The 2022 Nobel Prize in Economic Sciences was divided equally between the American economists, Ben S. Bernanke, Douglas W. Diamond, and Philip H. Dybvig. All the three laureates have significantly improved our understanding of the role of banks in the economy, particularly during financial crises. They also found out why avoiding bank collapses is vital. Their work has enhanced our understanding of banks, bank regulation, banking crises, and how financial crises should be managed.
Their analyses have been of great practical importance in how to regulate financial markets and deal with financial crises. The foundations of this research were laid by these economists in the early 1980s.
The prize amount of 10 million Swedish kronor was shared equally between the laureates.
About the Research
When the COVID-19 pandemic hit the world in 2020, significant measures were taken by economies worldwide to avoid a global financial crisis. The insights provided by these three laureates played a vital role in ensuring that the pandemic crises do not develop into new depressions like the Great Depression of the 1930s with devastating consequences for the society. The 1930 Depression had paralysed the world’s economies for many years and had vast societal consequences. Contributions made by these economists can be summed up as follows:
Ben Bernanke, a distinguished senior fellow at Economic Studies, Washington D.C., USA, analysed the Great Depression of the 1930s, which was the worst economic crisis in modern history. Among other things, he showed how bank runs were a decisive factor in the crisis becoming so deep and prolonged. When banks collapsed, valuable information about the borrowers were lost and could not be recreated quickly. Society’s ability to channel savings to productive investments was, thus, severely diminished. Thus, bank runs make banks and money volatile and vulnerable to shocks, sometimes.
Bernanke demonstrated through statistical analysis and historical source research, how failing banks played a decisive role in the global depression of the 1930s. He laid emphasis on the importance of well-functioning bank regulation. Bernanke was the head of the US central bank, the Federal Reserve, when the 2008 crisis hit, and he was able to “put knowledge from his research into policy” to save the bank from crisis.
Both, Diamond, a distinguished service professor of Finance, University of Chicago, US and Dybvig, a professor of Banking and Finance, Washington University in St. Louis, USA, worked together to develop theoretical models explaining why banks exist, how their role in society makes them vulnerable to rumours about their impending collapse, and how society could reduce this vulnerability. These insights “form the foundation of modern bank regulation”.
Their model captured the central mechanisms as well as weaknesses of banking. The model is based upon households saving some of their income, as well as needing to be able to withdraw their money when they wish. However, this does not happen at the same time for every household. Therefore, every household allows for money to be invested into projects that need financing. In this way, banks emerge as natural intermediaries that help in easing the liquidity.
Diamond and Dybvig discussed about the massive financial crises that have been witnessed in the history, particularly of the US. They tell us how banks need to be more careful about assessing the loans they give out or how bailing out banks in crisis might turn out to be. They show how banks could allow depositors to access their money when they wish, while also offering long-term loans to borrowers.
They discuss that the combination of these two activities—withdrawal and long-term loans—make the banks vulnerable to rumours about their imminent collapse. If a large number of depositors simultaneously run to the bank to withdraw their money, the rumour may become a prediction as this would lead to a bank run by the customers leading to the bank collapse. According to them these dangerous dynamics could be prevented if the government provides deposit insurance and acts as a lender of last resort to banks.
Diamond demonstrates another societally important function of banks—how banks perform. He says that banks can better assess borrowers’ credit-worthiness and can ensure that loans are used for good investments. These insights have improved the ability of economies to avoid both serious crises and expensive bailouts.
Though Alfred Nobel did not mention the economics prize in his will, the Sveriges Riksbank established the award in 1968, and the Royal Swedish Academy of Sciences was given the task of selecting the Laureates in Economic Sciences, starting in 1969.
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