At the Expense of Others

This year’s prize for the beginnings of financial macro was designed to showcase how economic science makes progress

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STOCKHOLM – Eight economists last week received invitations to Stockholm in December, three of them living, five of them dead. Three will show up, to accept their Nobel Memorial Prizes in the Economic Sciences.  The five Spirits summoned, all but one laureates themselves, are still teaching, though only as textbook legends. A sixth Specter, significant to the story, did not make the list. He died in 2018.

Ben Bernanke, an applied economist who gradually became a central banker; and theorists Douglas Diamond and Philip Dybvig, who remained university professors for forty years, were recognized last week for two particular papers about banking and financial crises they wrote in 1983

“Bank Runs, Deposit Insurance and Liquidity,” by Diamond and Dybvig, in the Journal of Political Economy; and “Nonmonetary effects of the financial crisis in the propagation of the Great Depression,” by Bernanke, in the American Economic Review, were the only the first statements of the problems on which they intended to work.  Many others technical papers followed, at first by the authors themselves, then by members of growing community of fellow-researchers determined to extend the boundaries of the field.

Neither of those first two papers settled anything.  Together, however, they announced research projects that constituted “discoveries,” in the language of the citation, which, in the course of time and combination with the insights of many others, “improved how society deals with financial crises” – the essential condition of any Nobel Foundation science prize.

How?  By demonstrating to a new generation of researchers how to approach exploring the previously uncharted territory of “financial intermediation, meaning the operations of the institutions that occupied the larges space between two well-established regions: Keynesian macroeconomics, and its’ preoccupation with business cycles; and “monetarism,” a somewhat old-timely fascination with the history and theory of money and banking.

In other words, this year’s prize recognizing the financial macroeconomics that has begun to emerge like a new text-book chapter from the void is more rhetorically powerful than it seemed, at least in the course of the usual show-business ceremony with which the prize was announced last Monday.

A 72-page essay on the scientific background of the award spelled out the story for those with the curiosity and patience to read. It tells a story of how economics makes progress: one generation of economists feasts on the glory of another. That is, newcomers to the discipline supplant one source of excitement with another.  In this case the new excitement arrived just in time.

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From the very beginning of their modern science, the background citation asserts, economists were well aware of the existence and nature of banks, of course. David Hume and Adam Smith were well aware of how bankers took deposits and then extended much more credit than the cash reserve they kept in the till.  Hume and Smith knew all about the panics that regularly occurred when all the depositors wanted their money back  at the same time. (The long citation mentions the Frank Capra movie, It’s a Wonder Life.)  Smith reasoned that free competition among banks would solve the problem, as long as lenders were prudent and followed the “real bills” rule.

During the nineteenth century, economists mostly left the discussion of banks to bankers (Henry Thornton) and journalists (Walter Bagehot) while they worked on the problems of supply and demand that they cared about most.  What they called “general equilibrium theory” emerged.  Only in 1888 did the pioneering mathematical economist and statistician Francis Ysidro Edgework construct the first model of fractional banking.

Fast forward to the years after World War II, when economists began to write in mathematics instead of natural language, the better to be more clear among themselves. The ramifications of competition gradually became clear by formally modeling it as though it were perfect. And the first major payoff of mathematical language was the discovery that, at least in some important ways, everyday competition definitely wasn’t perfect. A model of monopolistic competition had emerged in the 1930s,(a little too early for the Nobel Committee to take note of it, since Edward Chamberlin died in 1967, two years before the first prize was awarded. Meanwhile, banking, whatever it was, remained the business of bankers.

In the 1970s, a significant part of the excitement in mainstream economics had to do with something called the Modigliani-Miller theorem. The authors, Franco Modigliani and Merton Miller, had met in the 1950s as colleagues at the Carnegie Institute of Technology in Pittsburgh. In 1958 they agreed to teach a course in corporate finance in the business school there.  What emerged was what Peter Bernstein, in Capital Ideas, The Improbable Origins of Modern Wall Street (1992), called “the bomb shell assertion.” This was the proposition that, thanks to the  principle of arbitrage, the ratio of debt to equity in a firm’s capital structure didn’t matter; Under perfect competition, in the absence of frictions and asymmetries of all sorts, no matter how the firm was financed, the enterprise value of the firm would be the same.

Enter financier Michael Milken, who in the 1970s pioneered modern high-yield (“junk”) bonds. Soon the debt-based restructuring takeover boom of the 1980s was underway.  Modigliani was recognized in 1985 by the Nobel Committee “for his pioneering studies of savings and financial markets.  Five years later, Miller shared the prize with two other pioneers in finance for, in his case, his collaboration with Modigliani on “The Cost of Capital, Corporate Finance and the Theory of Investment.”

It was amid this commotion that the situation arose in which Diamond and Dybvig took up their challenge.  Banks in the 1980s were large, ubiquitous around the world, and enormously profitable.  But why did they exist at all? , In 1980, the author of one survey of the literature on banking stated: “There exist a number of rival models and approaches which have not yet been forged together to form a coherent, unified and generally accepted theory of bank behavior.

Diamond and Dybvig did just that, according to the citation, offering two critical insights in the process.  There were “fundamental reasons why bank loans are a dominant source of financing in the economy” for one thing, and “for why banks are funded by short-term, demandable debt. For another, that meant that “banks are inherently fragile and thus subject to runs.”

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Bernanke approached the problem of financial intermediation from a different direction – from curiosity about the mechanisms of business cycles characteristic of the Keynesian macroeconomics that he studied at the Massachusetts Institute of Technology.  Dale Jorgenson had been Bernanke’s adviser at Harvard College. Stanley Fischer supervised his dissertation, along with Rudiger Dornbusch and Robert Solow. He finished “Long-term commitments, dynamic optimization, and the business cycle” in 1979 and took a job at Stanford University.

As the citation puts it:

The dominant explanation at the time for why the Great Depression was so deep and prolonged was due to Friedman and Schwartz (1963). They argued that the waves of banking crises in 1930–1933 substantially reduced the money supply and the money multiplier. The failure of the Fed to offset this decline in money supply in turn led to deflation and a contraction in economic activity.

Friedman had moved from Chicago to San Francisco, where he taught part-time at Stanford. There was not much other than traditional money and banking in A Monetary History of the United States, by Friedman and Ann Schwartz, The citation continues,

Bernanke (1983) proposed a new (and in his view complementary) explanation of why the financial crisis affected output. According to this view, the services that the financial intermediation sector provides, including “nontrivial market-making and information gathering,” are crucial for connecting lenders to borrowers. The bank failures of 1930–1933 hampered the financial sector’s ability to perform these services, resulting in an increase in the real costs of intermediation. Consequently, borrowers – particularly households, farmers, and small businesses – found credit to be expensive or unavailable, which had a prolonged negative effect on aggregate demand. Bernanke combines examination of historical sources, statistical analysis, and (at the time) recent theoretical insights to build this argument.

The lingering controversy between Keynesians and monetarists persists even today – about the cause, length, and depths of the Great Depression – was it the result of bad monetary policy carried out by the Federal Reserve Board in the United States, according to Friedman, or the outcome a world-wise series of accidents dating from World War I, in  MIT’s Paul Samuelson’s view? The citation states:

To be clear, Bernanke’s analysis does not engage in the discussion of what caused the initial economic downturn in the late 1920s that subsequently escalated into the Great Depression, and this was not the focus of Friedman and Schwartz either. Similarly, when we discuss the Great Recession below, the core issue is not about its origins but on the mechanisms by which the recession played out.

Whatever the case, though, Bernanke stated his own view when, in 2002, in an important speech as a governor of the Fed at a celebration for Friedman’s ninetieth birthday, he concluded:

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.

The citation, however, sticks to what happened in 1983:

From the perspective of the contributions by Diamond and Dybvig, Bernanke’s work can be seen as providing evidence supporting their models. Specifically, he provides evidence that bank runs can lead to financial crises (as in Diamond and Dybvig, 1983), which in turn leads to prolonged periods of disruption of credit intermediation, consistent with bank failures destroying the valuable screening and monitoring services banks perform (as in Diamond, 1984).

Thus the guest list for this year’s prize celebration includes Bernanke, Diamond, and Dybvig. Perhaps the authorities will find a seat as well for Stanley Fischer, former president of the Bank of Israel. But the honored ghosts whose earlier work the three displaced will be present as well: Modigliani and Miller; Samuelson, Friedman, and Anna Schwartz, Only Dr. Schwartz failed to  receive the ultimate diploma, but then the centrality of A Monetary History was not yet apparent in 1976, neither the extent of her contribution to it, when Friedman received his prize.

As for what happened in 2008, the prize citation has nothing to say. Wall Street Journal columnist Greg Ip noted that “Outside of a footnote, the committee managed to ignore Mr. Bernanke’s central role in responding to that crisis. The Swedes chose to tell the story from its beginning, instead of its end. What, then, did we learn from the 2008 crisis? We’ll have to wait a little longer for that prize.

Meanwhile, what about that sixth Specter, the uninvited guest at the banquet?

That would be Martin Shubik, of Yale University, a long-time player in the Nobel nomination-league, who supervised both Diamond and Dybvig in their graduate studies. Shubik himself had worked, for a dozen years without conspicuous success, on the more forbidding problem of integrating the production of money and banking into the market system Not long before he died, he believed he had solved it.  A paperback edition of   (2016), with Eric Smith, appears next month.