The Nobel Prize Goes to Bernanke and Diamond and Dybvig

The Nobel Prize Goes to Bernanke and Diamond and Dybvig for their work on banking. Bernanke seems like an obvious choice. Doesn’t he have one already? Well, no. But few people have had as stellar an academic career topped by another stellar career in public policy. A few economists have became famous politicians but it’s difficult to think of any economists whose career in public policy consisting of implementing, applying and testing the knowledge they built in academia.

Bernanke, of course, wrote key papers on the Great Depression–the Nobel committee points especially to his 1983 paper Non-Monetary Effects of the Financial Crisis in the Propagation of the Great Depression which showed that it wasn’t just the decline of the money supply that mattered (ala Friedman and Schwartz) but also the decline of the credit supply. Another way of putting this is that the waves of bank failures in the 1930s reduced the economy’s ability to produce output in a way that could not be countered simply by printing more money. As Tyler and I emphasize in our textbook, Modern Principles, nominal and real shocks are often intertwined. Bernanke then famously brought this line of thinking to his actions as head of the Federal Reserve during the 2008-2009 Financial Crises. Bernanke believed that it was critical to rescue the banks and the shadow banks not because he was beholden to financial interests (he was not a Wall Street guy) but because he believed the banks were a critical bridge between savers and investors and if that link were broken the results would be catastrophic. Bernanke rescued the banks to save the bridges.

I’m also a fan of a second, somewhat less well-known paper that Bernanke also published in 1983 (the Annus Mirabilis paper phenomena), Irreversibility, Uncertainty, and Cyclical Investment. Bernanke in this paper pioneered what would later become the real options analysis of investment, i.e. thinking about investment as an option, akin to a financial option. Thus, investment has two key features–you can usually wait a little bit to gather more information before investing but once you strike, the investment is sunk, i.e. irreversible. These two features have important implications for investment decisions and writ-large business cycles. In particular, Bernanke showed something surprising which he dubbed “the bad-news principle.” The bad-news principle says that only the expected severity of bad news matters for the decision whether to invest, good news should not matter at all. The reason is that the real decision an investor must make is whether to invest immediately or wait a little bit to learn more but what makes waiting valuable is not the possibility of good news but the possibility of avoiding mistakes. Avoiding mistakes is what investors care about on the margin. In turn, what that means is that avoiding bad news–creating downside insurance–can generating a huge upside because it can trigger a wave of investment. Bernanke also took this lesson to his role at the Federal Reserve.

Large amounts have been written on Bernanke already, of course, including his own memoir and I don’t think I can add much to that torrent beyond emphasizing the remarkable consistency of Bernanke’s thoughts and actions from academia to central banking.

Diamond and Dybvig are responsible for the now canonical model of banking. You can read Tyler below for more details on Bernanke and an explanation of the DD model.