The Nobel Prize in economics this year has been awarded to Ben Bernanke, Douglas Diamond and Philip Dybvig, rewarding their in-depth economic work that proved critical in addressing and stopping the financial crisis that spawned the Great Recession.
Some Noble prizes are given for theoretical work, and some for specific or abstract theories. Usually, the award is for work that has led to a greater understanding of some portion of economics.
The early Nobels were for work that was sweeping. Recent awards have become targeted, specialized and perhaps harder for non-economists to appreciate. In this case, the prize went to findings with action at the core — and those were crucial in addressing an economic crisis.
Sometimes Nobel Prizes may seem to be given for an idea that was already well-known or simple. For example, “don’t put all your eggs in one basket” is an obvious concept. But modern portfolio theory (Harry Markowitz) formalized this in a way that gave the proposition much greater meaning.
Similarly, Walter Bagehot (1826-1877) had formulated rules almost 200 years ago for what to do in a banking crisis. He argued that authorities should lend to solvent institutions against good assets but at market rates that would discourage bad behavior in the future. Unsaid in the Bagehot rule is what to do when the distinction between good and bad assets evaporates and panic-selling puts all assets “on offer,” leaving no asset as a “good” asset.
Some may wonder: What’s the big deal? Don’t we know enough these days to save banks in a financial crisis? I think we did, and we do. But at the time there were still hard questions being asked about “bank bailouts.” And in the aftermath, there was even a Wall Street sitdown strike against “Banksters.”
The work of Bernanke, Diamond and Dybvig put a finer point on what was needed and why, in part, by leading to a clear understanding of the consequences and a stronger motivation to act. Not putting all your eggs in one basket is a good rule to know, but modern portfolio theory is better. Lending aggressively against good assets is a good rule to know, but sometimes that may not be enough.
There is a legacy effect from the Great Recession that traces back to the safety-net actions taken that were a product of this “new understanding” of financial relationships and risks. Many economists still abhor the action taken. Some still think it would have been better to let the crisis play out. This is easier to say in hindsight. At the time it did not seem like a very good option. In fact, we have implemented new regulations to prevent a relapse.
Laws have been changed to disallow some of what was done by policymakers in the Great Recession as well as new regulations formed to discourage bad behavior and damp its consequences even more strongly. The models and the experience have helped us to see that the financial system required design changes to prevent these risks since dealing with them in real time is so onerous.
All of this is part of the surviving financial landscape. The practice of QE (quantitative easing) — which had been developed and suggested for use in Japan where interest rates had hit zero — was eventually put into practice in the U.S. and elsewhere. And it is still with us.
The work of this year’s Nobel recipients in economics is a good example of what theoretical economics is and why it is useful. You can disagree with the policies employed in the Great Recession and still appreciate these awards. It is always better to understand things in more detail and to have a greater appreciation of risk and where that may lead.
This year’s award rewards work that led to a greater understanding of financial institutions and their role in the economy. They are not part of a class of interdisciplinary models used in “science” that are falling on hard times. I refer here to timeseries models that predict events (as opposed to help “understand”). Models of climate change, the spread of disease or the likelihood of inflation being transitory have become controversial and have shown their flaws. Do not confuse these different types of models.
The trend to more quantitative assessments in economics is firmly established. But the application of those findings as in the Great Recession will continue to depend on real world judgments made by people in the heat of the moment with less than perfect information. At a time like that, it’s best to know all you can about your options and about the risk.
Robert Brusca is chief economist of FAO Economics.
