Why Nobel Fails to Answer the Question of Extra Money

Nonetheless, what Baghote offered was just an informal theory. In the 20th century, economists have transformed such informal theories into mathematical macroeconomic models. Three such economists, Ben Bernanke, Douglas Diamond and Philipp Diebwig, have been awarded the Nobel Prize in Economics for 2022. So the question is why did these three economists share the prize.

You might also like

Why are TCS investors upset?

The promise and risk of flex fuel vehicles

Railways may ban Oracle if bribery allegation is proved

Why did this techie from Bangalore shift 5 houses in 6 years?

Consider an economy where there are no banks. Such an economy will also have investment projects that need to be financed. Without banks, families can finance them directly. The trouble is that families who are suddenly in need of money will be forced to end these projects early, leading to diminishing returns. In a 1983 research paper, Diamond and Diebwig explained that in such a situation, banks would “naturally emerge as intermediaries”.

People used to deposit money in banks which then lent that money. If required, depositors will be allowed to withdraw deposits early, “without losing as much as they had invested directly but terminated the project early. This dynamic, called ‘maturity change’, replaces short-term deposits.” In long-term loans like housing or business loans, it works only because most of the depositors leave their deposits with the bank most of the time.

However, this weakens the business model of banks. Irrespective of the financial position of a bank, a rumor may start, resulting in many people coming to withdraw their deposits at the same time. The bank may not have that much free cash, which forces it to prematurely end its long-term investment projects and sell assets in fire-sales. This can also be the reason for its downfall.

Diamond and Diebwig said government policies to insure deposits or a central bank acting as a lender of last resort could help prevent a bank run.

So, where does Ben Bernanke fit in? Bernanke is a scholar of the Great Depression that began in 1929. Until the early 1980s, the thinking was that this economic phenomenon occurred because the US government of the time caused banks to fail, causing a massive contraction in the money supply, falling prices, and hence the Great Depression.

In a 1983 research paper, Bernanke argued that the Great Depression occurred because people who had deposited money in banks became anxious and rushed to withdraw. The Federal Reserve did not offer insurance on bank deposits. With bank running becoming common, the remaining banks became reluctant to lend, leaving businesses unable to invest. This caused “financial hardship for farmers and ordinary families”. This is where Bernanke’s work meets Diamond and Diebwig.

A situation similar to 1929 emerged in 2008 and 2009. The runs were not on banks, but on shadow banks, which had become a large part of the American financial system. Many of them were in the business of borrowing for very short periods and lending for long periods. To survive, he needed money on an almost daily basis. The trouble was that the money market dried up after the investment bank Lehman Brothers went bankrupt in mid-September 2008.

While all this was happening, Bernanke was the president of the Fed and put his learnings into practice. The Fed acted as the lender of last resort, flooding the financial system with money and ensuring that both shadow and commercial banks did not collapse.

The idea was to prevent the next Great Depression. Soon, other central banks in the wealthy world were printing money and pumping it into the financial system by buying bonds and making sure there was enough money going into the financial system, with no fear of the bank running and falling.

The trouble was that Bernanke and other central bankers turned it into a habit. The initial idea was to print money and save banks from collapsing. But after 2010, the Bernanke-led Fed printed money to lower long-term interest rates in hopes of boosting consumer demand as well as getting businesses to borrow and spend more.

There was also hope that lower interest rates would bubble up in the stock and real estate markets. It will make people feel rich and will motivate them to spend more money. Other central banks followed the Fed, turning the global economy into a bubble economy and central banks into money-printing machines. There is still no clear plan on how these central banks are planning to withdraw the money printed by them.

Sadly, the Nobel committee made no mention of it, and neither are economists writing spectacles for this year’s laureates. The question remains: how will all this mass money-printing end? Maybe in the future the Nobel Prize will be won by economists who answer this simple question.

Vivek Kaul is the author of ‘Bad Money’.

Elsewhere in Minto

In Rai, Rahul Mathan writes on an IT Act change that will enable digital deals in real estate, L Viswanathan and Anu Tiwari write how a CBDC will help banks and fintechs Companies rediscover themselves. Long Story Explores the Curious Case of Becoming a Little-Known Bank a fintech darling,