Crisis Nobels: A reminder sound banking regulation is vital

The Nobel Memorial Prize in Economic Sciences for 2022 has been awarded to three economists based in the United States: Ben Bernanke, Douglas Diamond, and Philip Dybvig. The citation for the Prize notes that all the three economists in question have worked on the centrality of the financial system to economic crises, and on how governments can and should intervene to prevent or ameliorate such financial crises. Mr Bernanke famously was “the right man in the right job at the right time”, in that his studies of the responses, both successful and unsuccessful, to the 1930s Depression came in handy when he was chairman of the United States Federal Reserve during the 2008 financial crisis. Given the multiple sources of turbulence affecting the global economy today, some of which threaten to tip over countries into full-blown crises, there is no question that the Prize Committee was trying to make some sort of point about an informed response to economic crises, and that the financial system is often at the heart of both the problem and the solution.

Mr Bernanke, in particular, is a lightning rod for criticism from both the left and the right —maybe more than any other living economist save perhaps Larry Summers. The left blames him for bailing out the banks; the right for not saving Lehman Brothers and for praising loose fiscal policy and attacking “austerity”. More reasoned criticism of his record might note that the unconventional methods used after the crisis proved hard to withdraw, and must bear some responsibility for more than a decade of low productivity, growing inequality, and increasing debt that followed the crisis. Yet there is no question that, perhaps as a consequence of his understanding of the 1930s, he went the extra mile to try and save the banking and financial system. It is perhaps this notion of policymakers shaped by existing research, more than any particular stance, that the Prize Committee is trying to praise. Even during the Covid crisis, the Fed and several other central banks used the same crisis playbook, and even went beyond to save the financial system as well as the real economy.

The Diamond-Dybvig model, meanwhile, is almost four decades old but is central to understanding how banks function in the economy, how runs on banks should be understood, and how they can be prevented. Essentially, it became clear through the model that restoring credibility in the banking system is something best done at a high level — rather than, for example, by shutting off account closing or withdrawals. The Indian policymaking establishment revealed that it had internalised this advice when there were rumours about a run on one large private bank during the financial crisis, and it took a number of steps to bolster public confidence. While the context may be different, given the salience of public-sector banking in India, the basic importance of banking stability remains — for example, in India a bank crisis can all too soon become a fiscal crisis. The award, therefore, can be seen as being about the centrality of safe and sound banking regulation to macroeconomic stability. It may be hard to remember a time when the need to protect the workings of the banking system and possible response to a major crisis was as clearly understood.