On October 10^th, the winners of the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel were announced. Ben Bernanke, Douglas Diamond, and Philip Dybvig shared the prize for their “research on banks and financial crises” [1].

Though today top-of-mind for many economists, the topic was severely understudied even leading up to the financial crisis of 2008-09, making these economists’ contributions all the more forward-looking, and useful in a complicated and stressful time for policymakers.

Parsing through the smorgasbord of politically motivated Tweets, comments, and opinion articles, most directed at… you guessed it… the 14^th chairman of the Federal Reserve, is difficult. Indeed, the positions of all three are not without controversy, both in terms of their policy implications as well as their detachment from prevailing economic theories.

However, for those specialists familiar with the academic works of these economists, the consensus is a positive one. It is seen as a nod towards the ever-growing importance of financial institutions in our economy, their particular nature, and perhaps tacit acknowledgement that, in economics, there are many ways to analyze the same problem.

Developing influential research in the field of economics is, in short, HARD. These three economists have managed to do so and, for better or worse, that research proved to be invaluable for policymakers and economists during the financial crisis, and beyond.

Ben Bernanke, his research on the Great Depression, and his focus on credit markets

Of the many criticisms Ben Bernanke faced over the years, his qualifications for the position of chairman of the Federal Reserve was never one of them. It seems also, the quality of his academic research was never one either…

It is common knowledge that Bernanke was a student of the Great Depression. His seminal work, “Non-Monetary Effects of the Financial Crisis in the Propagation of the Great Depression” [2], written while at Stanford University, argues in a 50+ page paper that disruptions to credit markets may not be caused by, but instead themselves cause real economic consequences. The initial financial market disruptions of 1930-1933 only led to the more prolonged Great Depression through reduced allocative efficiency and availability of credit.

These concepts illustrate well Bernanke’s outlook on the mechanics of the macroeconomy and its interactions with the financial system. Greatly influenced by Milton Friedman and Anna Schwartz, Bernanke is considered by most a ‘monetarist,’ though is distinct in his focus on the importance of credit and credit cycles, while Friedman and Schwartz focus instead on changes in the money supply. In addition to his empirical studies, Bernanke’s view on this topic was likely sharpened by his acceptance, especially early on, of notions of ‘sticky prices’ and, according to some, a Keynesian perspective on business cycles [3].

Regardless, either via Friedman and Schwartz’s monetary channel or via Bernanke’s ‘credit channel,’ all three lay a large portion of the blame for the Great Depression at the feet of the Federal Reserve.

Also underpinning Bernanke’s research is a view that financial institutions, especially banks, play an outsized role in the economy as unique intermediaries in the face of asymmetric information, and important transaction cost economizers. His research on the Great Depression demonstrated that the failures of banks impacted all sectors of the economy, due in large part to the destruction of their “accumulated expertise, information, and customer relationships” [2], which in well-functioning markets minimize the “cost of credit intermediation” [2].

Other innovations which Bernanke researched and contributed to through his career include inflation targeting, quantitative easing, and a variety of additional monetary policy tools to be used in times of crisis, which extend well beyond the typical adjustments to the federal funds rate that show up in the headlines today.

Economists tout Bernanke as displaying a ‘remarkable consistency’ across his career. It is no surprise then that, as Federal Reserve Chairman from 2006 through 2014, Bernanke employed an aggressive, creative, and controversial combination of policies in an attempt to minimize bank failures, credit market disruptions, and prolonged real economic impact. Describing those policies and evaluating their effectiveness is not the purpose of this article.

It is and has been instead to describe the not-so-narrow pocket of economic studies that Ben Bernanke dedicated his academic research to, and to touch on the lasting impacts this work will have.

Douglas Diamond and Philip Dybvig, and their research on the nature of banking

Conciseness is but one reason I felt it appropriate to jam Douglas Diamond and Philip Dybvig into the same section. The other, and more important, reason is the centrality of the ‘Diamond-Dybvig model’ to the Nobel committee’s decision. Developed together, the former while at University of Chicago and the latter at Yale University, this simple mathematical model explaining the phenomena behind bank runs quickly became a staple in the financial economics curriculum, and has been used to support policy implementations leading up to, throughout, and even since the financial crisis…

According to some, the two economists “literally created modern banking theory” [4]. Though common knowledge today especially following the financial crisis, Diamond and Dybvig, like Bernanke, elaborated on the special nature of banks, this time especially in terms of the illiquidity of their mix of assets relative to the liquidity of their mix of liabilities.

Their seminal work, “Bank Runs, Deposit Insurance, and Liquidity” [5] describes a model where banks do not simply facilitate transactions, or do not even primarily provide otherwise inaccessible investment opportunities for their customers. Instead, banks are specialized in “creating liquid claims against illiquid assets” [6], uniquely providing customers with the ability to access funds on short notice. Depositors then have a type of insurance where each can take out claims when needed on a portfolio of loans and longer-term assets. However, the success of this model relies on an important assumption: depositors pull funds at “different random times” [5]… certainly not all at once.

Beyond the authors’ innovative description of the business model of banking, that of transforming illiquid assets into liquid liabilities, perhaps their most influential finding is that bank runs are both possible and rational under a certain “undesirable equilibrium” [5].

The possibility of a run, according to Diamond and Dybvig, is inherent in a bank’s business model. Instead of, say, a major natural disaster which calls for excessive insurance claims however, it is instead a shock to the demand for liquidity which leads to a maturity mismatch between assets and liabilities and potentially a run on a bank’s deposits. In Diamond and Dybvig’s model, shocks to the demand for liquidity arise from depositors’ “uncertainty about the timing of their consumption needs” [7]. In these scenarios, a run on even a solvent bank could be rational from each depositor’s perspective, as the total amount of deposit liabilities will exceed the total amount of liquid funds in the bank’s accounts plus, importantly, the total stock of illiquid assets, which it is forced to sell at below-market prices.

Diamond and Dybvig, also like Bernanke, reference Friedman and Schwartz in their research on bank runs, though highlight their own contribution as one that explains “why bank contracts are less stable than other types of financial contracts” [5]. While Friedman and Schwartz in “A Monetary History of the United States” [8] in 1963 demonstrated the significant economic impacts of bank runs, few had developed strong theories for their existence, or for the difficulties in preventing them.

Covered as extensively as the bank run problem in Diamond and Dybvig’s research are its possible solutions. With some additional nuances, the two primary solutions evaluated are banks’ actions to suspend convertibility, that is freezing or delaying withdrawals, and governments’ provision of deposit insurance. The former, generally implemented via a discount on withdrawals and indeed a useful solution in the U.S. prior to the advent of federal deposit insurance, is an improvement, though the authors demonstrate that uncertainty about the extent of the run makes setting optimal discounts or suspension terms difficult. Diamond and Dybvig land on the latter, government deposit insurance, as the definitive solution to bank runs. The government guarantee, backstopped by its ability to tax, makes bank runs a thing of the past according to the two.

The Diamond-Dybvig model can be, and certainly has been used as the basis for a variety of banking and portfolio models. Recently, Tyler Cowen of George Mason University described it as “our most fundamental understanding, in modeled form, of how financial intermediation works” [9]. So, while this is far from the only contribution of Philip Dybvig and even more so, Douglas Diamond who had 19 papers cited by the Nobel committee, it is certainly the most influential, and one that will likely stand the test of time in the financial sector, in the public sector, and in the financial economics curriculum.

The response from the economics community, and a personal opinion

A Nobel Prize for Ben Bernanke comes as no shock to the economics community, especially those familiar with his research into the Great Depression. Pulling back the curtain, despite their fame being mostly limited to the field of financial economics, the Diamond and Dybvig prizes also come as no shock in many circles. After all, “Bank Runs, Deposit Insurance, and Liquidity” has been cited 13,475 times compared with Bernanke’s “Non-Monetary Effects of the Financial Crisis in the Propagation of the Great Depression,” for example, cited 4,684 times. The fact that many of their findings seem intuitive today is in part a testament to the quality, applicability, and success of their research.

All three economists are criticized in various respects for their supporting arguments, and policy actions for that matter, in favor of greater government involvement in financial markets. Further, it is easy to imagine the scrutiny they faced initially in breaking away from prevailing neoclassical models, namely ones that assumed no transaction costs and perfect information, and in developing their own assumptions of how financial markets operate.

Most economists will freely admit that financial market and especially credit market shocks are poorly understood even today. While history seems to confirm Bernanke’s mostly empirically derived and tested hypotheses, the body of supporting theories to explain these hypotheses is lacking. Diamond and Dybvig’s concepts however, more microeconomic and more general, some would say are exceptions to this statement. While they have clearly proven useful for ancillary research as well as in practice, they are also perhaps more simply a major step in the right direction… one where the effects of financial crises can be better predicted through a series of widely accepted models, much like the same for crises resulting from ‘real shocks.’

While progress in this field may have temporarily required an abandonment of traditional economic models and assumptions, more work should be done now, and indeed is likely being done, to better integrate the two. Financial market concepts and crisis experiences should be increasingly ‘plugged’ more effectively into traditional price theory models, transaction cost economics models, and similar frameworks. I am not particularly specialized in the financial economics literature… rather, this instinct comes in part from the classroom, and in part from industry experience. Financial institutions, and even professional services organizations broadly, are often viewed as subscribing to a different set of economic laws. Some mistakenly purport, for example, that the ‘division of labor’ is a concept for manufacturing, not for finance. Others analyze financial markets only through the lens of ‘animal spirits,’ chalking up major events merely as products of psychology. Finally, the three Nobel Prize winners view banks, excessively in my opinion, as organizations with “special status” [10]. Long story short, there is much more to be learned from traditional economics for researchers with a strong understanding of, and perhaps direct experience in, financial services.

The three Nobel Prize winners are certainly deserving and made meaningful achievements which had nearly immediate usefulness for policymakers. However, as is always the case… our work going forward is cut out for us.

References:

[1] The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2022. NobelPrize.org. Nobel Prize Outreach AB 2022.

[2] Bernanke, B. S. (1983). Non-Monetary Effects of the Financial Crisis in the Propagation of the Great Depression. The American Economic Review, 73(3), 401-419.

[3] Gill, Alexander J. (2014): Ben Bernanke: Theory and Practice, CHOPE Working Paper, No. 2014-06, Duke University, Center for the History of Political Economy, Durham, NC.

[4] Lerner, L. (2022, October 10). Douglas Diamond Wins Nobel prize for research on banks and financial crises. University of Chicago News.

[5] Diamond, D. W., & Dybvig, P. H. (1983). Bank runs, deposit insurance, and liquidity. Journal of political economy, 91(3), 401-419.

[6] Lerner, A. K. (2015, June 15). Bank Runs Aren’t Madness: This Model Explained Why. Chicago Booth Review.

[7] The Diamond-Dybvig Model. (2016, November 15). University of California, Berkeley. Lecture notes.

[8] Friedman, M., & Schwartz, A. J. (1963). A Monetary History of the United States, 1867-1960. Princeton University Press.

[9] Cowen, T. (2022, October 10). The Diamond and Dybvig model. Marginal Revolution University.

[10] Bernanke, B. S. & Blinder, A. S. (1988). Credit, Money, and Aggregate Demand. American Economic Review, American Economic Association, 78(2), 435-439.