The Problem with Bernanke's Nobel Prize

Economics is in painful transition. After two decades of low inflation and good growth around the turn of the century, the global economy unexpectedly ran into the 2008 financial crisis.

Financial disaster was narrowly averted. The weakness of the subsequent recovery saw monetary policy dramatically eased, with policy interest rates set at zero in most big economies, which boosted asset prices everywhere but left the real economy still limp. Then, in the latest stage, inflation staged a dramatic and unexpected comeback. Strenuous efforts have yet to bring it to target.

In these disoriented circumstances, who would be a deserving recipient of the Nobel Prize in economics? The free-market simplicities of the late twentieth century seem at best a partial guide when governments must intervene so often to maintain stability in the hugely expanded financial sector stable.

Monetary policy has proved to be a feeble instrument, even when all manner of unconventional policies were devised to try to get some traction. Sophisticated modelling predicted none of the events and new theories had to be devised, ex post, to explain what happened.

Economists can’t look back on the past decade with much satisfaction. It looks like the received wisdom of the economics profession might need a rethink.

So, when Ben Bernanke, former chair of the US Federal Reserve and key player in this troubled period, was announced as a recipient of the Nobel Prize in economics, there was a stream of derision from the financially-savvy readers of the Financial Times.

Bernanke certainly deserves credit for saving not only the US banking system in 2008, but European banks as well, with Fed ‘swaps’ bailing out tottering continental banks.

But if Wall Steet was saved, Main Street was not. The housing collapse left many households devastated, while the bankers retained their fat bonuses and pensions, if not their jobs.

Occupy Wall Street

‘Occupy Wall Street’ reflected the public’s anger.

Many reforming proposals were explored to make the financial sector safe, with promises that risk-takers would never again be bailed out using taxpayers’ money. By the time Wall Street had exercised its lobbying powers in Congress, the banks had been reined in with heavier capital requirements, but the non-bank financial sector — the ‘shadow banks’ and financial markets — were left unrestrained. They were ready to expand rapidly into the gap left by the trammelled banks, with complex and untransparent transactions providing funding for speculation. Paul Volcker’s attempt to stop banks from joining this speculative game were weakened by the banks’ powerful friends in Washington. The Fed watched on without demur.

The interest rate is the key price joining the present with the future. It should never be negative in inflation-adjusted terms. Sooner or later, zero nominal interest was going to demonstrate its absurdity. Sooner or later, QE would have to be unwound, to the detriment of all those holding bonds, including central banks with their expanded QE holdings. In both cases, the exit from these Bernanke-initiated policies was bound to be painful and disruptive, because balance sheets had adapted to zero interest and over-flowing liquidity from QE.

Financial Fragility

Financial fragility became the norm – the ‘taper tantrum’ in 2013, the China scare in 2015, the repo meltdown in 2019, the COVID panic of 2020 and, most recently, the UK bond market turmoil. Inflation is still running way over target. Interest rates cannot be raised quickly enough to restore positive rates in real terms.

Is this the moment to reward the lead actor in this drama with the Nobel Prize?

There is another stream of economics which is grappling with the realities of today’s world. Larry Summers saw the weak growth of the post-GFC period as a reflection of structural issues, not amenable to monetary policy action. Olivier Blanchard has worked to revise the previously accepted role (or non-role) of fiscal policy in the business cycle, so that it could be used when monetary policy was impotent.

No-one yet has plotted a clear way forward. But few economists are looking back on this period with satisfaction that their discipline has provided an adequate guide for policy.

Pushing on a String

Perhaps, in his defence, Bernanke’s academic work before he joined the Fed might justify a Nobel prize. But the main message that we remember is his conversation with Milton Friedman (the latter on his deathbed), in which he pronounced that Friedman had been right in blaming the Fed for the Depression.

But Friedman got a good part of this story wrong. Yes, the Fed let banks go broke. But the money supply didn’t grow too slowly in the 1930s because the Fed was foolishly reining it in. It was creating base money (some would say ‘printing money’) as fast as possible, but the still-operating banks couldn’t identify any creditworthy borrowers amid the Depression wreckage. Monetary policy was, as the Fed chair at the time said, ‘pushing on a string’.

Perhaps it is this ‘pushing-on-a-string’ lesson that Ben Bernanke should have taken to guide him in the post-GFC decade. The lesson: set interest rates at a low but positive real number, and then proclaim loudly that the Fed had done all that it could sensibly do.

Diamond and Dybvig

Bernanke’s co-recipients – Douglas Diamond and Philip Dybvig — also represent a backward-looking view of the challenges of financial stability. Their principal work was to model the phenomenon of bank runs. Banks hold illiquid assets (loans), funded by liquid liabilities (deposits). These liabilities are fixed in nominal terms, so if there are any doubts about the health of banks, there will be a bank run as every depositor races to withdraw ahead of other depositors, before the music stops.

Does this sound familiar? Well, yes, because this has been front-and-centre in central-bank thinking for well over a century. Walter Bagehot set all this out in his book Lombard Street in 1873. The central bank advice he gave to restore stability (‘lend freely to solvent banks’) was the basic idea driving Bernanke’s finest hour, during the 2008 crisis.

So what was the contribution of Diamond and Dybvig? They showed how to make a mathematical model that would mimic bank runs. What happens in practice could, indeed, happen in theory. We have all learned from economic models, but policy-making in the unusual circumstances of the GFC and post-GFC era has benefited little from academic models, either in understanding what was going on or in predicting the future. Until 2008, the financial sector was a tiny appendage to standard economic models, providing few insights into the linkages with the real (GDP) sector.

Bleeding Obvious

Diamond and Dybvig’s contribution — that bank runs could be prevented by deposit insurance – again seems to be pointing out the bleeding obvious. Deposit insurance has, in fact, long been in place in many countries – in the US, since 1933. If there was any hesitation about introducing deposit insurance, it came from concerns about ‘moral hazard’ – insurance would undermine bankers’ sensitivity to risk. This dilemma is still unresolved.

But today’s quandary is trickier still: if deposit insurance is provided, then banks must be constrained by regulation and capital requirements, which encourage their intermediation function to shift to the shadow-banking sector. The non-bank financial sector has now become so big that it, too, has to be helped out in times of crisis. The need for central bank intervention has created ‘financial dominance’, where the financial sector excesses leave the authorities with no choice but to save the risk-takers.

Perhaps there is one virtue in awarding the prize to this threesome. Unlike the ‘real’ Nobel Prize, this one is not awarded by the original Nobel Committee, but rather by the Swedish central bank. This year’s award kept the prize within the central banking family, with Diamond and Dybvig being close friends of the central banking fraternity, reassuring central banks that what they were doing was based on sound theory.

Many still hold Bernanke in high esteem, mainly for his bold actions in 2008. This view is strengthened by his own accounts of recent monetary-policy history, where he examines his actions carefully and fails to find any fault. But the ground is shifting. It might have been better to hold the laurels for a year or two, until the outcomes of the Bernanke era had fully worked through and can be evaluated from a position of economic normality.