Ben Bernanke , Douglas Diamond and Philip Dybvig
The Swedish Academy Awards Three Economists the Nobel Prize in Economics for Contributions to Understanding and Managing Crises
On October 10th. 2022, the Swedish Academy announced that three American economists Ben S. Bernanke, Douglas W. Diamond, and Philip H. Dybvig were jointly awarded the Nobel Memorial Prize in Economic Sciences.[1] The Academy recognized their contributions, published in the early 1980s, as foundational in demonstrating the economic role of financial institutions, particularly during economic crises.[1]
Diamond and Dybvig are widely credited with the founding of modern banking theory, conceptually and mathematically formalizing the role of banks, and introducing the framework for understanding the inherent fragility of banks to runs. Bernanke’s work, on the other hand, gave an empirical demonstration of the severe adverse effects the failure of the financial system can have on the real economy, by studying bank runs during the Great Depression 1929-1932.
In their paper, published in 1983, Diamond and Dybvig set out to explore the functions banks assume within the economy, understand why banks fail given these functions, and examine the consequences their failure would have on the real economy.[2] To understand these dynamics, the study employed a game-theory model that allows for the possibilities of both a well-functioning financial system and conversely the disruption of the financial system with bank runs. On the role of banks, the first part of their study delineates the role of banks in enlarging the liquidity pool within the economy by funding long-term (illiquid) loans with short-term (liquid) deposits by customers. This improves the overall welfare and increases the efficiency, of the wider economy. Further, based on this insight, Diamond and Dybvig explain how this system functions well in normal circumstances when depositors are assured that they can readily access their deposits.
But this vital assumption breaks down when panics take hold in the market. When markets are swept by waves of panic, the individual depositor will believe that the bank will start selling its long-term assets at a loss, which provoke depositors to demand immediate withdrawal of their deposits. In this case, the bank would not be able to return deposits to all of its customers.
In exposing the dynamics of bank runs, Diamond and Dybvig highlighted that the individual depositor might be acting rationally and optimally if a panic cycle takes hold in the market, even though the bank run would be collectively irrational and induce welfare losses for the economy as a whole. Based on these insights, they put forward some recommendations aimed at minimizing the opportunity for panic to emerge in markets. These include deposit insurances to protect depositors’ assets, as well as guaranteeing banks’ liquidity by governments acting as lenders of last resort. The insights following from the Diamond-Dybvig model became highly influential—later becoming one of the most cited models in economics, particularly for policymakers in spotlighting the importance of preventing panics from taking hold within financial markets. Their work also supported the emerging view at the time that the soundness of financial markets could have direct effects on the real economy.
Ben Bernanke’s work, on the other hand, focused on the impact of the financial system on real economic activity and macroeconomic outcomes. In the paper cited by the Swedish Academy, also published in 1983, Bernanke sought to explain how the failure of the financial system, during the early 1930s, resulted in the protracted economic downturn during the Great Depression, lasting nearly a decade.[3] Contrary to the prevailing view at the time, largely expounded by Milton Friedman and his proponents, Bernanke demonstrated that it was largely the hampering of the information-gathering function of banks that caused the prolonged slump in real economic output, and not only the contraction of the monetary supply through losses to depositors’ assets after the bank runs.
As Bernanke explained, banks perform the crucial task of screening borrowers for their ability to fulfill their obligations in case of defaulting on their credit. This is a crucial function for markets, considering the asymmetrical information between creditors and borrowers. In financial crises, as witnessed in the Great Depression, the information pertaining to the solvency of agents becomes scarce, and the ability of financial intermediaries to channel credit to the most productive borrowers is disrupted, causing real economic losses, and crippling the economy’s ability to recover. Bernanke’s paper thus highlighted the importance of credit mechanisms as propagators, and even causes, of economic growth downturns.
These insights had a major influence on Bernanke’s policies during his tenure at the helm of the FED that were geared towards preventing the breakdown of the financial system in 2008 to avoid a severe economic collapse, potentially on the level of the Great Depression. His tenure, nonetheless, drew criticism of his policymaking prior to and during the crisis. The bailout packages that financial institutions received as part of the FED’s attempts to restore the viability of the financial sector, historically unprecedented in scale, are said to have reinforced the moral hazard problem, distorting the incentives of these very financial institutions, and paradoxically undermining the same objective of maintaining well-functioning financial markets. The same reasoning has also called for better monitoring, screening, and detection mechanisms for the pressures within the financial system in order to preempt systematic crises.[4]
This criticism, though not directed to Bernanke’s empirical contribution for which he was awarded the Nobel Prize, also relates to Diamond and Dybvig’s modeling of the financial sector. Aside from the major contributions of their approach, recognized by the Prize, there remains several limitations that contrasted with market realities. The Diamond-Dybvig model crucially leaves out the potential for leverage, which is a chief instrument financial institutions employ to create more deposits and extend more credit. This leaves out one of the major underlying reasons for bank runs; the fear of banks being overextended by debt buildup. Therefore, despite its elegant simplicity and acute insight, more recent crises have demonstrated some of its limitations, particularly the 2008 crisis.[5]
[1] Officially, the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel.
[2] Diamond, D. W., & Dybvig, P. H. (1983). Bank Runs, Deposit Insurance, and Liquidity. Journal of Political Economy, 91(3), 401–419. doi:10.1086/261155.
[3] Bernanke, B. (1983). Non-Monetary Effects of the Financial Crisis in the Propagation of the Great Depression. doi:10.3386/w1054.
[4] For critical assessment of the FED role during the crisis, consult the following references:
- Dowd, K. (2009). Moral hazard and the financial crisis. Cato J., 29, 141.
- More talk, more action. (n.d.). The Economist. Retrieved November 2, 2022, from https://www.economist.com/books-and-arts/2015/10/17/more-talk-more-action
- Chan, S. (2010, September 2). Bernanke Says He Failed to See Financial Flaws. The New York Times. https://www.nytimes.com/2010/09/03/business/03commission.html
[5] For assessment of the Diamond-Dybvig model see:
- DeAngelo, H., & Stulz, R. M. (2015). Liquid-claim production, risk management, and bank capital structure: Why high leverage is optimal for banks. Journal of Financial Economics, 116(2), 219–236. https://doi.org/10.1016/j.jfineco.2014.11.011