Three economists share this year’s Nobel Prize in Economics this year. While you may not have heard of Diamond and Dybvig, Ben Bernanke, former Fed chair, is a familiar name. Their research in financial crises led to regulations and policy that have prevented a repeat of the Great Depression.

EconExtra is a series of posts that go beyond the textbook, relating current events and recent developments in economics to content standards, and providing resource suggestions to help you incorporate the current events into your lessons. This week: Monetary Policy and Market Failure.

The Headlines

“Bernanke Put His Theories Into Practice” was the Wall Street Journal headline of the article by Greg Ip. (Subscription may be required)

“Bernanke, bank bailouts and economics Nobel” was the title of the Indicator from Planet Money podcast.

The headlines pull Bernanke’s name out as the one we all recognize. While the podcast focuses on Bernanke, the WSJ article explains the contributions of Diamond and Dybvig as well.

The Prize-Worthy Theories

Greg Ip makes it pretty clear in his opening paragraph why this time, the Nobel went to economists whose theories were put into practice to the benefit of all.

“The laureates independently developed theoretical foundations for why banks exist and why bank panics hurt. 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.

Douglas Diamond (University of Chicago) and Philip Dybvig (Washington University of St. Louis)

In the early 1980’s, Douglas and Diamond explained how banks solve two problems: information asymmetry and maturity transformation. Think about how banks function--they invest savings from individuals by lending that money to others. Those borrowing money obviously know more about their creditworthiness than the savers possibly could. Banks have the expertise to evaluate the creditworthiness of the borrowers and perform the due diligence. (They can also require collateral—more on that below.) So banks solve the information asymmetry problem.

They are also able to take the deposits, which depositors expect to be liquid and available at any time, and make much longer-term (illiquid) loans to their borrowers--maturity transformation. Can you imagine how difficult it would be to match individual savers and borrowers without the banks? But it is exactly this maturity transformation—the fact that the banks’ assets are illiquid—that makes them vulnerable to runs.

Ben Bernanke’s 1983 Paper

Bernanke’s paper focused on the Great Depression. As banks failed, they took with them all of that knowledge about borrowers and information asymmetry became much greater. To fight this, collateral became more important. But in 1930-33, the value of the assets used as collateral kept dropping relative to the amounts borrowed, and credit dried up. (This concept was later developed further and is known as the collateral accelerator—during a boom, asset values rise and borrowers are more credit worthy, and vice-versa during a bust, thereby accelerating the business cycle.) Bernanke’s paper concluded that banks didn’t fail as a result of the crisis, but the bank failures actually caused the crisis.

Deposit Insurance helped reduce the risk of bank runs, but when you look at the 2007-09 crisis, you see that housing was the “collateral” that was at issue, and that much of the lending had moved to non-bank capital markets and shadow banks, out of the purview of banking regulations and deposit insurance. While the Great Recession was bad, Bernanke used his knowledge of the Great Depression to keep things from getting anywhere near as bad by focusing on liquidity.

The Planet Indicator podcast gives a great overview of Bernanke’s work and his contributions. It makes three points:

• 1) Bernanke’s research (1983 Paper) gave great insight into the Great Depression and what made it so much worse (credit dried up without banks, and there was no confidence in banks.)
• 2) As the Great Recession began, the free fall in asset prices threatened credit markets beyond just the banks, and Bernanke directed the Fed to establish lending facilities to get them all through the crisis. This was the beginning of Quantitative Easing (the Fed purchase of Treasures and mortgage-backed securities.)
• 3) The Fed has been using the same playbook since the Pandemic hit. In the future, economists will be looking back to see if it was necessary.

The bottom line: FDIC deposit insurance prevents bank runs/crises, and bank bailouts prevent a bank crisis from developing into a full-blown depression.

Lesson Plan Ideas

Students can read the article and then listen to the podcast.

Whether through class discussion or written assignment, make sure students understand the following concepts:

• Information asymmetry
• Maturity transformation
• Collateral accelerator

What were the three main takeaways from the Indicator podcast regarding Bernanke’s contribution to economics.

About the Author

Beth Tallman

Beth Tallman entered the working world armed with an MBA in finance and thoroughly enjoyed her first career working in manufacturing and telecommunications, including a stint overseas. She took advantage of an involuntary separation to try teaching high school math, something she had always dreamed of doing. When fate stepped in once again, Beth jumped on the opportunity to combine her passion for numbers, money, and education to develop curriculum and teach personal finance at Oberlin College. Beth now spends her time writing on personal finance and financial education, conducts student workshops, and develops finance curricula and educational content. She is also the Treasurer of Ohio Jump$tart Coalition for Personal Financial Literacy.