An economics Nobel by and for central bankers

Now that the 30 days are up, I’m posting my entire WSJ op/ed on the latest winners of the Nobel Prize in Economics, the morning the prize was announced.

An economics Nobel by and for central bankers

Winners have views on dealing with the financial crisis that many financial economists find strange.

By David R. Henderson

Oct. 10, 2022 at 6:34 pm ET

The committee that awards the Nobel Prize in Economics announced on Monday that it has chosen three US economists for the 2022 prize: former Federal Reserve Chairman Ben S. Bernanke, Douglas W. Diamond of the University of Chicago and Philip H. Dybvig of the University of Washington in St. The Louis Prize is for “Research on Banks and Financial Crisis”. The committee commended the winners for doing work of “very practical importance in regulating financial markets and addressing financial crises”. Many financial economists would disagree.

A casual reader of Mr. Bernanke’s award-winning work may have found it to be Milton Friedman and Anna J. See Schwartz’s 1963 book, “A Monetary History of the United States, 1867-1960” adding some detail. Actually, it was quite different. “I want to tell Milton and Anna: About the Great Depression. You’re right, we did it. We are very sorry. But thanks to you, we won’t do it again,” said Mr. Bernanke, then a member of the Fed’s board of governors, at Friedman’s 90th birthday party in 2002. Unfortunately, as Fed chairman, Mr. Bernanke, along with his fellow Fed governors, have done it again.

The main conclusion that Friedman and Schwartz reach in their analysis of the Depression is that the Fed, failing to act as a lender of last resort, allowed the money supply to contract by 30% between 1929 and 1933. Still, in explaining his choice, the Nobel committee on this year’s award wrote, “Before Bernanke [1983] study, the general impression was that the banking crisis was a consequence of a declining economy, rather than a cause.” This would probably surprise even Mr. Bernanke, who, he noted, placed too much weight on the Friedman/Schwartz intuition.

The difference between the Bernanke and Friedman/Schwartz views was that Mr. Bernanke felt that providing more liquidity during the crisis was not enough; He stressed the importance of rescuing particular financial intermediaries, even if some of them should arguably have gone bankrupt. Although his academic work on the subject was deep and impressive, his tenure as Fed chairman unfortunately forced him to ignore liquidity during the financial crisis. Many financial economists, including Jeffrey Hummel of San Jose State University at the time and Scott Sumner, an economist at Bentley University who studied under Friedman, recognized that the key was to expand the money supply rather than select specific firms to help.

As Mr. Hummel pointed out in 2011, Mr. Bernanke did not expand the money supply enough. Quantitative easing, which expanded the money supply, got all the press. Less talked about were two of Bernanke’s initiatives that stifled money supply growth. One was the sale of Treasury securities, which took much of the money the Fed injected into the economy in 2008 through the Bear Stearns bailout and term auction facilities. Economists call this “sterilization.” The result is that in the year ending August 2008, the monetary base (currency plus bank reserves) grew by $20 billion or 2.24% less. If Mr. Bernanke had only increased the money supply substantially, as Alan Greenspan did in response to the 1987 market crash, the 2007-09 recession would have been shorter and shallower. A second measure of liquidity control was Mr. Bernanke’s 2008 choice to pay interest on bank reserves, causing banks to sit on reserves instead of lending them out.

Messrs. In the case of Diamond and Dybvig, their 1983 model provides a theoretical explanation of bank operations, but what is called a “bank” is not the same as any bank as we know it. George Mason University’s Lawrence H. As White points out in his 1999 book, “The Theory of Monetary Institutions,” the model envisions an economy in which a single bank does not make loans and does not issue checking accounts. The reason banks run according to the model is that investors (not account holders, since there are none) get nervous and try to cash out their investments. The Diamond/Dybvig model uses this bank-driven potential to justify deposit insurance.

Mr. White noted that there are ways to “run-proof” real banks. One is to make checking accounts more like money-market funds. Although the Fed, mistakenly in my view, opposed “breaking the buck” during the financial crisis, allowing money market funds to be redeemed at 97 or 98 cents on the dollar would have set off a run. Another way to prevent runs is for banks to stipulate that depositors cannot access their deposits until they mature. Another, which occurred before the Federal Reserve was established in 1913, was the suspension of convertibility of deposits into currency. That way, people can still write checks, but the bank, if only liquid but not insolvent, won’t suffer.

The Nobel Prize in Economics is funded by Sweden’s central bank, not the Nobel Foundation. I usually don’t think it matters, but in this case I wonder if it does. The 2022 award appears to be an affirmation by central bankers of the value of central banking.

Mr. Henderson is a research fellow at the Hoover Institution at Stanford University and editor of the Concise Encyclopedia of Economics.

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