Analysis | The 2022 Economics Nobel Should Come with a Warning – The Washington Post

by | Oct 10, 2022 | Financial

Comment on this storyCommentGift ArticleThe 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.AdvertisementDespite 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 cris …

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