Most Nobel laureates develop theories; Ben Bernanke put his into practice – with insight from The Wall Street Journal

Use Spotify? Access BizNews podcasts here..Use Apple Podcasts? Access BizNews podcasts here..___STEADY_PAYWALL___.Most Nobel Laureates Develop Theories; Ben Bernanke Put His Into Practice.The former Fed chairman and two other academics developed the theoretical foundations for why banks exist and why bank panics hurt.By Greg Ip.Critics sometimes ask what practical good economic theory has done. The Nobel Prize in Economic Sciences awarded to Ben Bernanke on Monday along with Douglas Diamond of the University of Chicago and Philip Dybvig of Washington University in St. Louis provides a rejoinder. The laureates independently developed the theoretical foundations for why banks exist and why bank panics hurt. Mr. Bernanke put those theories into practice when the stakes could scarcely have been higher: as Federal Reserve chairman during the global financial crisis of 2007-09..All of finance deals with a problem known as "information asymmetry": Borrowers know more about their creditworthiness than lenders do. Savers can't undertake all the due diligence necessary to determine who is a safe borrower. Moreover, they often want their money back without notice, before the borrower's project has earned a return..Mr. Diamond and Mr. Dybvig in the early 1980s explained how banks solve this problem. Savers entrust their money to banks who develop specialized knowledge about who is a worthy borrower. By aggregating many savers, they can give each access to cash on demand while still financing useful, long-term projects, a function called "maturity transformation.".At the same time, the Nobel committee observed, "it is precisely the maturity transformation, which makes banks more illiquid as a result of creating liquidity for depositors, that makes banks fragile and subject to runs.".In a seminal 1983 paper, Mr. Bernanke showed that the depth and length of the Great Depression was due in great part to financial factors: As the economy contracted and deflation took hold, banks failed, taking with them knowledge about borrowers that had been critical to sustaining credit..Mr. Bernanke added another crucial insight: Lenders, he noted, dealt with information asymmetry by demanding collateral, such as property, that can be seized if the loan isn't repaid. If collateral values are falling, even sound banks might not want to lend. The 1930-33 debt crisis was due to "the progressive erosion of borrowers' collateral relative to debt burdens," Mr. Bernanke wrote. The usual response of banks was "just not to make loans to some people that they might have…in better times.".The importance of collateral became the basis of what Mr. Bernanke and frequent collaborator Mark Gertler of New York University later dubbed "the financial accelerator." It explained how booms made borrowers more creditworthy by lifting collateral values and economic prospects, increasing the flow of credit. Busts did the opposite. Thus, the financial system wasn't just a reflection but an accelerator of the business cycle..By the 2000s, economists thought the financial-crisis problem had been solved with deposit insurance and the migration of lending from banks to capital markets. Mr. Bernanke, who became Fed chairman in 2006, wasn't so sure..In a prescient 2007 speech, he warned the financial accelerator was very much intact. If homeowners were highly leveraged, a decline in home prices could severely deplete home equity and thus impair their creditworthiness, he noted. Many banks and lightly regulated lenders, later called shadow banks, depended on uninsured deposits or raising capital from investors. A decline in these institutions' capital could cause them to lose access to funds, further impairing the supply of credit..These mechanisms became central to the global financial crisis that began just a few months after that speech. As home prices plummeted, so did the net worth of millions of homeowners, and the capital of countless banks and shadow banks. Mr. Bernanke responded by using every tool available, and inventing several new ones, to prop up floundering financial institutions and cushion the broader economy from bankruptcy and deflation. As a result the recession, though the worst since the 1930s, wasn't a repeat of the 1930s..The Nobel committee dwells at length on the relevance of the work of Mr. Bernanke, Mr. Diamond and Mr. Dybvig to the global financial crisis. Outside of a footnote, though, it manages to ignore Mr. Bernanke's central role in responding to that crisis. Yet Mr. Bernanke's contribution to economics can only be understood as a function of both, combining intellectual heft with small-p political acumen. From chairing Princeton University's economics department to running the Federal Open Market Committee and negotiating with Congress, Mr. Bernanke, now at the Brookings Institution, had a knack for eliciting cooperation from people with much bigger egos and sharper elbows than he..Beyond his work on financial crises, Mr. Bernanke also long advocated central banks adopt a formal inflation target. Originally a response to the high inflation of the 1970s, Mr. Bernanke also saw targets as a safeguard against the deflation of the 1930s. This interest grew in the aftermath of the crisis when inflation remained stuck below 2%, keeping interest rates near zero as well—robbing the Fed of its ability to boost the economy..In response, Mr. Bernanke introduced and refined "quantitative easing," or large scale bond purchases, and in 2012 persuaded the Fed to adopt a formal 2% target. In 2017, Mr. Bernanke proposed a temporary "price level" target under which the Fed, after a period of below 2% inflation, would for a while aim to keep it above 2%..The Fed adopted a version of that in 2020, just before inflation came roaring back. Today, the Fed is instead battling to get inflation down from too-high levels. With property values soaring in the past year and financial institutions well capitalized, the dynamics of falling collateral values and failing lenders that marked the Depression and the 2007-09 recession appear largely absent. Nonetheless, there are strains appearing, such as in the government bond market. The current situation is "not anything like the dire straits" of 14 years ago, Mr. Bernanke told reporters Monday. But the lesson of his work and of history, he noted, is that "even if financial conditions don't cause the problem, they can over time make problems worse.".Write to Greg Ip at greg.ip@wsj.com

Most Nobel laureates develop theories; Ben Bernanke put his into practice – with insight from The Wall Street Journal

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