJ piece and found it an intellectual tour de force. I’m certain that Bernanke and the Swedes will read it and hang their heads in shame. Bravo, sir.
Gene Laber
Oct 11 2022 at 3:12pm
David,
In the third column of the WSJ article you write, “The result was that in the year ending August 2008, the monetary base …..had increased by by less than $20 billion, or 2.24%.” You go on to say if Bernanke had increased the money supply substantially……the recession would have been shorter…..
From 12/07 to 8/08 the monetary base decreased by 3% (FRED). But from 8/08 to 9/08, it increased by 7.4%, and by 12/08 it had increased by 96% from 8/08. From 12/07 to 12/08 the increase amounted to 91%. There was a large injection of liquidity after August and for the year as a whole.
Meanwhile, nominal GDP growth was -.06% for 08Q1; 1.08% 08Q2; .22% 08Q3; and -1.96 08Q4.
As you point out there was the Bear Stearns collapse in early 2008 that was met with a bailout. But given that decision, the increase in the monetary base after 8/08 was
very sharp. Is your principal point that the Fed should have acted earlier in 08? If so, what information should have made that decision imperative? Of course, the first quarter of 08 was labeled the beginning of the recession, but that was well after the fact.
Jeff Hummel
Oct 12 2022 at 12:26am
Gene,
You are quite correct that after August 2008, there began a massive increase in the monetary base, and an even greater increase in the total size of the Fed’s balance sheet, as the Fed partly financed its bailouts by borrowing from the Treasury, which increased its deposits at the Fed by over half a billion dollars. But, as Bernanke reveals in his book on the crisis, he had switched to a different mechanism to offset any resulting impact on the total money stock. Previously, from March through August, as David points out, the Fed had been sterilizing its bailouts by allowing its portfolio of Treasuries to decline. After that the Fed switched to paying interest on reserves for the first time, resulting in the steady rise of the aggregate bank reserve ratio, with banks eventually holding more than 100-percent reserves behind M1. The rate of growth of M2 still slightly increased, but not enough to offset the leveling off and subsequent small decline of nominal GDP growth. This is something Brian Kantor alludes to in his comment on David’s post. And it is why Scott Sumner has argued (and I agree) that Fed policy was too tight throughout the crisis.
As far as Bernanke knowing there was a crisis, the Fed, even before bailing out Bear Stearns with its Maiden Lane subsidiary (Mar 2008), had already created both its Term Auction Facility (Dec 2007) to increase lending to banks and its Liquidity Swap Lines (Dec 2007) for foreign central banks. In the same month as the Bear Stearns bailout, the Fed initiated both its Term Security Lending Facility and its Primary Dealer and Other Broker-Dealer Credit Facility. As early as September 2007 the British bank Northern Rock had suffered a run and been nationalized because of its mortgage exposure; in late 2007 the TED spread had started going through the roof; and in January 2008, Countrywide Financial, having already gone under, had been taken over by Bank of America. So Bernanke was well aware that a crisis was in the offing in early 2008, as he also admits in his book, although he may not yet have been aware of how bad it would get.
Gene Laber
Oct 12 2022 at 9:46am
Jeff,
Good clarification. Thanks.
Comments are closed.