And the winner of the 2022 Nobel prize in economics is… Ben Bernanke!

Or, as The New York Times reported somewhat more formally:

The Nobel Memorial Prize in Economic Sciences was awarded on Monday to Ben S. Bernanke, the former Federal Reserve chair, and two other academics who have helped to reshape how the world understands the relationship between banks and financial crises.

 

Douglas W. Diamond, 68, of the University of Chicago and Philip H. Dybvig, 67, of Washington University in St. Louis — two economists who created a seminal model that explained the dynamics of bank runs and financial meltdowns — won the prize alongside Mr. Bernanke, 68, who is now at the Brookings Institution in Washington.

Bernanke is famous, at least among the circles I travel in, for, of course, staunching the financial fallout from the 2007/2008 global financial crisis as head of the US Federal Reserve at the time. 

Less well-known is the subject of his academic focus for his entire career, which was pivotal in  backstopping the actions he took and the decisions he made in the midst of the crisis. The focus of his lifetime of research was the Great Depression and in particular the role that bank failures played in turning that from a garden-variety recession into a once-in-a-century depression.

Everyone knows that bank failures were a prominent national and even International feature of the Great Depression, but until Bernanke’s work (primarily in a 1983 paper)  we had the causality backwards. The conventional wisdom was that the economic downturn caused banks to fail, but Bernanke inverted that and demonstrated quite conclusively that failing banks were the cause, not the result, of the severity of the depression

 How did this work?

Fundamentally, Bernanke’s work was premised on the realization that in a modern industrial economy, like it or not, banks actually are very special and require special treatment by regulators–unlike any and all other industries.  A surprising amount of populist vitriol arose in response to the “TARP” program (“Troubled Asset Relief Program”), although on net the federal government ended up making a profit on its emergency loans to banks.  (Profits exceeded losses and writeoffs.)  I can understand why people unfamiliar with the ins and outs of central banking felt banks were singled out for relief–they were!

So back to why banks are special.  Banks occupy a position unlike any other industry for a very specific and tangible reason:  They are the intermediaries between savers and investors. Savers deposit their money into banks and the banks loan it out in the form of mortgages, business expansion loans, working capital lines of credit, construction bridge loans, and much much more.  So far so good.

The diabolical and little appreciated flaw in this tidy little model is that savers can withdraw their ”demand deposits” on, what?, demand, whereas the bank’s assets, its loans outstanding, cannot be called in on demand.

In the case of banks, “fractional reserve” banking can be seen as aggravating the problem.  For what I hope are self-evident practical and prudential reasons, banks are not required to hold 100¢ in reserves for every $1.00 they lend.  They can leverage their equity and lend 10, 20, or even 30x their actual cash and liquid assets on hand.  So long as the requests for withdrawals on any given day or week or month fall anywhere other than the extreme high end tail of the normal bellcurve distribution, no problem.  It’s only when the well-known “run on the bank” kicks in–hitting an extreme high point on the right tail of that bell curve–that all heck breaks loose.

The problem is exactly what destroyed Lehman Brothers, Bear Stearns, the thousands of failed banks during the Great Depression, and for that matter practically every conspicuous law firm that has imploded over the past few decades (Howrey, Dewey, Heller Ehrman, Thelen, Brobeck, etc.):  Short term borrowing, long term lending.

Bernanke’s 1983 paper was recognized almost immediately as staking out new and critical ground in the dynamics of major economic downturns:

The research remains “one of the most clear and beautiful papers in modern economics,” said Kenneth Rogoff, an economist at Harvard University.

One more insight:  Why shouldn’t we just let banks fail these days?  After all, deposit insurance in advanced economies will come to the rescue of the innocent depositors, right?

Not so fast.

The subtle but enormously powerful results of widespread bank failures–like an undersea earthquake, immensely consequential but not seen or heard–is the destruction of highly specific, granular knowledge about the condition of each of the bank’s borrowers.  

This critical component is buried in Bernanke’s published “abstract” of his 1983 NBER paper (emphasis supplied to highlight the key, somewhat oblique, phrase):

This paper examines the effects of the financial crisis of the 1930s on the path of aggregate output during that period. Our approach is complementary to that of Friedman and Schwartz, who emphasized the monetary impact of the bank failures; we focus on non-monetary (primarily creditrelated) aspects of the financial sector–output link and consider the problems of debtors as well as those of the banking system. We argue that the financial disruptions of 1930-33 reduced the efficiency of the credit allocation process; and that the resulting higher cost and reduced availability of credit acted to depress aggregate demand. Evidence suggests that effects of this type can help explain the unusual length and depth of the Great Depression.

In much plainer and more direct English:

banks monitor borrowers on behalf of savers and have a unique insight into businesses that can’t quickly be replaced by newcomers if they go bust.

 

“When a bank fails, this knowledge disappears,” Mr. Hassler explained [John Hassler was spokesman for the Nobel Prize committee and announced the award]. “That is why banking crises have long-lasting consequences.”

Law firms, not unlike attentive and responsible banks, often have unusually privileged insight into their clients’ businesses.  That’s the main reason why clients who have used one firm primarily and above others for an extended period of time face very high “switching costs” if they want to leave your firm for your competitor across the street.  

It wouldn’t hurt you personally as relationship partner, nor your firm, to maximize those client insights and gently let your clients know, by timely and granular observations and advice, how expensive and disruptive it would be for them to retrain a new law firm.  After all, a massive and abruptly imposed requirement that corporations “retrain” their bank/lenders was so costly it inflicted the Great Depression on us.

Ben Bernanke graduated from Harvard and earned his Ph.D. in economics at MIT.  For many years, he taught economics at Princeton (and for a period chaired the Department) before leaving for his post at the Fed.  He’s now a senior fellow at Brookings.

Courtesy The New York Times