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Nobel Memorial Prize in Economic Sciences

Context

  • Former Fed Chair Ben Bernanke and two other US economists, Douglas Diamond and Philip Dybvig, were awarded the Nobel Memorial Prize in Economic Sciences. They were recognised for their work over four decades on the role of bank bailouts in financial crises.
  • The work for which Bernanke, Dybvig, and Diamond have been recognised dates back to the early 1980s, and it has laid the groundwork for modern bank regulations.

Relevance

GS Paper 1: Effects of globalization on Indian society.

Mains Question

Do you believe that bestowing the Nobel Peace Prize on certain individuals and organisations strengthens the voices of peace and human rights around the world and in India? Express your thoughts. (250 words)


During the Great Depression

  • The Great Depression was a severe worldwide economic depression that lasted from 1929 to 1939 and was precipitated by a significant drop in stock prices in the United States.
    • Between January 1930 and March 1933, US industrial production fell by 46%, unemployment increased to 25%, and the Gross Domestic Product (GDP) fell by 30%.
  • It lasted nearly a decade and was characterised by steep declines in industrial production and prices (deflation), mass unemployment, banking panics, and sharp increases in poverty and homelessness rates.
  • Economists and historians cannot agree on the precise causes of the Great Depression.

Ben Bernanke’s study:

  • In 1983, Ben Bernanke published a research paper on the Great Depression
  • He emphasised that “Bank Runs” were the primary cause of a relatively normal recession spiralling into the greatest economic crisis in modern history.
    • A bank run occurs when large groups of depositors withdraw money from banks at the same time out of fear that the institution will fail.
    • If enough people do this at the same time, the bank’s reserves cannot cover all of the withdrawals, and the bank goes bankrupt.
  • Due to bank runs, the 1929 recession had morphed into a full-fledged banking crisis by 1930, with half of the banks going bankrupt.
  • Bernanke demonstrated that the economy did not begin to recover until the government finally put in place strong measures to prevent further bank panics.
  • Today, Bernanke’s views — that allowing banks to fail often worsens a financial crisis — are accepted wisdom, supported by empirical studies.

Analysis by Douglas Diamond and Philip Dybvig:

  • In 1983, Douglas Diamond and Philip Dybvig published another research paper highlighting “fundamental conflicts between the needs of savers and investors.”
    • Savers always want access to at least some of their savings for unexpected use; this is also known as the liquidity need.
    • They want the ability to withdraw money as needed.
    • On the other hand, borrowers, particularly those taking out a loan to build a house or a road, require the funds for a much longer period of time.
  • Borrowers can’t function if they can’t get their money back quickly.
  • This is commonly referred to as the Diamond-Dybvig model.

Banks’ Role in the Diamond-Dybvig Model:

  • Diamond and Dybvig presented a mathematical model demonstrating how banks act as intermediaries between savers and borrowers, smoothing out incompatibilities in their needs.
  • Savers want to be able to invest and withdraw funds in the short term, whereas borrowers, such as businesses, require long-term loans and commitments.
  • Because savers do not generally need to withdraw all of their funds at once, banks can absorb fluctuations in order to maintain ‘liquidity,’ allowing money to circulate and society to benefit.

The significance of this study:

  • Throughout the 2008 Financial Crisis –
    • The financial crisis of 2007-08 was the most severe since the Great Depression.
    • As predicted by Diamond and Dybvig’s model, the crisis began with a slump in the housing sector and progressed to financial market panic.
    • That crisis was widely attributed to reckless lending by banks to borrowers in the housing market who lacked the ability to repay their debts.
    • Diamond and Dybvig’s work had already demonstrated how perverse incentives can emerge in the banking system to drive such risky lending strategies.
    • The crash highlighted the need for banking regulation to prevent such behaviour.
    • Bernanke’s recognition that factors other than traditional economic thinking, such as behavioural biases, feedback loops, and the role of confidence collapse, can cause system instabilities was likely critical in navigating the 2008 crisis.
  • Throughout the Covid-19 Pandemic –
    • Such lessons also aided in reducing the risk of illiquidity during the Covid-19 pandemic lockdowns.
  • For example, the European Central Bank intervened by providing banks with financial assistance and incentives to lend to consumers and businesses.

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