- [Narrator] The Nobel Prize is awarded every year
to people who have made outstanding contributions
to the world in the fields of literature, physics,
chemistry, medicine, peace, and of course, economics.
The prize is normally awarded many years
after initial contributions are made
in accordance with a general theme.
This means that if two economists or scientists
both make amazing discoveries in a given year,
they both have a chance to win the prize.
The prize is also pretty significant.
This year it was 10 million Swedish krona,
the equivalent of around 960,000 US dollars,
which is to be split amongst the three recipients.
This is normally funded by the estate of Alfred Nobel,
who was a chemist and the creator of dynamite,
but in the case of the prize in economics,
it's funded by the Sveriges Riksbank,
the central bank of Sweden.
I cover the winners of the Nobel Prize every year
but this one really stands out for a few important reasons.
If you've been paying any attention to it,
you will already know it's incredibly controversial
for a reason we'll explore shortly,
but apart from that, it's also really important
because this year's prize was awarded
to the laureates for their contributions
to the understanding of banking's role in the economy
particularly during economic crises.
I'm sure it's obvious to most of you watching
why that might be a particular interest
to a lot of other economists at the moment.
So how did this year's Nobel Prize winners actually improve
the way that we deal with financial crises?
Could we use their lessons to fix the economic issues
we are facing in the world today?
And finally, why is a Nobel Prize given to people
who can help economies avoid serious reductions
in living standards so controversial?
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The Sveriges Riksbank prize in economic sciences,
in memory of Alfred Nobel, was awarded this year
to Philip Dybvig, Douglas Diamond, and Ben Bernanke.
You might understand now
why it was a little bit controversial.
Ben Bernanke was the chairman of the Fed
from 2006 to early 2014,
which meant that he oversaw the years leading up to
and the recovery from the Global Financial Crisis,
which was caused by wild speculation on subprime lending,
something that he had direct responsibility for
as the Fed chairman.
A lot of people see giving Bernanke the Nobel Prize
for his work in fixing economic crises
as the equivalent of giving the nuclear operators
at Chernobyl a prize for the contributions that they made
towards the understanding of acute radiation sickness.
The reality is that the prize was awarded to him
for research he did nearly 40 years ago in 1983,
culminating in a paper he wrote
called "The Non-Monetary Effects of the Financial Crisis
in the Propagation of the Great Depression."
In theory, his role as a former chairman of the Fed
and his part in the Global Financial Crisis
played absolutely no part
in the committee's decision to award him the Nobel Prize.
In reality, I personally find it very hard to believe
that the committee didn't foresee this
being a controversial choice, they made it anyway,
maybe outta pure academic merit
or maybe because it drew attention to an award
that a lot of people don't even know is happening.
I'll let you make up your own mind there.
What I will say is that Bernanke's 1983 paper
is kind of brilliant.
It's based on the research he did
on the Great Depression of 1929
and the role that banks played
in turning a market collapse into an extended depression,
which effectively lasted up
until the outbreak of World War II.
Banks and other financial intermediaries
play a very important role in the economy.
They connect people
who want to deposit their money for safekeeping
with people who want to borrow money to work
on a new venture that they can't directly afford.
That venture could be buying a new house,
starting a new business,
or even just going on a shopping spree.
All of these actions benefit the economy in some way
and are made possible by loans from banks.
The one vulnerability in this system
is that deposits can be demanded at any time,
whereas investments have fixed payback periods,
so if there are enough depositors
who want to withdraw their money,
the bank can run out of cash
which will panic other depositors
who will try to withdraw their money,
and the system can fall apart very quickly.
This is known as a bank run.
During the initial market crash of 1929,
many banks experienced bank runs
and a lot just went outta business
because the loans and investments they made
lost enough value
that they couldn't cover the deposits
they were supposed to be responsible for
even if they had enough time to collect them all back.
The collapse of these banks
meant that there were less institutions to loan money
to borrowers, which meant less business activity
and less consumer demand, which lowered overall output
in the economy for an extended period of time.
Bernanke pointed out that while the loss of money
in the system was an issue,
there was something more important at play.
He proposed that the actual fall in the money supply
was not sufficient to explain the subsequent fall in output
all by itself, people had to deposit their money somewhere,
so while there were fewer banks,
the ones that did survive had more money
that they could they could use to lend to people.
The problem was that a lot of business owners
and consumer borrowers had no relationships
with the surviving banks.
Before standardized credit scores,
banks could only lend money to people that they trusted,
and gaining that trust
normally meant having a long-established relationship
of doing business with an individual bank.
If a business owner had been working
with a bank for 20 years to manage their payroll,
line of credit,
and general business incomings and outgoings,
then that business owner would find it very easy
to get a reasonable loan
if they wanted to open a new location
or invest into a new piece of equipment or whatever it was
that they were doing to improve their business.
But if that bank collapsed,
then not only did they lose their financial infrastructure
and any operating cash they had on hand,
they also lose the relationship
that took them 20 years to work on.
If they set up accounts with another bank,
there would be a difficult transition period
with interruptions in payment,
even if the business itself was operating exactly the same
as it was before the first bank collapse.
If they did get a loan to buy that new piece of equipment,
then it would likely come with a higher interest rate
because the new bank has to balance the risk of working
with a new business that has no history of paying them back.
In a situation where businesses are going under
left, right, and center,
those interest rates would need to rise significantly
because there's a good chance
the bank never will get their money back,
which will put them in the same situation
as the other banks that were forced to close down.
If interest rates get too high,
then the business might decide
that it's simply not worth it to take out the loan
to open the new location or get that new piece of equipment
because even if everything works well,
they still end up losing money to the interest payments.
Bernanke identified that the difficulty and expense
in getting a new loan caused by the breakdown
in banking relationships is what turned a large,
but not unprecedented, downturn
into the most severe economic collapse in history.
So what did he learn from his 1983 paper
when he became chairman of the Fed in 2006?
Did he save the economy?
Well, yeah, sort of.
We can break the GFC and the Great Depression
into two distinct parts,
the financial crisis and the subsequent economic depression.
Financial crises can happen
without causing depressions or even recessions,
and recessions can happen without causing financial crises,
but in both the case of the GSE and the Great Depression,
it did follow this pattern.
The GFC was kicked off
by a system of over-leverage financial instruments
betting on an over-inflated housing market,
and the Great Depression was kicked off
by a collapse in stock prices
after a huge speculative bubble.
The financial collapse of 1929 was less severe
than the financial collapse of 2008,
but the Great Depression was far worse than the recession
that followed the subprime mortgage crisis,
and a big reason for that was that banks were less dependent
on non-standardized relationships,
and the system itself was reestablished very quickly,
thanks to large bailouts pushed by people like Bernanke
that had learned all went wrong in the 30s.
That, of course, didn't help him or his predecessor,
Alan Greenspan, see the problem coming,
but it did enable him to take steps to control the problem
once it did happen.
So yeah, Bernanke was a controversial choice
but still one that is very deserving of the prize.
But he was not this year's only winner.
The prize was split equally amongst Bernanke
and the other two winners,
Douglas Diamond and Philip Dybvig.
I really wanna call these guys D and D
for the sake of brevity
but I feel like that would be doing them a disservice
because they actually know how to write.
Anyway, the actual split is not necessarily indicative
of their contributions,
it's just that Bernanke published his contributions
towards economics individually,
whereas Dybvig and Diamond
conducted their research together.
In reality, most laureates,
especially in the field of economics,
are already quite wealthy
and they tend to donate their prize money
to a cause that they find worthy,
so it's the recognition that's most important
to the winners.
Diamond and Dybvig did not work directly with Bernanke,
but they did make findings that were very complimentary
of one another, and I don't mean that
as in they said nice things about each other in their papers
but rather their papers supported
and furthered the findings of each other's research.
While Bernanke focused
on how bank collapses can hurt the function
of efficient capital allocations slowing down the economy,
Diamond and Dybvig were theorizing new ways
that banks could run more efficiently
to avoid these situations in the first place.
Diamond and Dybvig proposed that people had access
to an amount of cash and they were always unsure
of exactly when they were going to need that cash.
Even people that budget very well are still gonna be subject
to unexpected expenses or maybe everything they buy
in a given week or month or year is on sale
and they end up using a much smaller portion of their cash
than they were expecting.
The problem this creates is that it makes it very difficult
to use that cash productively
because people always need it sitting around
because they don't know when they're gonna have to use it
or not use it.
The solution to this is a bank
that can split the difference.
They will give someone a small return on their cash,
and they will maintain the right to access that cash
whenever they need it.
This gives the depositor the ability to make some return
rather than no return on their idle cash,
and it allows the economy to access a vast pool of capital
that can be used on long-term projects
to improve overall well-being in that economy.
It sounds overly complicated
but they are basically just describing a savings account.
Diamond and Dybvig did not create the savings account,
it existed long before they were even born,
what they did do, though, is propose a system
for monitoring and predicting the level of demand
for withdrawals given certain conditions in the economy.
If a bank can properly predict
how many withdrawals will be demanded
over a given timeframe,
they can make sure they have just enough cash on hand
to one of these withdrawals
without keeping too much cash on hand
that could be loaned out
to make the bank money and improve economic outputs.
They found that while withdrawals are random,
they are predictably random
given certain market information.
If people heard rumors that a bank was going to go under,
then demand for those deposits would increase.
If people were punished for taking their money out early
from things like term deposits,
then the demand for deposits would decrease.
For the first time ever,
this relationship also formally highlighted the importance
of guarantees from central banks and governments
in the form of lender of last resort protection
and deposit guarantees.
People are much less likely to demand their cash
when they have assurances from institutions that they trust
that their money is safe.
This means that banks can lend out more money
and more projects can get off the ground,
creating a better economy.
Now, you'd be forgiven for thinking
that none of this sounds particularly impressive,
after all, most of us knew that bank runs were bad
and were more likely to happen
during periods of economic turbulence,
it also probably didn't require a research paper
to show that things like deposit guarantees
help people feel more comfortable keeping their money
with these institutions.
But what you have to remember
is that this research was done four decades ago
and it was so influential
that today we take a lot of it for granted
as common knowledge.
Before the work of these men,
banking was normally considered by economists
as just another type of business
with no particular importance to the economy
beyond the jobs that they create
and the services they provide.
I myself struggled to see how their research
was all that impressive
because I started formally studying economics in 2010,
long after their contributions were just a given thing.
Everybody knows that banks are vitally important
to the smooth functioning of an economy,
thanks largely to the work of these men.
The work of Bernanke, Dybvig, and Diamond
showed that financial intermediaries do more
than take deposits and give out loans,
they provide a place for people to store their capital
for easy use while also mobilizing savings,
evaluating projects, managing risk, monitoring managers,
and facilitating transactions.
If people had to do this individually,
it would be prohibitively expensive
to invest in most things that make an economy function.
Just think, if your neighbor wanted to buy a new car
but they didn't have the cash to do it,
you might indirectly end up loaning them that money
through your deposits in a bank account.
But if you were to do it directly,
you would personally have to assess their credit worthiness,
write up a legally binding contract,
set up a system for repayments,
and be prepared to start legal proceedings
if the loan goes bad.
It's just not feasible without the economies of scale
that institutions like banks provide.
Now, the last point of controversy
is that this line of thinking really supports the idea
that banks are too big to fail.
If bank failures mean more to the wider economy
than just a few job losses, then there is the moral hazard
that they can always expect to be bailed out
by the government
because the government understands the damage
that they can do if they go under,
this is one of the big trade-offs that Bernanke alludes to
in his work.
It's important that banks are there to provide capital
to good ideas, but there needs to be a system in place
to make sure they're not putting money
towards overly risky or bad ideas.
This was perhaps what caused him pause
when it came to the bailouts
of Merrill Lynch and Lehman Brothers.
Today's economic slowdown didn't start
in the financial sector,
it's mostly been caused by sustained inflation
and the increasing interest rates that have been implemented
to fight that inflation.
Yes, getting a loan is going to be more expensive these days
because interest rates have increased
but that is because the central bank wanted them
to increase, not because banks are crumbling
and everybody's desperately trying to get ahold
of as much money as they possibly can.
So while it might not be the most popular Nobel Prize,
their contributions
towards how our modern economies are shaped
are perhaps some of the most influential ever.
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