Nobel Prize in Economics Paul Krugman explains the importance of the work for which the 2022 Nobel Prizes were awarded

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In a series of tweets, the Nobel Prize for Economics, Paul Krugman, celebrated but above all explained what the Academy awarded by awarding the Nobel Prize this year to economists Douglas Diamond and Philip Dybvig, who were awarded together with the former head of the Federal Reserve, Ben Bernanke.

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What did Paul Krugman say?

“There is a classic article by Nobel laureates Douglas Diamond and Philip Dybvig on the ran to the counterswhich exemplifies the kind of economic analysis I’ve always liked: a relatively simple model that transforms our understanding so that we never see things the same way.

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If you are a normal human, the document may not seem simple or even understandable to you. But believe me: Diamond and Dybvig wrote the simplest possible model of what banking does, because it serves a useful purpose, but because it is vulnerable to self-fulfilling panic.

The idea is that people want liquidity (quick access to their wealth, if needed), but to make a productive investment (such as a long-term credit to a business) you need to immobilize a large amount of wealth in illiquid assets that cannot be quickly converted into cash.

Banks solve this problem by offering people the ability to make deposits that can be withdrawn at will. And at the same time they invest most of those deposits in illiquid business loans, etc. This usually works because not all depositors need cash at the same time..

Reconciling the need for liquidity with the need for illiquid investments, banking enriches society. But … it creates the risk of crisis.

If, for some reason, people lose faith in banks, they will all try to withdraw their funds at the same time, which can force banks to liquidate and cause fundamentally sound institutions to fail, and bank runs can be contagious.

What’s the answer? One answer is to make a Central Bank, which cannot run out of money because the press, lending to banks experiencing deposit withdrawals in a crisis. Another answer is deposit insurancewhich guarantees people that their money is safe.

However, both answers create moral hazard: a temptation for banks take excessive risks and / or commit fraud. So, if you are going to have a financial safety net, you need it too. effective financial regulation; otherwise, you could suffer huge losses from moral hazard, such as the savings and loan crisis in the 1990s.

Diamond and Dybvig did all sorts of understandable things. The fact is, in the 1990s, most economists thought this was a solved problem. We had deposit insurance plus bank regulation. Financial panic must have been ancient history.

What not enough people realized was that more and more banking transactions were being carried out by institutions that weren’t large marble buildings with rows of cashiers. The “hidden banking business” became a majority part of the financial system. Bypassing conventional banks also meant bypassing regulation, allowing for slightly higher returns, but without a safety net. People (who no longer remembered the old financial crises) didn’t care, until suddenly yes.

So, for example, much of what went through regulated banks went through repo – overnight loans using things like mortgage-backed securities as collateral. All of this suddenly collapsed; We all went around muttering “Diamond-Dybvig”

And on a metaphysical level, once we read DD, we understood the possibility of various types of self-fulfilling financial panic, such as the 2011-12 euro crisis or the recent British government bond (gilt) crisis.

In short, a well-deserved award. As usual, many other people as well ben bernanke They deserved to share. (Would you say that about mine? Yes!) But this is an award for a work that has really contributed significantly to understanding the problems and risks of the financial system.

Source: Clarin

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