On October 10, the Royal Swedish Academy of Sciences awarded its Prize in Economic Sciences (commonly known as the Nobel Prize in Economics) to a trio of academics for their work studying banks and financial crises. Far from being a reassuring sign that rigorous work is being done on financial stability, though, the award reveals how disconnected macroeconomic research is from reality. A tradition of neglecting the importance of currency, banks, and capital markets has led the field to ignore key empirical lessons from finance. Far from being revolutionary, the work cited by the Academy merely reminded academic economists of lessons that were learned by the financial world more than a century ago.
Douglas Diamond and Philip Dybvig, two of the economists awarded the Nobel, were cited for a 1984 paper they coauthored that built a model showing why banks are fundamentally vulnerable to runs. First, they describe how balancing liquidity with returns causes people to pool money with other savers in a bank. By making investments communally, rather than individually, any single withdrawal will be a small portion of the total investment, lowering the risk of needing to cancel a long-term project due to unexpected liquidity needs. The mismatch between liquid savings and illiquid investments, though, means that if everyone tries to withdraw their money at the same time, the bank will not have enough money to pay them all back. Moreover, since only the first depositors to the withdrawal window will get their money back if the bank fails, even depositors without an immediate need for cash will join the run.
Diamond and Dybvig go on to show how deposit insurance can arrest the need for anxious depositors to withdraw their money at the first hint of trouble, making bank runs unlikely. In their scientific background paper, the Academy praises the simplicity of the model, calling it “remarkably robust”. But it is precisely this simplicity that means these dynamics are clear to any financier who has given thought to the practice of banking (or, for that matter, the way people act when there’s a fire in a movie theater). Walter Bagehot, a British journalist and businessman, wrote extensively about these topics in his 1873 classic Lombard Street, including the inherent vulnerability created by liquid deposits funding illiquid investments. Deposit insurance was instituted in America in 1933, well before this analysis was published. Diamond and Dybvig’s chief achievement seems to have been repackaging existing knowledge into an optimization model so that other economists could understand it.
The Academy further cites Diamond for a 1984 article describing how banks provide a valuable service by monitoring the portfolio of loans that they make, a specialized activity that takes a significant amount of time. Since it would be too costly for individuals to do this themselves, they are willing to delegate the task to banks, which results in more credit being extended than otherwise would be. Diamond’s conclusions are correct, but could have been arrived at through basic engagement with financial practice. The asset management industry exists because portfolio management is a full-time job that investors are willing to pay someone else to do. And although finance is riddled with charlatans, it is undoubtable that professional management gives savers the confidence to make more investments than they otherwise would.
Similarly, Bernanke’s cited paper, from 1983, argues that banks provide value to the real economy by being important stores of private information about borrowers. In other words, if a bank stops extending credit, other lenders cannot simply step in and frictionlessly replace it. During a banking crisis, as banks scramble for liquidity and stop lending, this mechanism can cause harm to production by causing a credit contraction. This paper would prove surprisingly prescient for Bernanke’s time at the helm of the Federal Reserve, America’s central bank. While managing the 2008 crisis, Bernanke saw first-hand how the idiosyncratic nature of lenders could result in a credit crunch.
But these insights were not novel in 1983. That banks are not merely passive intermediators but active facilitators was well known to economists Eugen Böhm-Bawerk and Joseph Schumpeter, both writing in the 1910s. That credit creation (and contraction) can have an influence on the real economy has been known since the work of economist John Maynard Keynes in the 1930s. Connecting these to conclude that bank failures can harm the economy seems like common sense, but went against the tenets of macroeconomists steeped in rational expectations theory. Bernanke had admit that the world has non-zero transaction costs to write his paper, violating a key assumption held by his colleagues.
Paul Krugman, an economist who won the Nobel in 2008, took to Twitter to defend his fellow researchers from claims that their simplified models offered nothing new. By providing a general model of banking, Krugman argued, the trio showed that a growing number of financial institutions were subject to bank run dynamics. “What not enough people noticed was that a growing share of banking was being carried out by institutions that weren't big marble building with rows of tellers.” The credibility of this argument is weak, especially considering that Bernanke, as chair of the Fed during the Global Financial Crisis, did not see the run risks to the shadow banking sector until after the runs had started.
It is indicative of the current state of macroeconomic research that the Nobel prize has gone to forty-year-old simplified models of existing knowledge, rather than any cutting edge research on the unprecedented shifts in monetary policy over the last several decades. Still, that the importance of banks is starting to factor into macroeconomic research is a step in the right direction. Several research economists do conduct their work with an eye to the importance of the financial system, including Richard Werner and Perry Mehrling. But until the practical aspects of banking, money, and finance are incorporated into macroeconomic models, the field will remain woefully misguided, stuck regurgitating old knowledge in new formats.
Title photo features Ben Bernanke, courtesy of Medill DC under a Creative Commons license.
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