Nobel for Economics highlights crucial role of banks

The Nobel Prize for Economics 2022 has gone to three American economists, one of them former Federal Reserve chair Ben Bernanke. The other two are Douglas Diamond and Philip Dybvig. They belong to the same generation. Bernanke and Diamond were born in 1953 and Dybvig in 1955. The Nobel committee chose them for the prize for their explanation of the role of banks in a modern economy, how they are important and at the same time how vulnerable they are, and why governments need to prop them up as it were.

Daimond and Dybvig explain how the banks perform the most essential and useful role: the money saved in the banks by depositors is channelled into productive investments, which in turn keeps the economy running, creates jobs, and fuels economic growth. If the people did not deposit money in the banks as savings, then the banks would not be able to fund the borrowers to start and run businesses. But the depositors keep the money in the banks so that they can access them any time they want because it is their money. But if there are larger number of depositors, then it is expected that not all depositors would want their money back at the same time. If all the depositors were to demand their money at the same time, then it would mean that there is a run on the bank and the bank would collapse. It is to prevent this collapse that governments guarantee deposit insurance, which is needed to keep the system running. Bernanke studied the role of the banks during the Great Depression of the 1930s and found that it was the collapse of the banks that precipitated the Depression and lengthened its duration. That is why, when he was Fed Reserve chair at the time of financial meltdown of 2008 in America, he drew upon the lessons of his study and pumped in funds to bail out the big banks so that the economy would not collapse. It was the biggest government-managed rescue package in a free market economy.

The Nobel committee chose to recognise the work of these three economists at a time when the central banks are playing a crucial role in managing the economy and protecting it from runaway inflation. Central banks in many of the developed countries are doing this by raising interest rates to cool inflation. A researcher working on the theory of the role of central banks and the calibration of interest rates would win the Nobel for economics in the future as many experts feel that management of interest rates is one of the effective ways of managing inflation.

The Nobel for Economics is formally known as the Sveriges Riksbank Prize in Economic Sciences, and it was established in 1970. The economics prize has been open to criticism and debate much more than the other prizes. For example, the 1997 Nobel Prize was given to Robert Merton and Myron Scholes for their work on the valuation of stock options, and how the risk involved in it is distributed through derivatives. But in 1998, the theory faced its greatest setback as the stock markets crashed. And it is the Credit Default Swap (CDS) that was the trigger for the collapse of investment banks in 2008. This was indeed the Black Swan event in the history of the Nobel Prize for Economics. Most of the awardees were recognised for their work on different aspects of modern economy, The Nobel for Economics brings to the fore some of the complexities of the system as it works on the ground and how theory helps understand the phenomenon.