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Decoding the root to the current economic crisis

A system is only deemed solid when it faces adversities predicted and unimagined by the most remarkable human minds.

In today’s world, the financial system, where millions of people lean on heavily, is constantly faced with multiple setbacks. As a result, countless economists are at work every day to ensure that the system doesn’t fail. This year three esteemed American economists were awarded the “Sveriges Rilksbank Prize in Economic Sciences in Memory of Alfred Nobel,” commonly known as the Nobel Memorial Prize in Economics. Because of their contribution to the banking sector of the financial system, The Royal Swedish Academy, who oversees the award, decided that it was time the economists above received their fair share of recognition.

Ben Bernanke, Douglas Diamond, and Philip Dybvig wrote their name in the history books with their impressive paper revolving around the working mechanism of banks and the regulations during a financial crisis. Diamond, Dybvig, and Bernanke are all from prestigious backgrounds. Diamond is a professor at the University of Chicago Booth School of Business, Dybvig is a professor at the Olin Business School of Washington University in St.Louis, and Bernanke, who is relatively more known than his counterparts, was chairman of the Federal Reserve from 2006 to 2014. He presently works at the Brookings Institution in Washington.

Incidents like the Great Depression, the housing market crash, and the covid-19 pandemic remind us how fragile our systems are. A post-covid-19 pandemic context coupled with the events mentioned above pushed the research paper into the light. The combined effort of the research papers portrayed a properly structured understanding of how the banks work during the financial crisis. While their work has gathered dust over the years, it has been instrumental in laying multiple foundations on many concepts and proved fruitful during the 2008 financial crisis. Furthermore, the constant evolution of the economy and its impacts on people shows us how even today, we need it.

The work which propelled them to extraordinary territory are two theoretical contributions by Diamond and Dybvig (1983) and Diamond (1984), and an empirical contribution by Bernanke (1983). There are two stakeholders in play.   The Diamond Dybvig work focuses on the balance between banks’ role in mitigating the conflict between clients wanting access to their money and the economy needing savings to be put into long-term investments. Their work further looks into how the Government can help banks prevent issues by providing deposit insurance and acting as a lender of last resort. On the other hand, Ben Bernanke’s work offers a different yet in-depth analysis of how and why bank runs were a crucial aspect behind the crisis being longer than expected.

When we take a closer look, the research touches on a few crucial perspectives and answers critical questions.

To start off, the Diamond-Dybvig paper explains the real trade-off between returns and liquidity. The report talks about how Financial intermediaries – banks can tackle the unpredictable need for sudden current purchasing power needs of individuals by selling liquid liabilities. Diamond and Dybvig also describe how financial intermediaries don’t necessarily need to function like conventional banks. The intermediaries generally can be better stable by investing primarily in illiquid but high-return assets. On the other hand, they also mention how investing in high-return assets has a possibility to anchor down financial intermediaries. If at any particular point, for example- an economic crisis, everyone decides to withdraw their funds together, banks will have difficulty liquidating their investments. For this reason, the paper includes how Government and central banks can act as last-resort lenders so that the banks don’t fall apart.

On the other hand, Ben Bernanke illustrated how Banks function when they fail during any dreadful financial crisis. He also explained the apocalyptic impacts failing banks could have on the economy and the people.

The question on everyone’s mind after the announcement was the probable impacts the papers could have or had in any profound moments after they were released. Any economic research that had any potential value probably changed the world for the better, and the papers of the awardees this time weren’t any different. The Diamond-Dybvig paper showed that banks could still function properly during tough times and keep the system in check. It established firm conclusions regarding deposit insurance, bank systems, and liquidity. The paper also mentioned how during disasters, policy responses should cater more to mitigating the risks of people’s panic then to preventing financial crises. Bernanke provided a sharp and impressive picture of the bank mechanism from a different perspective with respect to the Great Depression.

However, their work only answers a few questions that we ask today. The papers neither tell us what we should do during financial crises or what the banks should do to avoid it. It needs to provide a definite framework on the regulations the financial system should pass during an emergency or what the people should do. As a result, many experts think the economists who won don’t deserve it. Some criticized that the Diamond-Dybvig model was simply fancy math on a specific topic people knew before. Some even claim that Bernanke’s status as a previous chairman got him the award.

While it is true that none of the economists discovered anything new or revolutionary, they changed the entire narrative on bank systems and their situation during critical moments. People’s claim might be constructive, but it’s still not enough to take away the accomplishment Diamond-Dybvig-Bernanke deserves. 30 years down the line, and with those papers, we have shaped our narratives and tackled the consequences of crises.


Author- Malik Araf

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