The bankers bag Nobel prize in Economics

By Prof Satya Narayan Misra*

The Nobel Prize in Economics was the last to be instituted in 1968 by Sweden’s Central Bank to commemorate the bank’s 300th anniversary. Herbert Simon was the first non-economist to win the prize in 1978 and Daniel Kahneman, the psychologist got it in 2002 for his pioneering work in behavioral economics. Of the 89 individuals who have received the prize so far, two are women, including Esther Duflo who got it in 2019 along with Abhijit Banerji. This year’s prize will be shared by Bernanke, Diamond & Dybvig for their pioneering research work in the 80s for dealing with financial crises more effectively.

For economies to function, savings must be channelized into investments. However, there is an inbuilt conflict, as savers want instant access to their deposits, while investors and businesses want the funds to stay with them longer. Diamond & Dybvig show how banks offer an optimal solution to this problem. If a large number of savers simultaneously run to the bank to withdraw their money, the rumor may become a self-fulfilling problem. It is only by acting as a lender of last resort and providing deposit insurance, such run-ins can be averted by the apex banking institution.

Diamond demonstrated how as intermediaries between savers and borrowers, banks are best suited to assessing borrowers’ creditworthiness and ensuring that loans are used for a sound investment. Bernanke’s primary research work was what caused the great depression of the 1930s. It was Milton Friedman; the monetarist & Nobel winner of 1976 was of firm belief the economic depression happened because the Federal Reserve Bank reduced the money supply. Citing Friedman in his doctoral thesis he strongly argued in favor of lowering interest rates significantly and even to ‘helicopter drop’ of money to fight deflation. He was popularly called Helicopter Ben.

Bernanke, the Professor from Princeton, remained the Federal Reserve bank Governor (2006-2014) , during a period marked by the subprime crisis (2007-2008). In his book The Courage To Act (2015), Bernanke writes that due to the efforts of the Fed that a crisis greater than the great depression of the 1930s could be averted. The Fed interest rates were lowered from 5.25% to 0% in a year’s time. When this was considered insufficient to abate the liquidity crisis, he initiated quantitative easing, creating $1.3 trillion to buy financial assets from banks and the government. Such firewalling & bailout initiative by Fed was emulated by the EU & Japan, which brought the financial crisis under control in a quick time.

There is a perceptible difference in the viewpoint of economists who believe in fiscal interventions to stem fiscal crisis as opposed to monetarists like Friedman & Bernanke, The Nobel laureate Joseph Stiglitz strongly believes that the root cause of the financial crisis in 2007-2008 was because of poor regulation of the banks by the government, shadow banking and the proliferation of toxic assets like CDOs. Paul Krugman was of the view that because of the repeal of the Glass Stegall Act (1933) which prevented banks not to indulge in investment in 1999, the banks indulged in excessive speculation, leading to a financial crisis.

All the same, these three economists have made a seminal contribution to our understanding of how bank collapses exacerbate financial crises and how that can be averted through easy money policy.

They also strongly believe that monetary policy should be guided less by discretion and more by a fixed target of inflation. In India, RBI’s policy during the Covid-19 was largely guided by the easy money policy by bringing down the repo rate as low as 4%. It also facilitated the disbursal of the fiscal stimulus package to the SMEs which was collateral free. Traditionally, the role of RBI is to regulate credit, provide adequate currency in circulation and ensure that inflation remains within a reasonable band. The Government has signed an MOU with RBI to ensure that inflation remains in the 4-6% band. Since inflation has been breaching the upper band for quite some time, the RBI has increased the repo rate to 5.5%. Bernanke strongly believed that inflation targeting should be a thrust area for the apex monetary institution. Interestingly, the first winner of the Nobel in Economics Jan Tinbergen (1969) famously propagated that there should be one policy to combat one problem, the repo rate to combat inflation. The Nobel Prize winners in economics this year have seamlessly conflated sound theoretical understanding of monetary policy to real-life financial challenges triggered by banking collapse. Easy money policy during the financial crisis and inflation targeting are their lasting bequest. It is often said that monetary policy has effective brakes but poor accelerators, to promote growth. It is only when monetary and fiscal policy actions are in tandem as the two wheels of a nation’s economic chariot, fiscal stability and economic growth can happen.

 

 

*Prof Misra teaches Macro Economics

 

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