The Nobel Prize in economics for 2022 was awarded to Ben S. Bernanke, Douglas W. Diamond and Philip H. Dybvig for their research on the role of banks in economic growth and on how banks can set in motion a severe economic crisis. In this article, we focus on the work of Ben Bernanke while making brief comments on the work of the other laureates.
Diamond and Dybvig Maturity Transformation Theory
Diamond and Dybvig developed theoretical models to explore the role banks play in the economy along with the reason for bank runs. Specifically, they presented a theory of maturity transformation, showing that while using demand deposits to finance long-term projects is the most efficient arrangement for commercial banks, but leaves them at risk for bank runs.
We believe this arrangement is very beneficiary for banks, since banks can take individuals’ money placed in demand deposits and lend out that money. The Nobel laureates believe that lending money without the consent of individuals owners of demand deposits is a valid way of generating monetary liquidity.
It did not occur to them that this type of lending amounts to unbacked by savings lending—i.e., lending out of “thin air.” This in turn sets in motion an exchange of nothing for something and in turn to the menace of the boom-bust cycle.
The so-called bank runs are a result of the lending out of “thin air.” To stop the run, banks should stop their fiat lending, all of which is a casualty of fractional reserve banking.
Our Nobel laureates, however, believe that the central bank should intervene to prevent bank runs. We suggest that free market banking and ending central bank interference will have more success.
Ben Bernanke’s Financial Accelerator Model
Bernanke presented the importance of the credit channel for the propagation of the depression. The former Fed chairman believes that changes in financial and credit conditions are important in the propagation of the business cycle, a mechanism that is also known as the “financial accelerator.” According to Bernanke, during a severe economic crisis which results in declining output and falling prices, the real debt burden increases, leading to widespread financial distress among borrowers and lessening their capacity to pledge collateral. The decline in the financial health of potential borrowers during a severe economic crisis impedes the efficient allocation of credit, so argues Bernanke.
A key concept in Bernanke’s model is the external premium, which activates the “financial accelerator.” The premium is defined as the difference between the cost to a borrower of borrowing money in financial markets and the opportunity cost of internal funds. On this Bernanke says:
External finance (raising funds from lenders) is virtually always more expensive than internal finance (using internally generated cash flows), because of the costs that outside lenders bear of evaluating borrowers’ prospects and monitoring their actions.
Hence, the external finance premium is generally positive. The external finance premium that a borrower must pay depends inversely upon the strength of the borrower’s financial position. According to Bernanke, a borrower with a healthier financial position (measured in terms of net worth, liquidity and current and expected cash flows) relative to other borrowers is going to pay a lower premium. The inverse relationship of the external finance premium and the financial conditions of potential borrowers generates a situation when otherwise short-lived economic shocks may have long-lasting effects.
For example, because of a sudden disruption in the supply of credit, the finance premium tends to increase, creating a disruptive amplified effect on the real economy. Because of the higher premium, borrower cash flows come under pressure and damage their financial health.
In response to this situation, banks likely will curtail lending, countering the increase in bad loans, which further increases the interest rate premium. From this, one can see that a disruption in the credit markets can set a financial accelerator in motion, amplifying the damage to the real economy. According to Bernanke, once financial disruptions occur, central bank must act swiftly by aggressively pushing money to prevent the financial accelerator from damaging the economy.
If a disruption in credit markets occurs, then credit expansion falls. This, in turn, slows the growth rate of money and consequently the pace of economic activity is likely to follow suit. On this Bernanke suggests:
A weak banking system grappling with non-performing loans and insufficient capital or firms whose creditworthiness has eroded because of high leverage or declining asset values are examples of financial conditions that could undermine growth.
Bernanke claimed that the Great Depression of the 1930s became deep and protracted in large part because bank failures destroyed valuable banking relationships, and the resulting credit supply contraction left significant scars in the real economy. Bernanke did not discuss what the key causes behind the Depression were.
The question that must be asked is what gives rise to the emergence of such conditions? Disturbances in financial markets do not emerge out of the blue. We suggest that the major cause that sets in motion these disturbances is likely to be the central bank itself.
The reckless monetary policies of the central bank weaken the process of wealth generation. As a result, individuals’ time preferences are increasing, which puts upward pressure on market interest rates, increasing the finance premium and, in turn, activates the financial accelerator.
Whenever the Fed loosens its stance, a rising growth momentum in the money supply is set into motion. Conversely, whenever the Fed tightens its stance, it sets the foundation for the declining growth momentum of money, leading to boom-bust cycles.
Contrary to Bernanke, it is not the high level of debt that leads to a crisis, but rather loose monetary policy of the central bank. As a rule, the crisis is always set in motion once the central bank reverses its loose stance—the money supply growth rate starts to decline. A tighter stance undermines various nonproductive activities and in turn weakens their ability to serve the debt they have incurred—a financial crisis emerges.
Observe that a tighter stance slows down the shift of real savings from wealth generators to nonproductive activities. This puts pressure on the nonproductive activities. Hence, monetary pumping by the central bank that aims at countering the emerging financial crisis in fact only further weakens wealth generators and thereby poses more problems to the economy.
If the pool of real savings is in bad shape, then Bernanke’s recommendation to counter the effect from the so called “financial accelerator” will, in fact, worsen general economic conditions. If the pool of real savings is still expanding, the financial accelerator is not going to be activated.
By pumping more money while the pool of real savings is declining, the wealth generation process will further weaken. This, in turn, will lift the finance premium and undermine financial and economic conditions. Hence, contrary to Bernanke, the downward spiraling effect of the financial accelerator can be restrained only by closing the major loopholes for the generation of money out of “thin air” by preventing the Fed from buying assets.
The 2022 Nobel laureates in economics have generated plenty of description without much explanation of the key causes behind bank runs and boom bust cycles. According to the model of Nobel laureate Ben Bernanke, a sudden disruption in financial markets can seriously disrupt the real economy.
To counter this scenario, Bernanke calls for the central bank to neutralize the negative effect from various shocks by new money pumping. By countering shocks that have resulted from the Fed’s previous policies, the Fed makes economic fundamentals even worse. The work of the other Nobel laureates—Diamond and Dybvig—endorses fractional reserve bank lending, which we already know promotes economic instability and bank runs.