The 2022 Economics Nobel should come with a warning

The Nobel medals. (Image: AFP)

The Nobel Prize committee has rightly recognized three economists — Ben Bernanke, Douglas Diamond and Philip Dybvig — for their research on a topic crucial to human prosperity. If only regulators would do a better job of putting their insights into practice.

The research that the prize cites highlighted an important flaw in the prevailing academic orthodoxy. At the time, the dominant models — used by policymakers to understand and manage the economy — assumed that the financial sector played little role in booms and busts, simply operating in the background to turn savings into investment. But Diamond and Dybvig pointed out that borrowing short-term to make long-term investments (that is, leverage combined with maturity transformation) made banks uniquely susceptible to debilitating panics. And Bernanke showed how this dynamic played a central role in making the Great Depression of the 1930s as bad as it was.

These efforts proved suddenly relevant in 2008, when a burst bubble in mortgage lending triggered a panic that crippled both traditional banks and lenders in the so-called shadow banking sector, leading to the failures of several large institutions including Lehman Brothers Holdings Inc. The accompanying credit crunch ultimately threw millions out of work and destroyed an estimated $1.4 trillion in economic output in the US alone.

Despite his scholarship, Bernanke — who chaired the Federal Reserve from 2006 to 2014 — was slow to respond to the brewing crisis. As late as 2008, the central bank considered the largest US financial institutions sound enough to keep making shareholder payouts that reduced their equity capital and increased their leverage. Their capital buffers soon proved woefully inadequate, requiring the Fed and other authorities to put up trillions of dollars in taxpayer money to pull the financial system back from the brink of collapse.

Regulators have since responded with more stringent capital and liquidity requirements, designed to limit leverage and ensure banks have enough cash to weather a crisis of confidence. Yet even among traditional banks, capital levels would need to be a lot higher to ensure resilience in a severe crisis. And as illustrated by incidents such as the recent travails of UK pension funds and the implosion of Archegos Capital Management, regulators must do still more to limit leverage among nonbank financial institutions — for example, by setting minimum collateral requirements in lending and derivatives markets.

The economics Nobel usually rewards research that has long been broadly accepted and acted on. Not this time. The world once again finds itself heading into an economic downturn with little confidence that the financial sector will be a source of strength, rather than of contagion. Let this prize serve as a reminder: The job of addressing the vulnerabilities that Bernanke, Diamond and Dybvig described — and that the 2008 financial crisis laid bare — is far from done.