The 2022 Nobel Prize in Economics highlights the key role of central banks in avoiding the crisis
As the World Bank and International Monetary Fund warned of a possible global recession in 2023 and central banks rushed to raise interest rates to control inflation, a trio of US economists United won the 2022 Nobel Prize in Economics. Prize for significantly improving “our understanding of the role of banks in the economy, especially during financial crises”.
The US trio of former US Federal Reserve Chairman Ben Bernanke, Douglas Diamond and Philip Dybvig received the Nobel Prize in Economics this year for their research on financial sector regulation and supporting failing banks to avoid economic crises.
Observing that their analysis was of great “practical importance”, the Nobel Committee added: “The actions taken by central banks and financial regulators around the world to deal with two major recent crises – the Great Recession and the slowdown induced by the Covid pandemic – were largely driven by the research of the winners”.
The Nobel Prize committee’s words are further validation for Bernanke, the former head of the US Fed when the financial crisis began in 2008, and was criticized for bank bailouts that sparked a public backlash. However, Bernanke, a scholar of the Great Depression, believed the economy could be saved by saving the existing financial system.
He was credited with using innovative methods to protect the financial system from default, including bringing the interest rate near zero for the first time in Fed history and initiating widespread quantitative easing (the central bank buying government securities and assets to stimulate the economy).
“He (Bernanke) was instrumental in stabilizing the US and global economies,” Mark Carney, Canada’s former central bank chief, said in 2013, as quoted by Reuters.
Mr Bernanke is undoubtedly one of the most high-profile winners – perhaps the first former Fed chief to win the prize. Nevertheless, the contribution of Douglas Diamond and Philip Dybvig, both frequent collaborators and namesake of the Diamond-Dybvig model, is invaluable as they laid the theoretical foundations of bank runs and financial crises.
Diamond, who is associated with the University of Chicago, and Dybvig, a professor at Washington University in St. Louis, postulated in 1983 that the liquidity needs of savers clash with borrowers who want to take out long-term loans. . This, according to the model, is a source of stress for banks.
In normal situations, banks allow savers to access their savings. At the same time, borrowers are getting their long-term loans, while many savers rushing to withdraw their savings could lead to a bank collapse.
Their analyzes showed that the government (the central bank in the modern sense) acting as a lender of last resort could help protect the banking system. Finally, as intermediaries, according to them, banks can analyze the creditworthiness of borrowers and avoid “bad debts” as much as possible.
“Bad loans” (read subprime loans in the US) were one of the triggers of the 2008 global financial crisis and led to the collapse of banks around the world.
Raghuram Rajan, former head of the Reserve Bank of India, paid a rich tribute to the duo in a LinkedIn post, calling Diamond “the father of modern banking theory.” He added that their articles also prompted Bernanke to make the Diamond-Dybvig model required reading while the Fed grappled with the financial crisis.