Why the Nobel fails to answer question of excess money

2010 onward, the Ben Bernanke-led Fed printed money to drive down long-term interest rates in the hope of driving up consumer demand as well as getting businesses to borrow and spend more. Photo: AFP
2010 onward, the Ben Bernanke-led Fed printed money to drive down long-term interest rates in the hope of driving up consumer demand as well as getting businesses to borrow and spend more. Photo: AFP


  • A liquidity backstop for banks has academic backing but how is this extra money to be withdrawn?

Walter Bagehot became editor of The Economist in 1860. As an editor, he witnessed the failure of financial firms in London, turning these experiences into a book titled Lombard Street. The central point of this book was: “In wild periods of alarm, one failure makes many, and the best way to prevent the derivative failures is to arrest the primary failure which causes them." This failure was to be prevented by the Bank of England by lending freely and becoming the lender of last resort.

Nonetheless, what Bagehot offered was just an informal theory. Economists in the 20th century have turned such informal theories into mathematical macroeconomic models. Three such economists, Ben Bernanke, Douglas Diamond and Philip Dybvig have been awarded the Nobel Prize in Economics for 2022. So, the question is why these three economists shared the award.

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Consider an economy where there are no banks. Even such an economy will have investment projects that need to be financed. Without banks, households can finance them directly. The trouble is that households in sudden need of money will be forced to terminate these projects early, leading to low returns. In a 1983 research paper, Diamond and Dybvig explained that in such a situation, banks would “naturally arise as intermediaries".

People would deposit money in banks which would then lend that money on. If required, depositors would be allowed to withdraw deposits early, “without losing as much as if they had made a direct investment but terminated the project early". This dynamic, which is referred to as ‘maturity transformation’, turns short-term deposits into long-term loans like housing or business loans. It works simply because most depositors leave their deposits with the bank most of the time.

Nonetheless, this makes the business model of banks vulnerable. Regardless of the financial state of a bank, a rumour can start, resulting in many people turning up at the same time to take their deposits back. The bank may not have so much free cash, forcing it to terminate its long-term investment projects prematurely and sell assets in a fire-sale. This might even lead to its collapse.

Diamond and Dybvig said that government policies of insuring deposits or a central bank acting as a lender of last resort can help prevent bank runs.

So, where does Ben Bernanke fit in? Bernanke is a scholar of the Great Depression that started in 1929. Up until the early 1980s, the thinking was that this economic event happened because the US government of the day let banks fail, leading to a massive contraction in money supply, falling prices and hence the Great Depression.

Bernanke in a 1983 research paper argued that the Great Depression happened because people who had deposited money in banks got worried and rushed to withdraw. The Federal Reserve did not offer insurance on bank deposits. With bank runs becoming common, surviving banks turned reluctant to lend, leaving businesses unable to finance investments. This led to “financial hardship for farmers and ordinary households". This is where Bernanke’s work meets that of Diamond and Dybvig.

A situation similar to 1929 erupted in 2008 and 2009. There were runs, not on banks, but shadow banks which had become a large part of the US financial system. Many of them were in the business of borrowing for the very short-term and lending for the long-term. To survive, they needed money on an almost daily basis. The trouble was that after investment bank Lehman Brothers went bust in mid-September 2008, the money market dried up.

While all this was happening, Bernanke was chairperson of the Fed and he put his learnings into practice. The Fed acted as the lender of last resort, flooded the financial system with money and ensured that both shadow and commercial banks did not collapse.

The idea was to prevent the next Great Depression. Soon, other central banks of the rich world were printing money and pumping it into the financial system by buying bonds and ensuring that there was enough money going around in the financial system, with no fear of bank runs and collapses.

The trouble was Bernanke and other central bankers turned this into a habit. The initial idea was to print money and save banks from collapsing. But 2010 onward, the Bernanke-led Fed printed money to drive down long-term interest rates in the hope of driving up consumer demand as well as getting businesses to borrow and spend more.

The hope also was that lower interest rates would stoke bubbles in the stock and real estate markets. This would make people feel richer and nudge them to spend more money. Other central banks followed the Fed, turning the global economy into a bubble economy and central banks into money-printing machines. There is still no clear-cut plan on how these central banks plan to take out the money they printed.

Sadly, the Nobel committee makes no mention of this, nor do economists writing panegyrics to this year’s laureates. The question remains: How will all this massive money-printing end? Maybe a Nobel prize will be won in the future by economists who answer this seemingly simple question.

Vivek Kaul is the author of ‘Bad Money’.

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