A toolkit to fix Bernanke’s fixes may qualify for a future Nobel
PremiumThe remedy for a crisis often sows the seeds for the next calamity
Congratulations to Ben Bernanke, Douglas Diamond and Philip Dybvig, this year’s Nobel laureates in the Economic Sciences. As the citation reads, the trio have “significantly improved our understanding of the role of banks in the economy, particularly during financial crises." Few of us in life, and vanishingly few economists, get to put their work into practice on the largest stage, as Bernanke did in 2008. The former chair of the US Federal Reserve was not merely debating hypotheticals with his graduate students. He made critical decisions under the most intense pressure. And there should be no doubt that his understanding of the precise nature of the crisis [now often called the Great Recession] saved the global financial system in 2008.
Keeping the credit creation process intact by bailing out large US banks was a critical element in fostering the subsequent recovery. Unlike many of his peers, Bernanke grasped what was at stake. As his Nobel citation notes, bank collapses involve losing valuable information about borrowers that can’t be re-created quickly. The credit creation process is best handled by banks, but when they are weighed down by non-performing loans and lack of capital, they can’t perform that vital role.
In Europe, measures to support the banking sector were less structured and comprehensive, with an emphasis as much on “punishment" of those perceived to have been culpable for the crisis. As a consequence, Europe’s under-capitalized banks played no useful role in its post-crisis recovery. Instead, many countries remained in or near recession, ultimately leading to a series of sovereign crises, the echoes of which are still around today.
Another way of looking at the American banking recovery compared with that in Europe is to plot the KBW Nasdaq Bank Index, which has risen 65% since 2008, against its nearest European equivalent, the Euro Stoxx Bank Index, which, almost 15 years later, is still more than 70% below its pre-crisis level.
Indeed, despite their relative inaction, Europe’s banks and governments effectively got a free ride from Bernanke’s swift action to save US lenders. Had the US not acted, a global systemic collapse was a very strong possibility.
And yet, there is ultimately no escaping the fact that the 2008 financial crisis was in large part driven by policymakers and economists (in Bernanke’s case, it was one and the same) placing too much faith in the banking system’s ability to manage credit creation unburdened by oversight. Bernanke was very much at the vanguard of that movement.
This undue confidence in one of the most basic principles of market efficiency has been a factor in many celebrated economics Nobels. Gary Becker, the 1992 winner, argued vociferously that the labour market was so efficient that no action was required against racist employers because market forces alone would resolve the issue by driving them out of business. That argument has not stood the test of time.
Similarly, Franco Modigliani, who won an economics Nobel in 1985, and Merton Miller, who won in 1990, did valuable work on the capital structure of the firm. Yet their simplifying assumptions regarding the cost of bankruptcy did much to normalize high levels of corporate debt and leverage. This was one reason economists were so sanguine as debt spiralled ahead of the 2008 meltdown.
The timing of this year’s Nobel award is notable. It comes at a moment when the world is struggling with the consequences of extreme monetary intervention of the type that accompanied the bank bailouts. We may have made some progress since 2008 in understanding the need for pragmatic bank regulation.
However, we are no closer to recognizing that the remedy to a crisis often sows the seeds for the next calamity. Indeed, the financial sector is increasingly the cause of our problems rather than a hapless victim of the economy. That involves economists who run the show.
Economics has a history of producing Nobel laureates who present strong insights while also failing to grasp the practical realities and consequences of their findings. So, ‘well done’ to Bernanke and his fellow prize winners. But let’s not forget that the former Fed chair was at least partly to blame for the conditions that led to financial fragility in the early 2000s in the first place.
It would be harsh to say Bernanke was a firefighter who put out his own fire. Nevertheless, regarding the merit of the award, Friedrich Hayek, the Nobel 1974 winner, probably put it best: He said that the Nobel prize “confers on an individual an authority which in economics no man ought to possess."
Stuart Trow is a credit strategist at the European Bank for Reconstruction & Development.
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