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Banking on It
What is the 2022 Nobel Prize in Economics about?
If you want to understand geology, study earthquakes. If you want to understand economics, study the biggest calamity to hit the U.S. and world economies.
The 2022 Nobel Prize in Economics (or Sveriges Riksbank Prize in Memory of Alfred Nobel, shout out to the pedants out there) went to former Fed Chairman Ben Bernanke, and professors Douglas Diamond and Philip Dybvig. The overarching theme was banks and bank failures, and how, spoiler alert, they’re bad. But let’s elaborate.
Why Banks Fail
When you ask people how bank runs happen, the likeliest answer is probably “a bank has a lot of deposits and not enough money to cover them, then people ask for their money and the bank fails”. And while it’s not wrong, it also doesn’t really explain why banks that are perfectly financially stable also fail during bank runs - or have runs on them at all, given that consumers should know that their bank is sound. So the real question is why bank runs happen on perfectly healthy banks, and what to do about it. Douglas Diamond and Philip Dybvig wrote a 1983 paper titled “Bank Runs, Deposit Insurance, and Liquidity“ that tries to come up with a model to answer that question.
Imagine an economy with two time periods and two assets: one that has to be frozen for all two periods, and one that can be cashed out at any moment. People are all identical in income, but can either have to consume that income in the first period (say, people who like shopping for trendy clothes) or in the second period (imagine someone who saves all year to go on a fancy vacation), and they can’t know ahead of time when they have to spend. Importantly, asset allocation choices are made before anyone has to spend any money, which poses an importan issue: people need to protect themselves from the unanticipated expenses associated with spending early. If everyone knew their moment to consume, then they’d just consume then, and not bother: people who spend on the first year would spend their income, and people who spend on their second period would just spend that plus interest.
Because people don’t know if they’ll have to spend on the first or second year, then a problem arises: the people who spend later gets the full amount either way, but people who have to spend on the first period have to save money they won’t get much out of so they spend less. Since this isn’t optimal, and centrally planning everyone’s expenditures isn’t a realistic possibility, then a solution can emerge: a bank. This bank doesn’t charge comission or any fees, and offers everyone a simple contract (before spending occurs): they give the bank their income, and if they need to spend money on the first period, then the bank covers it and simply claws back their interest when they’re done. Well, everyone spends their full amount, and people of the early-spending variety are insured from having to cut back unnecesarily out of precaution, with no harm to late-spenders, so everyone is incentivized to get a bank loan to insure themselves.
This has a big impact for the bank: its purpose is to provide its depositors insurance in case they need money ahead of time. It also means that it has a lot of assets that aren’t very liquid (i.e. are hard to cash out) but a large number of liabilities that are liquid. How a bank run happens is pretty simple.
Assume the bank can sell off all of its deposits to someone in the first period but at a loss, which results in everyone getting less than they would have if they withdraw - but only if they get in before the bank runs out of money. Late-spenders know that the bank owes a lot of money and won’t be able to pay back the full amount if it gets into trouble. Assume there’s only two of them for simplicity. If one of them thinks the other one is going to withdraw, then it makes sense to withdraw too, because the alternative is getting to the bank too late and perhaps getting nothing. But if the other late-spender is keeping his cool, then it makes sense to wait too, because then they won’t have to take a cut on their interest payments to not get any benefit. This makes bank runs fundamentally undetermined phenomena: bank runs happen if people expect them to happen, but people only expect them to happen if they think other people expect them to happen, which only occurs when other people expect people expect a bank run to happen. Quite the tongue twister.
The big change here is that bank runs were traditionally considered irrational phenomena, people panicking and stampeding towards their bank to get their money back when the vibes were off. Instead, Diamond & Dybvig show that bank runs are reasonable responses to the way banks are structured - panics are actually rational, and they depend on expectations of other peoples’ expectations. If there are multiple banks in the economy, then the situation is worse, because some people randomly mistrusting their bank means that that bank could fail, and suddenly everyone gets antsy that their (perfectly sound) bank could fail, and you have a full-on panic.
The main implication here is the response to a bank run. A very simple solution is what’s called “suspending convertibility”, i.e. not letting anyone withdraw their money over a certain amount. The problem is that some people actually do need to spend, and the withdrawal limit is going to have to be too small for them because of mathy reasons (and common sense, since everyone has the same income), so a lot of people will be mad as hell. Banks could also simply not make it so that people get their money by order of yelling for it, which disincentivizes a run a little bit but not entirely. An alternative is that no banks that insure early spenders can also take deposits from late spenders, which is called narrow banking and is controversial (especially because the whole manner of insurance, per D&D, is that they mix up the two). Lastly, the government could create deposit insurance: a part of deposits is to be guaranteed by some third party, or a “bank for banks” would help banks in need. This is normally what’s done, and it’s not uncontroversial for various reasons.
The biggest innovation here is to think of a bank as a mechanism and not as like a sector of the economy. Mechanism design is a really complicated (and fascinating) field, but in general, it deals with situations where groups of people would be better off trading with each other than on their own, but can’t because it involves revealing information that is private. A big example is kidneys: people often have loved ones who are willing to donate one, but aren’t compatible. Since buying them is illegal, it’s hard to do anything in that situation unless you luck into a perfect stranger donating a kidney spontaneously. However, it’s also possible that there’s a stranger who has a relative who’s willing to donate, and while each donor isn’t compatible to their relative, they’re compatible to the other one. A mechanism to solve this would be a kidney exchange, where people sign up their kidney suppliers to trade in case a match of that nature happens. They’ve been tried, they work, and the guy who came up with the idea won a Nobel for that kind of work exactly ten years ago.
… because of institutional changes and misguided doctrines, the banking panics of the Great Contraction were much more severe and widespread than would have normally occurred during a downturn. Bank failures and depositor withdrawals greatly reduced the quantity of bank deposits, consequently reducing the money supply. The result, they argued, was greater deflation and output decline than would have otherwise occurred.
What happens if a lot of banks fail? Nothing good, obviously. But why?The last time in US history that a large chunk of the country’s banks failed was the Great Depression. But to talk about the Depression, first you have to talk about Milton Friedman.
In the 40s and 50s, the story of the Depression was that monetary policy was stimulative (because interest rates were at zero) and that fiscal policy (first the New Deal, then World War Two) saved the day, so the onus of stabilization had to be on spending and taxes, while monetary policy simply moved rates around to determine investment. But Friedman’s book “A Monetary History of the United States”, co-written with Anna Schwartz, looked for and found pretty convincing evidence that the Depression was all around a monetary affair.
The most important item here was that the money supply shrank 25% in 1929 - so monetary policy wasn’t stimulative, in fact it was contractionary. This was a result of the US being unable to do much about anything because of the gold standard but, more importantly, because a lot of banks failed and took their deposits with them. Additionally, the Fed didn’t want to do anything about all these failing banks because they thought that letting “"weak banks” go bankrupt would result in a stronger financial system, since they were probably failing because of their own mistakes and not because their customers one and up decided to withdraw all their money.
A good way to explain why a lot less money going around results in a recession comes from Paul Krugman, talking about a babysitting co-op that used coupons to trade baby-sitting hours:
… the number of coupons in circulation became quite low. As a result, most couples were anxious to add to their reserves by baby-sitting, reluctant to run them down by going out. But one couple’s decision to go out was another’s chance to baby-sit; so it became difficult to earn coupons. Knowing this, couples became even more reluctant to use their reserves except on special occasions, reducing baby-sitting opportunities still further.
In short, the co-op had fallen into a recession.
Simply put, Friedman’s position is that the Great Depression was so bad because the supply of money in the economy crashed, and bank failures contributed merely because banks create a lot of the economy’s money - when banks fail, money is scarcer (and also wealth lower because deposits just vanish), effective interest rates go up, and demand goes down. Ben Bernanke thinks this is right, but not the full picture.
Bernanke, I might add, is a big admirer of Friedman, and fundamentally agrees with his thesis. His speech (as a Fed Governor, not Chairman) for Friedman’s 90th birthday ended with the shocking statement:
I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.
But his Nobel-winning work goes a step further: if banks have special functions besides printing money, then what’s their importance to the economy? Instead of seeing banks as simply money printers (which is a pretty fair view), Bernanke subscribed to the (unpopular in the 90s, now consensus) position that banks fundamentally are creators of credit - i.e. loans. This means that when banks fail, people can get fewer loans to buy and invest, which harms the economy. This happens, according to Bernanke, because banks have to ration credit to profitable but risky projects: if banks are going belly up, the rest won’t want to take any risks with their money, lest mobs start lining up to withdraw their savings. Additionally, people often put up assets as collateral in loans; when inflation rates become negative, such as in the Depression, then debts become more valuable for the same collateral (or less, because it might go down in value), and as a result lending becomes too risky - borrowers will simply default. Banks, therefore, lend even less In consequence, monetary policy acts by making it less risky to lend, and therefore stimulating credit.
The most important component of Bernanke’s work isn’t really that he came up with the (in hindsight, a bit banal) idea that banks collapsing was bad because people need loans, but rather, that he used (at the time) novel empirical methods to both support his view and also to find evidence for how interest rates affect the economy: the direct effects on credit purchases seems to be fairly small, while effects stemming from risk and uncertainty are much bigger, and amplify the normal monetary aspects.
The policy implication here is pretty simple. Once again, quoting Bernanke’s speech:
For practical central bankers, among which I now count myself, Friedman and Schwartz's analysis leaves many lessons. What I take from their work is the idea that monetary forces, particularly if unleashed in a destabilizing direction, can be extremely powerful. The best thing that central bankers can do for the world is to avoid such crises by providing the economy with, in Milton Friedman's words, a "stable monetary background"--for example as reflected in low and stable inflation.
Bank runs are bad and letting banks collapse to own them for their bad management practices is such a bad idea it made the Great Depression extra severe. Shocking.
In another speech congratulating Milton Friedman for living a very long time (the early 2000s Fed didn’t have a lot to do, it seems), he talks about the conclusions drawn from his work and from the Depression particularly:
However, in my view, the most fundamental policy recommendation put forth by Milton Friedman is the injunction to policymakers to provide a stable monetary background for the economy. I take this to be a stronger statement than the Hippocratic injunction to avoid major disasters; rather, there is a positive argument here that monetary stability actively promotes efficiency and growth. (…)
Do contemporary monetary policymakers provide the nominal stability recommended by Friedman? The answer to this question is not entirely straightforward. As I discussed earlier, for reasons of financial innovation and institutional change, the rate of money growth does not seem to be an adequate measure of the stance of monetary policy, and hence a stable monetary background for the economy cannot necessarily be identified with stable money growth. (…)
Ultimately, it appears, one can check to see if an economy has a stable monetary background only by looking at macroeconomic indicators such as nominal GDP growth and inflation. On this criterion it appears that modern central bankers have taken Milton Friedman's advice to heart. Over the past two decades, inflation has fallen sharply and stabilized around the world, not only in the industrialized nations but in emerging-market economies and in even the poorest developing nations.
Diamond & Dybvig
See “Argentina, 2001” for an example. Although confusingly “suspending convertibility” meant, in that context, breaking the 1-to-1 peg between the peso and the dollar.
“Fun” fact: as many women have received a Nobel Prize in Economics as (unrelated) people with the last name “Diamond”. And 4.5 times more laureates have the name “Robert” than XX chromosomes (don’t start any stupid discussions, I’ll just reword that part if Deirdre McCloskey ever gets the Nobel).
Fun sidenote: Bernanke’s interest in macroeconomics seems to come from a similar story about his family’s finances during the Depression. His grandmother told him that her family was proud that their kids always had new shoes to wear to school, instead of keeping tattered ones. He asked his grandmother why nobody else could buy any shoes, and her reply was “because they lost their jobs when the shoe factory closed”.