The 2022 Nobel Prize for Economics 2022

On Feb 9, 2022

Dr. Swapnamoyee Palit,
Asst. Professor of Economics, School of Humanities

Dr. Sukanta Chandra Swain,
Professor of Economics, School of Humanities

Introduction:

The 2022 Nobel Prize for Economics, known as the ‘Sveriges Riksbank Prize in Economics Sciences’, has been given to three economists from United States. The recipient of this prize for Economics this year are:

Prof. Ben Bernanke, a senior fellow of Economics Studies, at the Brookings Institution, Washington DC, USA.
Prof. Douglas Diamond, Associate Professor of Finance, at the University of Chicago Booth School of Business, and
Prof. Philip Dybvig, Professor of Banking and Finance at the University of St. Louis at Olin Business School of Washington,

The Prize has been given to these economists for their research contribution in the area of banks and financial crisis.

The awardees have been lauded for their research inputs, which have aided in improving the understanding about the significant roles the banks play, particularly during a financial crisis in the economy. According to them, the financial intermediaries bridge the gaps between the lenders and the borrowers through their ‘Maturity Transformation Functions’. These activities include taking short-term financial resources like the depositors’ deposits and converting them into long-term borrowings like mortgages. Thus, the banks facilitate the withdrawals on demand while ensuring the borrowers’ long-term financing needs for investment. In fact, the banks’ balance sheets reveal that the assets of the banks have longer maturity than their liabilities and that the return from their assets are higher than what they pay for their liabilities, thus creating a positive return to their shareholders. The maturity transformation and diligent monitoring of borrowers for lending activities are socially productive activities of banks. These activities not only aid in reducing the cost of credit but also in minimizing the wasteful costs of bankruptcy. Thus, according to these Nobel Laureates, by suitably managing the inherent fragility of the banks, the economic system will work more smoothly.

Contribution of Prof. Ben Bernanke:

Prof. Bernanke (1983) has analyzed the worst financial crisis in the modern history— the Great Depression of the 1930s. He showed that during a financial crisis, the ‘Banks Runs’ are one of the most decisive factors in deepening and prolonging the economic crisis. These ‘Bank Runs’ refer to the condition when many depositors simultaneously withdraw the whole balance of their deposits from a banking organization out of concern that the latter is, or might become, insolvent. Such activities reduce the economy’s ability to mobilize the savings into productive investments. Along with this, there occurs detrimental loss of information about the borrowers, which cannot be quickly recreated. He has shown that whenever banks have failed to comply with these vital tasks of a ‘diligent monitor’, the consequence was a financial crisis. The monitoring task, according to Diamond (1984), builds in ‘informational capital’ of the banks. It cannot be transferred between banks and is destroyed when these institutions fail or experience a bank run. This was discovered to be a crucial factor in the prolonged nature of the financial crisis, such as the Great Depression.

According to the model given by Prof. Bernanke, the banking system’s primary function is to distinguish between good and bad borrowers. The cost of transferring money from the ultimate savers/lenders into the hands of reliable borrowers is what is meant by the term “cost of credit intermediation” (CCI) in the context of a competitive banking system. The CCI accounts for the losses anticipated from problematic borrowers as well as the costs of screening, monitoring, and accounting. Banks probably select operational practices that reduce the CCI. This is accomplished through becoming skilled at assessing potential borrowers, building enduring connections with clients, and providing loan terms that enable potential borrowers to self-select favourably. It can explain the effects of two main elements of the financial crisis on the effectiveness of the credit allocation mechanism using this univocal inflection.

Contribution of Prof. Douglas Diamond and Prof. Philip Dybvig:

Professor Diamond and Professor Dybvig have worked together to develop theoretical frameworks that explain the existence of banks, the degree to which they are vulnerable to claims that they will fail, and the ways in which society can help to mitigate these vulnerabilities in order to withstand the situation. The rumours become a “self-fulfilling prophesy,” resulting in a widespread run on the bank as savers attempt to withdraw their money, which eventually cause the institutions to collapse. These Nobel Laureates have proposed ways for the government to intervene in order to avert and recover from the crisis by offering ‘deposit insurance’ and shielding the banks from it by serving as the ‘Lender of Last Resort’. By rigorously establishing the creditworthiness of the borrowers to ensure that the loans are invested productively and there are no defaulters of banks’ credit, they have shown that the banks have a very significant role to play in the society in order to prevent the occurrence of such economic havoc.

Three crucial elements are illustrated by the model presented by Diamond and Dybvig. First, by facilitating better risk-sharing among consumers who need to consume at different arbitrary times, banks issuing demand deposits can improve in a competitive market. Second, the demand deposit contract that offers this improvement has an unwanted equilibrium (a bank run) in which all depositors panic and withdraw right away including even those who would have preferred to leave their savings in it, if they were not worried about the bank failing. Third, because even ‘healthy’ banks can fail, resulting in the cancellation of loans and productive investment, ‘bank runs’ really generate economic issues. Additionally, their model offers an appropriate framework for examination of the tools that are typically employed to deter or prevent ‘bank runs’, which is as good as the ‘lender of last resort’ service of the central bank.

Diamond and Dybvig (1983) provided an explanation of how banks can draw deposits even when they are the target of ‘bank runs’, by demonstrating how bank deposit contracts out-perform “exchange markets” in terms of allocation. When such runs occur, out of panic, banks frequently liquidate a number of their assets even at a loss. Contagious panic causes disruptions in the monetary system, financial system, and overall economy. They have offered models to illustrate how the government’s provision of deposit insurance can weather such a financial crisis while delivering superior contracts. Their studies have provided valuable insights to policymakers in understanding the role of banks in such crises. They have also facilitated in understanding the way to confront the unprecedented financial crises, like the Great Recession and the like of economic turmoil generated recently by the Covid 19 pandemic.

Conclusion:

When exogenous shocks or policy errors throw the economy off course, institutions that develop and function successfully in normal times may start to work against them. This idea is exemplified malfunctioning of the financial institutions in the early 1930s. However, researches of these three Nobel Laureates on the crucial role played by banks before and after an economic crisis have contributed to illuminating the key elements that trigger these crises as well as providing the means of preventing or lessening their severity in the future. As a result, the weight of expensive bailouts for revival, which waste the money of the savers in fruitless channels, can also be lessened. The models developed by these Nobel Laureates will be helpful in comprehending and lessening the banking and corporate finance difficulties.

References:

Diamond, Douglas W and Philip H. Dybvig (1983): Bank Runs, Deposit Insurance, and Liquidity. The Journal of Political Economy, Vol. 91, No. 3.pp.401-419. http://links.jstor.org/sici?sici=0022- 3808%28198306%2991%3A3%3C401%3ABRDIAL%3E2.0.CO%3B2-Z
Diamond, Douglas W., (1984): Financial Inter-mediation and delegated monitoring, Review of Economic Studies 51, 393–414.
Dybvig, Philip H., 1993, Remarks on banking and deposit insurance, Federal Reserve Bank of Saint Louis Review January/February 1993, 21–24.
https://www.nber.org/system/files/working_papers/w1054/w1054.pdf