Why are banks important to the economy? What role do they play in the functioning of the economy? Why are they called financial intermediaries? What happens when people lose their trust in banks? What role did banks play in the prolonging of the 1930s Great Depression?
These are some of the crucial issues that the three economists who won this year’s Nobel Prize — Douglas Diamond, Philip Dybvig and Ben Bernanke — researched during their careers.
Banks are called financial intermediaries because they literally mediate between depositors and borrowers. People need loans for various reasons — businesses, to fund their long-term investment plans or short-term working capital needs; people, to buy houses, and vehicles, fund education, and other consumption needs. At the same time, people also need a place — a “safe haven” — to deposit their savings.
This is where banks come in as financial intermediaries. They channelise deposits from the public and lend that money to borrowers. But deposits are typically short-term in nature whereas borrowing is long-term. Banks could be in trouble if all their depositors land up at their doorstep one day and demand their deposits back as that money would have been lent for a longer tenor. This is called a “run on banks”, a panic situation where the depositors for a variety of reasons lose trust in the banks. This could lead to a collapse of banks and have serious systemic effects on the economy.
Diamond and Dybvig solved this “maturity transformation” problem by advancing the case for a deposit insurance scheme. If the government steps in and plays the role of guarantor in assuring depositors that in the case of a bank collapsing their deposits are safe and covered by it (government) or even provides funds to the banks, such panic wouldn’t occur. Diamond and Dybvig’s work led to far-reaching reforms in the financial sector.
Bernanke’s research on the 1930s Great Depression showed how the collapse of the banking sector worsened the situation and prolonged it. The standard ‘Keynesian’ model says that the Great Depression was a result of a collapse of “aggregate demand” or consumption and its revival was key to the economy’s recovery. Bernanke’s research showed that the people’s lack of trust in banks and their collapses were equally responsible for the prolonging of the Depression.
Bernanke: for and against
The Nobel Prize committee in an unusual move honoured Bernanke, an economist who muddied his hands in the messy world of policy-making. Bernanke during his eventful stint as US Fed Reserve chief between 2006-14 had to deal with Global Financial Crisis of 2007-08.
Bernanke too like a lot of other economists failed to see the crisis coming. In fact in early 2007 in a deposition to the US Congress he said that the sub-prime mortgages and rising housing loan defaults will not pose a systemic threat and spill over into the real economy. But then later that year Lehman Bros collapsed and all hell broke loose.
But once the crisis became full-blown, Bernanke quickly got into the act, by injecting faith and trust back into the US financial system and preventing a recession. His ‘Quantitative Easing’ programme pumped liquidity into the system through the US Fed’s massive bonds buying programme. Under his stint, the US Fed balance sheet surged to more than $4 trillion from less than $1 trillion.
His task was two-fold — to lend money to the US government to bail out banks in trouble as well as buy bonds and securities in the markets to inject funds into the banks that they could use for productive lending to revive the investment cycle.
Bernanke’s Nobel win has typically divided opinion with some hailing him as a saviour of the US economy during the 2007-08 crisis and some slamming him for the current global economic mess. The detractors argue that it is Bernanke’s legacy of easy money policy that has led to the current volatility in global financial flows.
So is Bernanke a hero or a villain? The reality, as always, lies somewhere in between. Bernanke in the end had a job on hand, which he did to the best of his ability given the constraints. Economic policies always have consequences some of which are impossible to predict. To blame Bernanke for today’s mess is a tad unfair as the causes of today’s runaway inflation are very different.
Bernanke’s detractors would be better off criticizing the reckless behaviour of the big US investment banks in the build up to the 2007-08 financial and the toxic financial products they unleashed on the market.
Musings on meritocracy
A speech that Bernanke gave to Princeton University graduates in 2013, which barely got any media attention, gives us a glimpse of his views on issues other than economics. In the speech, Bernanke debunked the fairness of meritocracy saying luck played a major role in the kind of opportunities one gets in life. So if you go to Princeton, it’s more because you were lucky enough to be born in the right family.
It’s interesting to see an establishment economist like Bernanke having a rather radical view on meritocracy. However, for having enjoyed such privilege, he also advised Princeton graduates to work towards the betterment of the world.
So did Bernanke deserve the Nobel? This could be debated till the cows come home.