The Economics Nobel Prize Could Save the Economy

The Nobel Prize for Economics was announced in early October by The Royal Swedish Academy of Sciences . The winners were the former US Federal Reserve Chair Ben S. Bernanke, and his American academics Douglas Diamond and Philip Dybvig. As economists universally would agree, Dvbvig and Diamond’s work has been foundational for studies on banking and its vulnerabilities. As a former Ph.D. scholar in the field myself, it is a lot of intellectual joy to learn about research that goes beyond mere theory, and can make a practical difference.? This study on banking crises can play a pivotal role in preparing for the next few years, and understanding how we can avoid the worst of it. Here’s why.

It was nice to find an actual banker on a list usually filled with academics. The Academy changed its tune and included an actual practitioner of economics policy – Bernanke who led the Reserve for a challenging tenure during the US financial crisis. Diamond and Dybvig - the other two laureates published a paper together in 1983 on how deposit insurance can prevent bank failures. This was so foundational to the field that most students have read it at some point – we call it just Diamond-Dybvig or DD. The two academics wrote it such that it could be understood by bankers who were not economist theory experts. It really proves that simple explanations can accompany the most path-breaking discoveries!

The revolutionary paper explains banking in terms that could be understood even by school children. Some people have money while others need money. The paper basically explains how “banks mediate between them. Banks guarantee to the savers that they’ll be able to withdraw their money at a moment’s notice. And banks guarantee to the borrowers that they won’t have to pay back their loans at a moment’s notice, which gives the borrowers the breathing room to do long-term projects. Everybody is better off because banks exist than if individual savers and borrowers had to make arrangements directly with each other.”

Where does this go wrong? If savers start worrying about getting their money back from the bank, they line up to withdraw it all at once. Bernanke’s research on the Great Depression comes in here, establishing how this banking collapse is what causes recession. The bank also is an entity that possesses in-depth knowledge of which borrowers would make productive investments. When they collapse, so does this knowledge capital. The economy soon follows too.

The solution might lie in a little something called deposit insurance. As Diamond and Dvbvig write, the state can offer insurance by promising savers to get their money back, if the bank is unable to repay them. This can ease the anxiety of a saver and not make them rush to withdraw money on rumours of a collapse. The insurance also might mostly remain as theory and never actually used. Everyone stays happy.

There is a lot more that this research can contribute to shaping our banking systems and fail-proofing them, you can read some here and here. I’d love to know your thoughts about this study, tell me in the comments below.