While Federal Reserve Chair Jerome Powell faces increasing pressure to curb economic activity in order to bring down widespread inflation, one of his predecessors is getting plaudits for his research on how to avoid financial downturns.
Ben Bernanke, who helmed the central bank through the financial collapse of 2007–2008, was awarded the Nobel Memorial Prize in Economic Sciences on Monday for his research on the role of bank runs in deepening and prolonging the Great Depression of the 1930s. Economists Douglas Diamond and Philip Dybvig were also honored for their work on the related topic of how banks mediate the relationship between borrowers and lenders, and how they should be regulated to avoid crises.
“The laureates’ insights have improved our ability to avoid both serious crises and expensive bailouts,” said Tore Ellingsen, chair of the Committee for the Prize in Economic Sciences, in a press release.
The winner's conclusions aren't necessarily new — the work being recognized came out in the 1980s — but it's proven highly relevant in the past four decades, as successive banking crises have provided opportunities for putting theory into practice.
Bernanke, for instance, cited his research on the Great Depression to justify an unprecedented monetary intervention following the collapse of the subprime mortgage market. The Fed at the time propped up failing banks with billions of dollars in asset purchases, known as quantitative easing, to stabilize the financial economy.
This stemmed directly from a desire to avoid the kind of cascading bank failures that Bernanke argued were a major reason for the severity of the 1930s depression. As his research pointed out, half of U.S. banks collapsed over a three-year period, mostly because they didn't have enough funds to pay for all of the panic-induced withdrawals.
Bank runs "happen when people who have deposited money in a bank become worried about the bank’s survival, and so rush to withdraw their savings," the committee explained in a document breaking down the insights in Bernanke's research. "If enough people do this simultaneously, the bank’s reserves cannot cover all the withdrawals and it will be forced to conduct a fire sale of assets at potentially huge losses."
While previous scholars treated the bank failures as a result of the Great Depression, Bernanke saw them as one of its main causes, extending what might have been a more short-lived recession into one of the worst economic downturns in history.
The committee's summary of the research also pointed out that banks became hesitant to make long-term investments, cutting off the supply of loans. "These problems with obtaining bank loans made it difficult for businesses to finance their investments, as well as huge financial hardship for farmers and ordinary households," it said.
In addition to Bernanke's efforts as Fed chair, other central bankers have seemingly internalized this lesson. Powell, for instance, acted quickly early in the pandemic to shore up banks' balance sheets to avoid a liquidity crisis that could have sent shockwaves through the world economy.
Since then, of course, very different economic challenges have come to the fore. With inflation near a 40-year high, Powell and other central bankers are raising interest rates and selling off assets purchased through quantitative easing. The goal is to curb economic activity such that it lowers prices, while avoiding a full-blown recession.
At the moment, it's unclear if Powell and company will stick the landing. Just last week, the Bank of England intervened in UK treasury markets to avoid a potentially devastating liquidity crunch, marking a sudden reversal of the bank's tightening measures. Indeed, the lessons being celebrated today are still top-of-mind for bankers, even as new obstacles present themselves.