Why former Fed chair Ben Bernanke deserves his Nobel Prize—despite the naysayers

11 Oct Why former Fed chair Ben Bernanke deserves his Nobel Prize—despite the naysayers

Most Americans, understandably, know Ben Bernanke as the person who was head of the Federal Reserve during the financial crisis of 2007-2009 (aka the Great Recession), and who took extraordinary measures to try to prevent banks and other financial institutions from collapsing and credit markets from seizing up. But before he was Fed chairman, Bernanke was an academic economist, who wrote a famous paper in 1983 explaining why bank collapses were bad, and how they damaged the economy. And on Monday, it was that paper that won him a Nobel Prize in Economics.

Already, though, the move has drawn some controversy. Some, including the Wall Street Journal editorial board, have criticized the Nobel committee for bestowing the award to the former Fed chair, arguing that despite having written about the danger of financial crises, he’d failed to anticipate and do enough to prevent the crash that set off the Great Recession.

The criticism, though, is misplaced. Bernanke can be faulted for being initially slow to recognize the signs of impending disaster, and arguably for letting Lehman Brothers go under (though he could argue that the Fed didn’t have the ability to keep that from happening). But on the whole, Bernanke’s response to the crisis was aggressive and innovative. More to the point, the Nobel, which he won along with Douglas Diamond and Philip Dybvig (authors of an essential paper on why bank runs happen, which also helps explain why banks exist in the first place), is well deserved because Bernanke’s work changed the way economists think about banks and the role they play in exacerbating—or stanching—an economic crisis. His 1983 paper, “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression,” combined historical research with deep theoretical insight to show that bank failures weren’t simply an unfortunate consequence of economic downturns, but that they instead could help deepen and prolong them.

That may seem obvious, but it’s an example of a funny aspect of economics, which is that it often requires complex work to explain things that the rest of us kind of take for granted. For most people, it’s not really confusing that banks exist, or that it’s bad for banks to fail. But for economists, the role of banks has always been a bit murky: Why do you need these intermediary institutions between people with money and people who want to borrow it, and why would it make a difference if banks collapse during a financial crisis? And the paradox is that starting from that strangeness lets economists help us to understand things we think we already understand, but really don’t.

At the time that Bernanke’s paper appeared, the prevailing assumption among economists was that banks were simple financial intermediaries. If they failed, other intermediaries, or market mechanisms, could replace them. Even economists who thought bank failures mattered believed they were important only because they reduced the money supply, a problem the Federal Reserve could solve by simply being more aggressive in pumping money into the economy. Economists who wrote during the actual Great Depression had put a lot of emphasis on the impact of bank failures and credit crunches. But by the early 1980s, their work had pretty much been forgotten.

Bernanke, though, showed that those old economists had been onto something, and that bank failures had a much bigger impact on the economy than contemporary economics recognized. Bernanke’s key insight was that banks are not just trivial intermediaries, channeling money from savers to borrowers. Instead, banks play a central role in making credit markets work, in gathering information, assessing the potential prospects and risks of households and businesses, and monitoring them after the fact. Assuming banks do a pretty good job of this, credit is more available and cheaper than it would be if households and businesses had to borrow money directly from individuals.

The consequence of this is that if you have banks fail en masse, as happened during the Great Depression, the supply of credit freezes up, and loans become more expensive or simply not available at all. This won’t necessarily affect large businesses, which can raise money via the stock or bond markets. But the contraction of credit will hit households and businesses that are dependent on bank loans very hard. When banks vanish, then the amount of lending plummets; and since modern economies run on credit, the overall level of economic activity plummets as well. And since it takes a long time for new banks to spring up, or insolvent banks to be recapitalized, the impact of bank failures can last a surprisingly long time.

Bernanke showed that this wasn’t just theoretical. Instead, he documented his ideas with empirical data from the Great Depression, showing how bank failures were followed by a sharp decrease in the amount of credit available and a sharp increase in its price. And he showed that, as the theory predicted, bank failures hurt households, farmers, and small businesses much more than they did large companies, and that the contraction of credit lasted for years.

The Nobel award to Bernanke, then, is justified recognition for important and influential work. It’s also testimony to how economics as a whole has evolved over the years. When Bernanke’s paper appeared, academic economics had a not-undeserved reputation for being excessively theoretical and dependent on unrealistic assumptions, and for producing papers that were heavy on equations but light on real-world implications. Bernanke’s work, by contrast, was relatively clear and accessible, grounded in empirical reality and tied to real-world concerns. The same was true of the work of his fellow winners, Diamond and Dybvig. All three of them were groundbreakers not just in terms of the conclusions they reached, but also in terms of the questions they asked and the real-world consequences of their work.

Bernanke’s work is also important because it gave us a deeper conceptual understanding of things that policymakers were already doing, and that most people just took for granted. After all, the idea that letting banks collapse en masse might be bad for the economy, and that we should take steps to prevent bank runs, had become conventional wisdom, at least outside the academy, by the 1980s. But what Bernanke did, in effect, was solidify that conventional wisdom by giving it a deep theoretical, and empirical, underpinning. Bernanke’s response to the financial crisis as head of the Fed was not perfect. But it was far better than many Fed chairs would have mounted. And when he made the decisions that helped stave off complete financial-market chaos and economic collapse—expanding the kind of institutions eligible for deposit insurance and access to Fed lending; effectively nationalizing companies like AIG; brokering the acquisition of failing banks by bigger players, and so on—he wasn’t just following conventional wisdom. He was following the lessons of his own work.

Source: Fast Company