A Timely Economics Nobel—and a Warning

As a long-standing skeptic of the idea that economics should be considered a hard science alongside chemistry and physics, I wasn’t planning to write about this year’s Nobel in Economics, which was announced on Monday. The prize committee changed my mind. In honoring Douglas Diamond, of the University of Chicago; Philip Dybvig, of Washington University at St. Louis; and Ben Bernanke, the longtime Princeton professor who served as chairman of the Federal Reserve from 2006 to 2014, the committee highlighted some pioneering research on banks and financial crises that is nearly forty years old, but still highly relevant.

So far, the current financial flap in Britain, which began with a new Conservative government’s unfunded tax cuts destabilizing the markets, hasn’t had a huge impact on this side of the Atlantic. But on Tuesday the Bank of England widened an emergency bond-buying program it announced last month and warned of “a material risk to U.K. financial stability,” and then further unnerved investors later in the day by saying the bond-buying program would end this Friday. More tremors are likely ahead as the Federal Reserve and other central banks raise interest rates to quell inflation.

At a press conference after the announcement of the Nobels, Diamond said the American banking system is sounder than it was in the run-up to the financial crisis of 2008. But he also noted that, in times of stress, the sorts of vulnerabilities that he and Dybvig identified in their research can materialize in other key financial institutions, such as insurance companies or mutual funds. Even “a well-structured financial system is very vulnerable to the fear of fear itself,” he said.

In a paper from 1983, Diamond and Dybvig explained why banks play such a crucial role in the economy, and why, during certain moments, they are vulnerable to runs on their deposits that can rapidly cause their collapse. Bernanke’s contribution, in a separate 1983 paper, was to show how the failure of the Fed during the early nineteen-thirties to prevent a series of bank failures vastly accentuated the Great Depression. After joining the Fed as a governor, in 2002, he vowed that the central bank wouldn’t repeat this costly error.

Six years later, Bernanke initially appeared to be ignoring his own advice. In September, 2008, Bernanke, along with Treasury Secretary Hank Paulson, took the fateful decision to let Lehman Brothers declare bankruptcy. When a full-blown financial crisis erupted, however, Bernanke heeded the lesson of the thirties, and the message of Diamond and Dybvig, going all out to prevent a wholesale collapse of the banking system. He encouraged Congress to bail out the biggest banks. Meanwhile, the Fed introduced a number of emergency lending programs, and it also cranked up its digital printing press to provide the financial system with trillions of dollars in additional liquidity—a policy known as quantitative easing. Some of these actions proved controversial—who likes bailing out irresponsible, greedy bankers?—but they also put an end to the panic and helped insure that the recession which followed the financial crisis was not as deep or extended as the Great Depression.

The cataclysm of 2008 discredited an entire way of economic thinking. Before the financial crisis, Wall Street lobbyists and free-market economists had claimed that banks could be left to their own devices, and that, if some of them did get into trouble, the regenerative powers of the free market would somehow prevent a broader economic calamity. Many macroeconomists, meanwhile, had become besotted with mathematical models of the economy that didn’t even include a proper financial sector. It took a peculiar blindness to the history of capitalism to truly believe in these approaches. Ironically, though, it was this sort of magical thinking that the Nobel committee in Stockholm had honored for decades.

The economics prize—unlike the prizes in physics, chemistry, medicine, and literature—didn’t exist until 1968. It “came out of strife between Social Democracy and business elites in Sweden,” the economic historians Avner Offer and Gabriel Söderberg pointed out in their 2016 book, “The Nobel Factor.” The Swedish central bank, which has close ties to the country’s business and financial élite, endowed the new prize. And under the guidance of Assar Lindbeck, a Swedish economist who was skeptical of the welfare state, the prize committee presented the award to a long string of economists associated with the free-market economics of the University of Chicago, or the Chicago School. Between 1974 and 1995, these recipients included Friedrich Hayek, Ronald Coase, George Stigler, and Milton Friedman. During the same period, many noted left-leaning economists, including John Kenneth Galbraith, Joan Robinson, and Hyman Minsky, were overlooked.

Not all of the conservative honorees took a cavalier approach to banking supervision. Friedman, for one, strongly believed that the Fed needed to keep banks afloat in a crisis. But the over-all message of the Chicago School was that governments should take a hands-off approach to capitalist enterprises, including those operating in the financial sector. As Offer and Söderberg emphasized in their book, the prize committee helped to legitimize this line of thought, and the sharp rightward turn in policymaking that it helped inspire.

This year’s prizes are, perhaps, a belated effort by the Stockholm committee to atone for its past sins. Since 2008, economic policymakers around the world have elevated the stability of big banks to a major policy concern, and forced them to hold a good deal more capital in reserve than they used to do. Also, in good university economics programs these days, gaining a reasonable working knowledge of the banking system, and its potential vulnerabilities, is part of the standard macroeconomics curriculum.

Some on the right refuse to modify their views, however. In an article reacting to the Nobel announcement, the editorial page of the Wall Street Journal argued that Bernanke’s “insights worked in theory but not in practice.” Given the success he had in helping to prevent another Great Depression, this argument is unfounded, but the Journal did raise a pertinent point. While creating new money and pouring it into the financial system, a policy the Fed reprised in early 2020 when the coronavirus pandemic spooked markets, can stop a financial panic, it can also create longer-term dangers. The economists Viral Acharya and Raghuram Rajan warn in a new article that many actors in the financial sector “become dependent on easy liquidity,” and “monetary policymakers thus find themselves in a very difficult position.” To bring down inflation, central banks want to withdraw money from the economy and push up interest rates. But in doing so, they raise the probability of another financial earthquake.

Out there somewhere, perhaps, there is a budding Keynes, or a budding Bernanke, with a workable solution to this conundrum. If there is, they should get in touch straight away with the Bank of England or the Fed. The need is urgent, even though the call from Stockholm may be many years away. ♦