The Nobel prize in economics is formally known as the Swedish Central Bank’s Prize in Economic Science in Memory of Alfred Nobel. Unlike the real Nobel prizes which were first awarded in 1901, the economics prize was instituted in 1969 by a group of Swedish economists who wanted to make economics look ‘scientific.’
It was a noble intent (pardon the pun), but it came with one flaw: economics is not a natural science. It is, has always been, and will always be a social science. Unlike physics, with which many economists would like to compare their discipline, it cannot be studied by means of rigorous mathematical models and strict, universally applicable laws.
Economists will argue passionately that the economy absolutely can be explained in mathematical terms. They are wrong: economics can only be studied properly based on the axiom that human nature—unlike physical nature—is unquantifiable.
Two of the winners of this year’s prize, Douglas Diamond of the University of Chicago and Philip Dybvig of Washington University in St. Louis, were selected precisely for their efforts to explain long-established business practices in mathematical terms. The third laureate, Ben Bernanke, who chaired the Federal Reserve from 2006 to 2014, gets the prize for having explained that when bank customers withdraw their money faster than the banks get payments from their debtors, banks are not very likely to give out new loans.
While Bernanke’s contribution is interesting from a documentary viewpoint—he concentrated a large amount of information regarding the Great Depression into one scholarly article—the originality of his work is elusive.
Before we dig deeper into the modestly impressive scholarship that earned this year’s economics prize, let us note that the professional activities of these three gentlemen are partly responsible for the high inflation we are having to endure today. Bernanke bears the brunt of the responsibility: while Federal Reserve chairman, he oversaw one of the largest monetary expansions since the 1970s. This expansion opened the proper transmission mechanisms from money to inflation. After that, it was only a matter of time before we would have a bad case of monetary inflation on our hands.
To be fair, some of the economics laureates over the years have made significant contributions to the discipline and the profession. The first two laureates, Ragnar Frisch and Jan Tinbergen, improved econometrics, i.e., the methodology for statistical analysis of economic activity.
Paul Samuelson got the prize in 1970 for having formalized macroeconomics and improved our understanding of static and dynamic analysis. In 1972, John Hicks was rewarded for pioneering work that later became the indispensable IS-LM model of macroeconomics.
A year later, Wassily Leontief was recognized for having developed the so-called input-output analysis, which effectively allows economists to see in great detail how individual sectors and industries trade with each other.
In 1984, Richard Stone got the prize for his contributions to national accounts, the accounting system’ for a nation’s entire economy.
Other laureates, among them Robert Merton and Myron Scholes, were unlucky enough to have their theories put to work in real life. Robert Mundell received the prize in 1999 for having laid the foundations for the euro zone.
This brings us back to Ben Bernanke, Douglas Diamond, and Philip Dybvig. If I were to summarize the motivation that the prize committee gave for picking them as this year’s laureates, it would be as follows:
If banks get risk-free government money, then banks don’t have to take risks.
Ihave been a student and practitioner of economics for more than 35 years, 22 of those as a Ph.D., and I have read the scientific explanation for almost every economics prize all the way back to 1969. Sad to say, this year’s explanation is one of the weakest (and I will not even belabor the spelling errors).
But wait—why does it even matter what these economists are being rewarded for?
Usually, it does not. The history of the economics prize is littered with trivial and openly illogical scholarship that has had at best marginal impact on the real world. My favorite among them is the work on which Finn Kydland and Ed Prescott got the prize in 2004. Their theoretical work is founded on the assumption that time can simultaneously be both historical and logical (i.e., you can travel back and forth in time at your own pleasure).
Try to put that theory to work and win big money. Or win big money without trying. QED.
So long as such logical somersaults are made within the confined space of academic economics, we who live in the real world have no reason to be worried. That changes when the rewarded research informs government policies, and when said policies lead to high inflation and piles of increasingly unsustainable government debt.
The contributions from Bernanke, Diamond, and Dybvig can essentially be divided into two parts. The first, for which Diamond and Dybvig are responsible, is centered around an article in the Journal of Political Economy (June 1983) called “Bank Runs, Deposit Insurance, and Liquidity.” Here, they present a mathematical model that proves two things:
- That banks are necessary for an economy where some people save money and others want to borrow money; and
- That banks are less inclined to fail if they get free money from government when they are about to fail.
To reach these conclusions, the two newly minted Nobel laureates focus on the fact that banks lend money on long-term loan contracts but accept deposits—in other words, borrow money from their customers—on mostly short-term conditions. This maturity imbalance between bank assets (loans) and liabilities (deposits) is a problem that has existed since the invention of the depository institution.
It is also a problem that bank executives have learned to master for just as long.
Diamond and Dybvig focus on what happens when people lose faith in their banks and set a ‘bank run’ in motion. Since banks cannot simply call in the loans they have given out, they end up in liquidity distress.
To prevent a financial crisis under these circumstances, Diamond and Dybvig want to see a system of deposit insurance, preferably anchored in a government guarantee. The last part is essential, they explain (p. 404), because the private sector is unable to provide this insurance on its own (p. 413), and government has taxation powers.
Bernanke gets the prize primarily based on his article “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression” (American Economic Review, June 1983). Here, says the prize committee, Bernanke shows that banks failed during the Great Depression in the 1930s mainly because of ‘bank runs’ caused by irrational panic. The resulting withdrawals drained the banks of liquidity and forced them to ration or even terminate new lending.
Again, this is the gist of why the Nobel economics prize committee gives him the prize. As it happens, this is not what Bernanke says in the aforementioned article. He mentions the bank-run phenomenon and gives it some analytical attention, but he does not find, nor does he claim to find, that bank runs caused bank failures during the Great Depression.
His main point, albeit inadequately spelled out, is that banks restricted lending because they were prudent about their balance sheets.
Long story short: Bernanke demonstrates convincingly that during the Great Depression, banks acted exactly as they could be expected to do. They wanted to solve the maturity mismatch problem by reducing the long-term maturity of their assets—in plain English, turning tomorrow’s revenue into cash today.
Banks were also highly restrictive in giving out new loans, and the reason, Bernanke almost spells out, was that it is difficult to find credit-worthy borrowers in the midst of an economic depression.
Again, the economics prize committee basically flies past this part of his research. Their spotlight is on the ‘bank run’ phenomenon, which runs on a side track in Bernanke’s article.
The lack of originality in the awarded research is obvious to anyone who bothers to study the literature on the role of uncertainty in economic activity. It has been well known since at least Frank Knight’s classic Risk, Uncertainty, and Profit (1921) that when businesses face uncertainty, they reduce their investment horizon and increase the liquidity in their assets. In this respect, banks are no different from non-financial corporations.
As I showed in my own doctoral thesis, households act exactly the same way.
There is a long tradition of research on how economic decision-makers respond to uncertainty. Much of it precedes Bernanke, Diamond, and Dybvig, often by decades. They could have benefited from Keynes’s Treatise on Probability (1921) as well as Armen Alchian’s exemplary “Uncertainty, Evolution, and Economic Theory” (Journal of Political Economy, June 1950).
But perhaps the most surprising omission by Bernanke et al is the entire Austrian school of economics. At no point do they pay any attention to it. This is unfortunate, to say the least: no theoretical strain in economics has more aptly explained the intertemporal role of money in the economy, and thereby how it is affected by uncertainty.
If there is one book that every monetary economist needs to read, it is Theory of Money and Credit by Ludwig von Mises. Published in 1912, this book established the thesis that money is no more, no less valuable than its role as a means of exchange. (Mises uses the term “commodity of exchange.”) At the risk of unduly under-reporting the significance of Mises’ contribution, it says that when economic decision-makers have no good reason to spend money, they will have no need to hold it. Therefore, money loses its exchange value.
The direct consequence of this value loss is that it does not matter how much money is piled up on bank balance sheets—nobody will demand it.
When this point is applied to the situations that Bernanke et al discuss, it immediately moots their conclusions. The most important policy implication of theirs is that the central bank should function as a lender of last resort and thereby a liquidity anchor for the banking industry. When banks end up in the crises that Bernanke et al analyze, the central bank is then supposed to print money and provide lines of credit for the commercial banks.
Here is where the central bank’s last-resort lender function turns it into a faucet of monetary expansion. The only way that the central bank can meaningfully save banks by printing money is if it lends them money on maturity terms that are so good that the banks will be guaranteed to have the cash available no matter when their loans expire. If their average asset matures in five years, then the central bank must lend the banks money for at least five years.
The central bank’s last-resort lender status creates an incentive for banks to disregard traditional market conditions for their operations. When they no longer have to manage the maturity imbalance between assets and liabilities, they can increase their exposure to risk in lending.
A defaulted loan, namely, is really nothing more than an asset with an infinite date of maturity. The central bank can easily compensate the commercial bank by extending its liquidity guarantee to the next Big Bang.
Which, of course, is the same as printing new money.
This year’s economics prize winners are good economists, but their research is far from the original contribution that should merit a Nobel Prize. While one example is not enough to make the case that the economics prize is past its prime and ripe for the history books, the 2022 prize is representative of a disturbing trend in how the prize is awarded. Trivial, sometimes outright illogical research is being elevated to the same status as winners of prizes in physics, chemistry, and medicine.