Peter Coy - The Economics Nobel Is Richly Deserved, but It’s Hardly the End of the Story
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It’s essential to prevent banks from failing en masse when their loans start going bad. That was well established by the three American economists, including the former Federal Reserve chair Ben Bernanke, who shared this year’s Nobel Memorial Prize in Economic Sciences.
But you know what’s equally essential? Preventing banks from getting into this predicament in the first place.
Regulators have become very good at the first mission, not so good at the second. Banks and other financial institutions keep doing dumb things that put the economy and taxpayers at risk. The latest example is in Britain, where a sharp rise in interest rates wrought havoc on pension funds because of their poorly conceived bets on interest rate derivatives. The Bank of England was forced to come to their rescue.
Let’s back up for a moment. The three economists, who were honored on Monday, explained why banks are fragile in the first place and why it’s important to keep them from cracking up all at once. If you’ve ever watched the 1946 movie “It’s a Wonderful Life,” you’re halfway to getting their Nobel-worthy idea.
Douglas Diamond and Philip Dybvig collaborated on a short paper published in The Journal of Political Economy in 1983 that’s so famous among economists that it’s known simply as Diamond-Dybvig or even just DD. (Actual title: “Bank Runs, Deposit Insurance and Liquidity.”)
Diamond said they wrote the paper “so that the average central banker who’s not an economic theorist can understand it.”
The Diamond-Dybvig paper explains that banks exist to solve a problem: Some people have money, and others need it. Banks mediate between them. Banks guarantee to the savers that they’ll be able to withdraw their money at a moment’s notice. And banks guarantee to the borrowers that they won’t have to pay back their loans at a moment’s notice, which gives the borrowers the breathing room to do long-term projects. Everybody is better off because banks exist than if individual savers and borrowers had to make arrangements directly with each other.
Most of the time this works fine, but once in a while there’s a bank run. It starts when savers notice that most of the money in the bank has been lent out. They worry that if lots of their fellow savers ask for their money back all at once, there won’t be enough in the vault and the bank will fail. People line up to get their money out, and the bank run becomes a self-fulfilling prophecy. (Just ask Jimmy Stewart or read the excellent explanation of Diamond-Dybvig by my colleague Paul Krugman, who has a Nobel of his own.)
Deposit insurance, which Diamond and Dybvig like a lot, stops bank runs by assuring depositors that they don’t need to rush to get their money out before others do, because the Federal Deposit Insurance Corporation has them covered. (I’ll get to the problems with this in a minute.)
Bernanke, for his part, showed that bank failures were a cause, not just a result, of the Great Depression. Milton Friedman had pinned most of the blame for the Depression on the Fed’s overcontraction of the money supply. Bernanke showed that bank failures made matters much worse by destroying institutional knowledge about borrowers, thus interrupting the flow of money from savers to the people who need money for productive investments.
Bernanke concluded that government should serve as an unstinting lender of last resort to banks that were temporarily in trouble but fundamentally sound — a conclusion that he put into practice as Fed chair during the global financial crisis of 2007 to 2009. “The world was incredibly lucky to have Ben Bernanke sitting in the Federal Reserve during the crisis,” Diamond told an interviewer for the Nobel Prize website.
All that makes perfect sense. There’s a problem, though. Bank shareholders don’t have enough skin in the game in the current setup. They don’t have to worry that dunderheaded lending decisions will cause depositors to flee, because deposits are fully insured.
Bank shareholders also know there’s safety in numbers. While the F.D.I.C. might close down one bad bank in an orderly way, protecting depositors while wiping out shareholders’ investments, the government wouldn’t dare to permit the simultaneous failure of a large number of banks. That would feel too much like the start of the Great Depression.
Even a single huge bank, such as JPMorgan Chase, is probably immune from bankruptcy. We all saw how the 2008 failure of Lehman Brothers, which was substantially smaller, shocked the world financial system. No matter how much regulators insist they have a system in place to wind down a giant like JPMorgan Chase, its shareholders appear to assume — probably correctly — that failure would never be allowed to happen. “There’s no way in the world they’re going to let Jamie Dimon’s bank fail,” Anat Admati, a finance and economics professor at Stanford’s Graduate School of Business, told me, referring to JPMorgan Chase’s chief executive officer.
How, then, to ensure that the prescriptions of Diamond, Dybvig and Bernanke don’t give a free pass to banks’ shareholders (among whom are their top executives)? It’s pretty easy: Require shareholders to have more skin in the game. More to lose, that is, if the banks make bad decisions. A strong bank raises a lot of its money by selling shares to shareholders or retaining profits. A weak bank, by contrast, depends more on selling bonds, raising deposits or borrowing from other banks. A strong bank can withstand a decline in the value of its assets — the loans it makes — far better than a weak bank. The strong bank’s shareholders will suffer, but the bank will still be able to meet all of its obligations to creditors and depositors. The weak bank is more likely to need a government bailout.
“Banks get away with inefficient recklessness,” Admati told me, citing her 2013 book with Martin Hellwig, “The Bankers’ New Clothes: What’s Wrong With Banking and What to Do About It.” Regulators have forced banks to become safer since the global financial crisis, but Admati argues that regulators haven’t gone far enough. She says banks should be required to raise more of their money from shareholders — a position that the banks themselves vigorously resist. (Dimon likes to say JPMorgan Chase already has a “fortress” balance sheet.) The Nobel organization doesn’t wade into that controversy but does cite a 2002 paper by Russell Cooper and Thomas Ross that discusses coupling deposit insurance with more stringent bank capital requirements.
Another insufficiently addressed problem is the risk in the “shadow” banking system — financial institutions that aren’t regulated like banks but perform some of the same functions, such as money market mutual funds.
The Nobel to Diamond, Dybvig and Bernanke is richly deserved, but as the economists themselves would undoubtedly agree, it’s hardly the end of the story.
Elsewhere: India’s Sex Ratio Imbalance Has Shrunk
According to India’s National Family Health Survey, the wide ratio between baby boys and baby girls in India has shrunk considerably. From a peak of 111 boys per 100 girls in 2011, the ratio fell to 108 to 100 in the latest survey wave, which was conducted from 2019 to 2021. That’s not too far above the natural ratio of 105 to 100.
A Pew Research Center study released in August said that for most of the past two decades, “India on average had one of the world’s most skewed sex ratios at birth, after Azerbaijan, China, Armenia, Vietnam and Albania.” The skew began to appear in the 1970s, when abortion was legalized and prenatal testing became widely available. To narrow the imbalance, India banned prenatal sex tests in 1994. In 2015 Prime Minister Narendra Modi began a campaign called Save the Girl Child, Educate the Girl Child. The sex ratio imbalance has declined the most among Sikhs, who had the biggest skew, as high as 130 to 100 in the 2001 census, according to Pew.
Quote of the Day
“The metaphor of a ‘marketplace of ideas’ suggests that individuals are eager to offer and receive ideas, and voluntarily part with ideas that are defeated by better ones. But not all ideas are such that individuals would simply want to trade them away, as if they were some random market products. Some ideas, beliefs and convictions are part of individuals’ identity — giving them away means cutting out chunks of the fabric of emotions, convictions and memories that make up one’s self.”
— Lisa Herzog, in an email paraphrasing a passage from her forthcoming book, “Democratic Knowledge: Markets, Experts, and the Epistemic Infrastructure of Democracy.”
Peter Coy has covered business for nearly 40 years. Follow him on Twitter @petercoy
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