The Nobel Memorial Prize awarded to Ben Bernanke, Douglas Diamond and Philip Dybvig is controversial, to say the least.
Mainstream economists are generally delighted that the Nobel Committee has at last honored research into banks and their fragility. But heterodox economists who have spent years trying to change prevailing beliefs about banking and finance are spitting blood.
I often prefer to sit on the fence when it comes to fights between different branches of economics. But this time, I am firmly on the side of the heterodox economists. I do not think this prize is deserved. No, I would go further. I think it is actively harmful. It confers authority on models that misrepresent how banks actually work, and makes it much harder for heterodox economists — including the brave researchers at the Bank of England who have done so much to advance understanding of modern monetary economics — to counter the pervasive myths about banking and finance that have too often led to damaging policy errors.
The model of banking beloved of mainstream economists says that banks “channel savings” from households to businesses. Households make deposits, which they are able to withdraw on demand; banks “lend out” a proportion of those deposits to productive enterprises for long-term investment. Banks are assumed to be purely passive intermediaries, and as a result, are often omitted from economic models.
The Nobel Committee’s explanatory paper justifying the award uncritically repeats this model:
“Financial intermediaries such as banks and mutual funds exist … to channel funds from savers to investors, receiving funds from some customers and using the funds to finance others. They also make it possible for the borrower to have a long-term financing agreement at the same time as lenders can withdraw the money they lent on demand.”
It then explains how the work of the three prize winners illuminates both the importance of banks to the macroeconomy and their inherent fragility.
Diamond and Dybvig’s paper on bank runs spawned an entire literature on financial frictions. Bernanke’s work draws on theirs and adds insights into the link between credit and economic performance, though only for economic downturns — he largely ignores credit booms, with, as we shall see, unfortunate consequences.
But all their work relies on the “pure intermediary” model of banking. And we now know that this model of banking is dangerously wrong. It omits the leveraging effect of bank credit creation. This is the key feature of the credit booms that always precede disastrous collapses like the Great Depression and Great Recession.
Models that ignore bank credit creation, or worse, omit banks completely — as Bernanke’s paper with Gertler and Gilchrist on how credit markets propagate shocks through the economy does — cannot possibly explain how financial crises happen and why they are so devastating.
As Mervyn King, governor of the Bank of England, ruefully observed in 2012: “There is no doubt that financial frictions such as asymmetric information, credit constraints, and costly monitoring of borrowers, to name but a few, are an important part of the story of how crises happen and why they impact on output. But those models do not provide a convincing account of the gradual build-up of debt, leverage and fragility that characterizes the run-up to financial crises.”
Belief that banks merely “channel” savings to borrowers, rather than actively creating purchasing power through lending, led central bankers to ignore the build-up of leverage prior to the Great Financial Crisis. And it also led central bankers and governments to mishandle the recovery. Instead of supporting households and businesses, they threw money at banks. I regard this as one of the greatest policy errors of all time.
During the Great Financial Crisis, banks stopped lending. Bernanke, the chairman of the Federal Reserve at the time, knew a sudden stop in bank lending was a major contributor to the Great Depression, so, worried about another Depression, he decided he had to get banks lending again. The mainstream model of banking says that the more money banks have, the more loans they will make. Obviously, therefore, the best way of preventing a depression was to give banks money. This was the original rationale for quantitative easing (QE). It was supposed to make banks lend.
But Bernanke did not realize that households and businesses were so over-leveraged, they did not want to take on more debt. And nor did he understand that banks didn’t want to lend.
Banks lend when the risk is low and the returns high. In a damaged economy with a gloomy outlook, there’s not much incentive for banks to lend, however much money you throw at them. Banks were also under pressure from regulators to reduce their risks, clean up their assets and build their capital buffers. None of this was remotely consistent with increasing lending. So despite mammoth QE, they didn’t lend.
Several years after the Great Financial Crisis, bank lending was still far below what it had been before it, and mainstream economists were scratching their heads wondering what had gone wrong. Their models said all that QE money should have sent bank lending to the moon.
We now know that QE works not by stimulating bank lending, but by supporting asset prices. In the immediate aftermath of the Great Financial Crisis, this short-circuited a disastrous debt deflationary spiral and probably did prevent a second Great Depression. As a result, Bernanke has been credited with “saving the world.” But this was more by accident than design. What he was actually trying to do was blow up another credit bubble. We know this, because it’s what his academic work recommends. The work for which he has been given a Nobel prize.
Uncontrolled bank lending such as that which preceded the Great Financial Crisis isn’t normal. Central banks shouldn’t encourage it. And economists shouldn’t get Nobel prizes for recommending it.
Bank lending actually recovered when the housing market did. This is hardly surprising, since banks nowadays mostly lend against real estate collateral, and most of that is residential property. It was the 2008 house price crash that stopped bank lending in its tracks. Had governments and central bankers understood this, they would have supported households to prevent defaults and foreclosures on mortgages, not thrown insane amounts of money at banks. And we might have had a much shorter and less devastating recession.
The Great Recession exposed fundamental flaws in the work of all three prize winners. All three failed to recognize in their models the leveraging nature of bank credit creation and the procyclicality of bank lending. Failure to recognize and “lean against” the fragility caused by excessive leverage is what made the Great Recession so disastrous. And erroneous beliefs about the functions and incentives of banks caused policy errors that resulted in a decade of stagnation.
I do not understand why the Nobel Committee has chosen to reward people who got things so disastrously wrong.
Frances Coppola writes the Coppola Comment blog and is author of “The Case For People’s Quantitative Easing.” She worked in banking for 17 years and received an MBA at Cass Business School in London, where she specialized in financial-risk management.