Sveriges Riksbank Prize in Economic Sciences 2022: Improving How to Deal With Financial Crises

The three United States-based economists who will share the 2022 Sveriges Riksbank Prize in Economic Sciences receive the award for demonstrating the importance of preventing widespread bank collapses, particularly during financial crises.

Ben Bernanke, a former professor at Harvard University and now at the Brookings Institution, shares the prize equally with Chicago Booth professor Douglas Diamond and Philip Dybvig, professor at Washington University in St. Louis, for decades of work that laid the foundations of research into why nations have banks, how to make them less vulnerable in crises, and how bank collapses exacerbate financial crises.

Improved Ability to Mitigate Serious Crises

In the official announcement, the members of the Prize Committee said the approach taken by the three economists had been of great practical importance in regulating financial markets and dealing with financial crises. Announcing the prize, Tore Ellingsen, chair of the Economic Sciences Prize Committee, explained: “The Laureates’ insights have improved our ability to avoid both serious crises and expensive bailouts.”

The Laureates’ contribution to the economics profession’s understanding of the role of banks in financial crises came through two discrete routes. Bernanke analysed the Great Depression of the 1930s, the worst economic crises in modern history.

In his classic 1983 paper in the American Economic Review, “Nonmonetary Effects of the Financial Crises in the Propagation of the Great Depression”, Bernanke explained why a mild recession in the United States in late 1929 turned into the Great Depression of the 1930s.

He showed that bank runs were a decisive factor in the crises becoming so deep and prolonged. When the banks collapsed, valuable information about borrowers was lost and could not be recreated quickly. Economic’s ability to channel savings to productive investments was thus severely diminished.

Before Bernanke published his article, the conventional wisdom among experts was that the Depression could have been prevented if the US central bank had printed more money. His analysis showed that factors that were directly linked to failing banks accounted for the lion’s share of the downturn in economic activity.

Theoretical Diamond-Dybvig Model

In the same year, Diamond and Dybvig published their seminal piece in the Journal of Political Economy, “Bank Runs, Deposit Insurance, and Liquidity”, that led to the development of the theoretical Diamond-Dybvig model which explains how banks create liquidity for savers while borrowers can access long-term financing.

Diamond and Dybvig also presented a solution to the problem of bank vulnerability in the form of deposit insurance from the government. When depositors know that the state has guaranteed their money, they no longer need to rush to the bank as soon as rumours start about a bank run. This stops a bank run before it starts.

For Tyler Cowen, Holbert L. Harris Professor of Economics at George Mason University, it was the most fundamental understanding, in modelled form, of how financial intermediation worked. “It is a foundation for how economists think about deposit insurance and also the lender of last resort functions of the [Federal Reserve].”

The two tracts of research combine to provide a comprehensive guide to handling financial crises. Diamond and Dybvig’s theoretical insights about the importance of banks and their inherent vulnerability provide the foundation for modern bank regulation, that aims to create a stable financial system. Bernanke’s analysis gives an insight into how regulation can fail and what countries can do to suppress an imminent panic.

Dealing With the Vulnerabilities

According to John Hassler, a member of the prize committee and economics professor at the Institute for International Economic Studies at Stockholm University, both contributions explained the role that banks play, their vulnerabilities, and what could be done to deal with that vulnerability.

“The theoretical work and Bernanke’s work on what was happening in reality in the 1930s fit together really well,” he said. “We can learn how important it is to make sure that the service the banks provide, namely transferring savings to productive investment doesn’t collapse. Because if it does, it has dramatic consequences.”

Bernanke’s scholarship in Great Depression economics was seen as key to his handling of the 2008/09 global financial crisis when he was the chairman of the US Federal Reserve board. When the Covid-19 pandemic hit in 2020, the Laureates’ insights played an important role in supporting the significant measures policymakers took to ensure that the impact on financial markets did not develop into a new depression.

As John Turner, a professor at Queens University Belfast, and Anil Kashyap, a former member of the Bank of England’s Financial Policy Committee, said in a joint piece for Economics Observatory, the award seemed “particularly timely”. “Their research has greatly improved our understanding of the role of banks – in normal times and in crises,” they wrote.

However, the committee was clear that timeliness of the issues surrounding bank collapses was not a relevant factor in making their decision in the award. “It’s true that it is very timely. That, of course, is nothing that we are unhappy with, but it was not the reason for giving the prizes,” Professor Hassler said.

Ben S. Bernanke

Ben S. Bernanke is a Distinguished Senior Fellow, Economic Studies, at the Brookings Institution in Washington DC. He served as the 14^th chairman of the Federal Reserve from 2006 to 2014. He was born 1953 in Augusta, Georgia, in the United States.  In 1979 he received his PhD from the Massachusetts Institute of Technology.

Douglas W. Diamond

Douglas W. Diamond is Merton H. Miller Distinguished Service Professor of Finance, University of Chicago, Booth School of Business, Illinois. He was born in 1953 and in 1980 received his PhD from Yale University. He is a former president of the American Finance Association (2003) and the Western Finance Association.

Philip H. Dybvig

Philip H. Dybvig is Boatmen’s Bancshares Professor of Banking and Finance at the Olin Business School of Washington University in St. Louis, Missouri. He was born in 1955 and received his PhD in 1979 from Yale University. He was president of the Western Finance Association from 2002 to 2003.