What the 2022 Nobel Winners Taught Us

Summary

• The winners of the 2022 Nobel in economics are former Fed chair and Princeton economist Ben Bernanke and the two academics Douglas Diamond and Philip Dybvig.
• Bernanke is one of the leading New Keynesian macroeconomists with impressive contributions to modern macroeconomic theory. He is also one of the most renowned experts on the Great Depression and financial crises, which is what ultimately won him the Nobel.
• Diamond and Dybvig are most famous for their original paper on banking crises that uses a game theoretical approach to show how banks can be subject to multiple equilibria.

The Great Depression and Financial Crises

The Great Depression was the largest, most prolonged economic downturn in modern economic history. US output declined by more than 25%, and the unemployment rate peaked at about 26% in 1933.

Economists’ understanding of the Great Depression has changed over time. Despite initially conflicting theories, Milton Friedman and Anna Schwartz’s account of the prolonged economic downturn became dominant after World War II. They focused mostly on monetary forces and the Fed’s misguided attempt to pop the asset price bubble of the roaring ’20s.

According to Friedman and Schwartz, monetary policy turned highly contractionary on the eve of the economic downturn. The asset price crash and decline in wealth and GDP led to banking crises. As financial institutions failed, the money supply contracted further, which led to subsequent declines in output.

Their analysis contains much truth but is also incomplete. First, it omits the interaction between banking and real economic activity. Second, Friedman and Schwartz completely ignore the international component of the Great Depression.

Bernanke has made extremely important research contributions on both points, which is why his work is so important.

How Banking Impacts Real Economic Activity

One of Bernanke’s first research papers on the Great Depression discusses the bank lending channel and how it interacts with the economy. The US banking failures in the early 1930s not only affected the economy by exacerbating the contraction in the money supply. The financial crisis also affected the real economy by disrupting banks’ financial intermediation function.

Credit to the private economy contracted sharply when banks started to fail. And it is precisely this credit contraction that aggravated the decline in output. In his early research, Bernanke therefore showed how credit contractions can have real effects.

Related research shows how credit shocks can create financial cycles that amplify the business cycle. Bernanke, Gertler, and Gilchrist developed a neo-Keynesian model that includes a so-called financial accelerator. Credit shocks can propagate the effect of a real or monetary shock, meaning even a small initial impulse can lead to a large contraction in output.

The financial accelerator also has significant implications for business cycle dynamics. The model generates a lead-lag relationship between asset prices and investment, which also has implications for monetary policy. Changes in interest rates affect asset prices and subsequently investment more than in the standard neo-Keynesian models that do not incorporate credit frictions. Bernanke’s early work therefore shows how monetary policy shocks can be amplified and generate large real effects via the credit market.

How Financial Crises Cross Borders: The Great Depression and 2008 Crisis

The Great Depression

Bernanke’s empirical work on the Great Depression show the effect of financial crises on output was very large across developed countries in the 1930s.

His work emphasizes how the failure of banks and financial institutions – independent of the contraction of the money supply – led to further contractions in output and so greatly aggravated the already deflationary forces.

Bernanke’s research also focuses on the gold standard and how the international monetary system in place was ultimately to blame for the worldwide depression.

As he explains, countries on the gold standard were subject to multiple monetary equilibria. Pessimistic expectations about banking system stability and potential future devaluation were somewhat self-fulfilling as they would lead to a flight of short-term capital and drain international reserves from the domestic banking system – threatening convertibility.

We already knew in the late 1920s that a global gold shortage could lead to worldwide monetary contraction and cause a global economic downturn under the gold standard.

Newer research has shown how it was mainly the massive accumulation of gold reserves from the Bank of France and to a lesser extent the Fed that imposed global deflationary pressures that caused deflation, asset price deflation, and ultimately banking crises.

An older paper by Eichengreen and Sachs explains how countries that left the gold standard early and depreciated their currency managed to recover much faster from the Great Depression. Leaving the gold standard would allow for the monetary expansion that reversed the contraction in output.

As the chart below shows, countries that left the gold standard early enjoyed a much quicker and faster recovery than countries that kept the peg to gold for longer.

Bernanke himself discussed on several occasions how Roosevelt’s decision to leave the gold standard was a reflationary policy that led to one of the swiftest economic recoveries ever recorded.

The 2008 Crisis

A substantial part of Bernanke’s lifework therefore examines the interaction between financial markets and the real economy. This research would become extremely relevant when the financial crisis of 2008 turned into one of the deepest and severest recessions in modern US economic history.

While the Fed has been heavily criticized for acting too slow and too timidly back then, it Bernanke rolled out one emergency program after the next in record time. And many were directly based on his research.

The Bernanke Fed was one of the first central banks to use forward guidance as a policy tool when interest rates hit zero. By promising to keep rates low for the foreseeable future, central banks can influence expectations and put downward pressure long-term rates, stimulating aggregate demand.

The Fed also supported the domestic banking system and the global financial system as a lender of last resort. When the financial system froze in 2008, the Fed provided ample liquidity provisions to domestic banks to prevent a financial meltdown and credit freeze.

Because of the dollar’s status as a global reserve currency, the Fed also set up dollar swap lines with various foreign central banks that could then lend out the dollars to their own domestic banking system. This prevented a global dollar shortage that could have undermined the stability of the global financial system.

Finally, the Bernanke Fed was the first central bank in the aftermath of the financial crisis to implement quantitative easing. The Fed started to buy both government bonds and commercial paper to support asset prices, helping the economy to recover.

There is a lot of empirical evidence that shows how the Fed’s programs boosted the economy after the financial crisis. A different Fed chair might not have overseen the Great Recession but a second Great Depression.

Moreover, all these programs were redeployed by the Fed and other central banks during the economic shock from Covid-19.

Banking Crises

Diamond and Dybvig were awarded the Nobel for their contribution to the academic literature on banking crises. They were the first to model the dynamics of a banking crisis using game theory.

While the model abstracts from cash, Diamond and Dybvig capture the nature of the banking business using some simplifying assumptions.

Ultimately, banks are in the maturity transformation business: they borrow short in the form of deposits and lend long in the form of credit, which exactly what the model describes.

While this business has obvious societal benefits, it is risky. Banks only hold limited reserves. When a too many depositors withdraw too much money simultaneously, even healthy banks can fail. This is the nature of a bank run.

Diamond and Dybvig show bank runs ultimately involve multiple equilibria and that even healthy financial institutions can be pushed into the bad equilibrium.

One takeaway is that some policies can prevent the bank run from occurring in the first place. That could be deposit insurance or a lender of last resort – like a central bank – which provides the banking system with ample reserves during financial turmoil.

Deposit insurance was expanded in many countries during the financial crisis of 2008 to prevent bank runs from occurring as fears about the stability of the financial systems materialized.

Central banks acted as lender of last resort and, especially the Fed, provided the financial system with a lot of liquidity as financial markets completely froze during the financial crisis.

Diamond and Dybvig’s research has become increasingly relevant. With the globalization of capital in recent decades, banking and financial crises have become somewhat more common.

In particular, emerging markets with poor institutions have attracted ‘hot money’ – short-term capital inflows – that can also easily be withdrawn during times of crises.

Data from the World Bank reveals an increasing number of countries suffered from banking crises in recent decades, especially in the 1990s and during the financial crisis of 2008.

The original paper from Diamond and Dybvig and follow-up research can guide policymakers to set up more robust institutions that would prevent such crises from occurring in the first place.

As financial markets are globally integrated, a robust financial framework is needed to keep the banking sector stable.

Why the Naysayers Miss the Mark

This year’s Nobel awards faced criticism for again rewarding economic orthodoxy. But nothing could be further from the truth.

The so-called freshwater school dominated the 1980s macroeconomic paradigm. It emphasized efficient markets and the importance of microfoundations. Asset price bubbles and credit bubbles cannot happen when financial markets are completely efficient.

The early microfounded macro models completely omitted the importance of credit and finance and even aggregate demand shocks. The so-called real business cycle tried to explain macroeconomic fluctuations with real shocks, meaning either innovations in productivity or labor supply, for example.

The work of Bernanke, Diamond and Dybvig was so important precisely because they challenged the economic orthodoxy at the time. Modelling multiple equilibria in a macroeconomic model is very hard, and most standard macroeconomic models avoid it. While abstracting from money, Diamond and Dybvig were the first to model a bank run with multiple equilibria.

Similarly, Bernanke emphasized similar dynamics for monetary policy under the gold standard. He showed that countries with a pegged exchange rate to gold were prone to capital outflows of hot money in the 1930s. Sharp declines in the money gold ratio implied multiple potential equilibria for the money supply.

Diamond, Dybvig and Bernanke’s work emphasize the importance of banking and credit in macroeconomics well before the financial crisis of 2008. While most macroeconomic models before 2008 omitted the financial sector altogether, Bernanke’s work includes his model on the credit-driven economic fluctuations and asset price bubbles – the financial accelerator.

His empirical research on the Great Depression shows how financial crises depress the real economy via various channels.

Macroeconomics has been constantly criticized for not being realistic enough as many models omitted multiple equilibria and the financial sector. So it is extremely ironic that this year’s prize has come under such heavy criticism since Diamond, Dybvig and Bernanke’s contributions brought these features back to the forefront of the macroeconomic research agenda.

True, many insights from this years’ Nobel are already contained in the works of Minsky, Kindleberger and others. But explaining these insights in simplistic mathematical models has great value – they are needed when doing policy analysis and analyzing counterfactuals, for example.