Winning a Nobel Prize… 40 years later

Sascha: [00:00:02] From Equity Mates media. This is the dive. I'm your host, Sascha Kelly. The Nobel prize for economics has just been awarded. And who are the recipients?

Audio Clip: [00:00:12] Former Federal Reserve chair Ben Bernanke is amongst the winners of this year's Nobel Prize in economics. He was recognised along with two US based economists. 

Sascha: [00:00:20] Three American economists whose work the awards committee lauded for showing, quote, why avoiding banking collapses is vital. End quote. I mean, I could have told you that. 

Audio Clip: [00:00:31] Thank you. Focused on the Great Depression, how dangerous bank runs can be. 

Sascha: [00:00:35] What's more, this work was published 40 years ago, back in the 1980s. So we wanted to get an understanding of what was happening with the Nobel prize for economics this year. Who won? Why does their work matter? And how has it changed the world today? It's Wednesday, the 19th of October. And today I want to know why should I care about the Nobel prize for economics? To do this, I'm joined by the co-host of Comedian vs Economist and the resident economist here at Equity Mates Media and undoubtedly the best man for the job. It's Thomas. Thomas. Welcome to the dive organisation. 

Thomas: [00:01:12] How are you going? 

Sascha: [00:01:13] I'm well. How are you? 

Thomas: [00:01:15] Yeah, I'm doing great. 

Sascha: [00:01:16] The Nobel prizes for economics has just been awarded. Can you tell us about the prize and how is it different from the other Nobel prizes? 

Thomas: [00:01:24] It's interesting because the Nobel prize came from Alfred Nobel, who invented dynamite, was a famous chemist at the time, and then in his will he wanted to support the advancement of humanity. And so I set up awards in physics, chemistry, medicine, literature and peace. And that was at the end of the 1800s. In 1901, I think the first award for the Nobel Prize went out. Economics wasn't in that list, and it was only in 1969 when Riksbank, the Swedish Central Bank, funded an award for economics. So it's not technically a Nobel prize the way the others are. It sort of has a different name. It's the Swedish Riksbank Award for Economics in memory of Alfred Nobel or something like that. But we just call it the Nobel prize in economics. 

Audio Clip: [00:02:11] I'm incredibly honoured, of course, to be a co-winner of the Riksbank prize in economic sciences in the memory of Alfred Nobel to give it the correct full name. 

Thomas: [00:02:22] And so they they sort of snuck that one in there. And then after that, I think the Nobel Prize Board went and we probably better draw a line under this and said, okay, that's the last one to get added to the list. From now on, there's no more no more Nobel prizes. So that's where it sort of sits. And that's why it's different from all the others. And it's really interesting in the sense that it's called the War for Economic Sciences. But back in Nobel's time, back in the end of 1800s, economics wasn't seen as a science. It was seen as part of the humanities discipline. And so probably wouldn't have even occurred to Nobel to have an economics prize. But then sort of through the early part of the 20th century, there was this push to cast economics as a science and sort of bring in some scientific rigour. And there's been a lot of criticism of that because it's been done more or less successfully. And that's why you look at this prize and it sort of is for work that was done 40 years ago is because economics is like we try to apply scientific rigour to our work, but a lot of it is it's a social science. We're dealing with people and we're dealing with things that aren't easily quantifiable. So if you discover a new element to add to the periodic table that's sort of established, then you can get a Nobel prize for that the following year. In economics, it takes a lot longer for things to play out and for us to understand the significance of particular advances in the practical application of particular ideas. And that's why I think you can get a lag like 40 years, which is what we've seen with this one.

Sascha: [00:03:52] I think that's really interesting because from listening to your show, what I've learnt is that economics sits in that Venn diagram between human nature and scientific theory or, you know, practical theory. The X factor really is how humans react to some of these ideas. 

Thomas: [00:04:08] Yeah, that's right. That's right. 

Sascha: [00:04:09] So this year's winners with three economists. Can you tell me a little bit about who they are? 

Thomas: [00:04:14] I guess we got three winners this year. We got Ben Bernanke, who was famous for being chair of the Federal Reserve during the financial crisis. And then we got two academic economists, Douglas Diamond and Philip  Dybvig. It's interesting in the sense that Diamond and David wrote papers together and worked closely together, but Bernanke never worked with them, as far as I'm aware. But the prize committee said that their work reinforced each other's and decided to award them as a cluster. Which itself is kind of interesting about the work that they're looking at is the role of financial crises in the way financial crises unfold and then the way we can protect an economy against the financial crisis. That's that's the sort of the broad umbrella of what they've got, kind of specifically diamond. And we looked at what they call. Maturity transformation. So some banks tend to borrow short and lend long, so they've got deposits which are really liquid, the most liquid asset in the economy. But then they lend a long, which has a long duration, a long time to get back. And that creates a sort of a duration mismatch where you can get a run, where people want their liquid assets back really quickly, but you can't go and get your illiquid assets because they're lent down the long run.

Sascha: [00:05:26] All right. Can I jump in just to make sure I'm understanding that you're talking about short as in and liquid assets as in your savings accounts and then the long being your mortgages and a home loan, because that's 30 years. 

Thomas: [00:05:37] Yeah, that's right. That's right. Yep. I mean, that's not the only sort of short, long assets in the economy, but that's sort of what we can sort of get a handle on. And your traditional bank runs that that's what happens there is that people decide they want their money back from the bank, but the bank has lent it out and it's going to take them a long time to get it back. They can't pay out those liquid assets and then they collapse. And that's your traditional bank run. But what what Diamond and did Dig showed is that that dynamic can play out all across the financial sector and that that maturity transformation creates vulnerabilities wherever it shows up in the UK pension system at the moment was caught short last week because for the exact same thing that that their assets crashed in the short term the liabilities spread over the long run and they got into trouble. So that's the lesson of the work that they did. 

Sascha: [00:06:24] So the award committee said that their work showed, quote, why avoiding banking collapses is vital, which is what you were just talking about there. That seems fairly obvious to me. How did their work actually prove this or show how we can avoid it or didn't it? Is that what we're finding out now? 

Audio Clip: [00:06:42] Bernanke was like 28 and then 30 years old when he wrote the papers that I think they're talking about, they are talking about in this, which is he changed our understanding of the Great Depression. 

Thomas: [00:06:52] I think that that central point comes from Ben Bernanke's paper in 1983. And so he was a great student of the Great Depression. And his contribution to understanding why the Great Depression was so great and took so long, it wasn't just a matter of and being an aggregate demand shock in a Keynesian sense or a lack of liquidity coming from the Fed. It was because the financial system itself got hollowed out because you had all these banking collapses and once you have the banks collapse and that hollowing out of the financial system, that gave you a much deeper and much more protracted crisis. And that was his contribution. And then that became a real practical application in the global financial crisis. Once banks started going to the wall or potentially going to the wall, the Fed stepped in in a massive way that printed heaps of money. They flooded the markets with liquidity. And the real agenda was, we're not going to let the banks collapse. We're not going to have a banking crisis because we believe that if we did that, then you end up with a much bigger depression rather than a recession. And that was the central idea. 

Sascha: [00:07:59] So you 've mentioned a few times that it's this idea that economics takes a while to kind of filter through and for us to really understand the impact. But you're talking about banking crises. We've had quite a number. Obviously, you just named the Great Depression, but there was also the one in the eighties and then the global financial crisis. Why has this work that's been mainly published in the 1980s, only now being recognised is it just literally that it took four decades or has there been something happened recently that's made it worthwhile? 

Thomas: [00:08:31] That's a really interesting question. I think the timing is really interesting because we are in a situation now where we have just flooded the financial system with cash. Again, we had that playbook that got established by Bernanke in the global financial crisis. We went to that playbook again with COVID and we flooded the market with liquidity and we pulled out all stops to make sure that our banks didn't collapse. Right now, that's potentially looking like it was the wrong move because inflation's got off the chain. We're creating all sorts of problems. Inflation's running wild. It looks like we may have misplayed that or we may have not understood that in enough nuance. It may have been the wrong thing to do. So it does almost look like the prize committee has come in and go, look, I just want to reinforce that saving banks in a financial crisis is a really awesome thing to do. I know you're all dealing with double digit inflation. I know you're dealing with rising interest rates. But we just really want to reaffirm that this was a good idea, that this was a good thing to do. That's why I'd like it. It's really interesting the timing and I think because I think like we are looking at a phase where maybe that wasn't the right thing to do and also that the priorities that come through is in that opening statement that you laid out at the start, it's that, yes, we don't want banks to collapse, but at what cost? And are we really going to put banks as the at the at. A centre of our priorities and make them a number one priority. And what about the moral hazard that we create if we say that we're not going to ever let banks collapse once they get beyond a certain size? We're not going to let them collapse no matter what happens, no matter what they do. That creates moral hazard and creates a whole bunch of problems. And we haven't really sorted that work that through. We have some ideas around it, but we haven't got any policy measures to keep that moral hazard in check. So I think the timing in that sense is interesting. For me, it's like there's an open question about like, is this attempt to flood the market with liquidity at all costs to save the banking system? Should that really be the number one objective of our central banks? I think there's a question around that right now. So the timing of this award is kind of interesting to me. 

Sascha: [00:10:44] MM So you're talking there about the size of the bank and the fact that they are talking about supporting them in times of crisis then kind of takes away the idea of consequence from the people running the banks. Is that what you're talking about in terms of moral hazard?

Thomas: [00:11:00] Yeah, that's right. That's right. I mean, one of the key practical applications of diamond and difficult work was the idea of a deposit guarantee so that Australia instituted this in the global financial crisis. So all deposits with a bank up to $250,000 are guaranteed. They're backed by the government. No matter what happens to that bank, those deposits are guaranteed by the taxpayer. That stops a run on the bank because people go, okay, I don't need to pull my money out because the government's got my back. But it creates an unlevel playing field for the big banks who have that deposit guarantee. That's a free kick. Like they, there's a certain risk premia goes down because governments got their back. That creates smaller banks or non-bank institutions that don't have that free kick and so they're paying more for their more interest as a result. Yeah. Is that an ideal outcome? I'm not sure. But that's what we've done with this work and that sort of way where it's a social science. Like it was like the way that they've mapped out how these bank runs work and the maturity transformation. Super useful, really interesting stuff. How we apply it, how we make that play out in our economy. There's still a lot of questions around it. 

Sascha: [00:12:11] Let's take a quick break here and I'll be back shortly with more from Thomas from comedian, vice economist. 

Audio Clip: [00:12:27] That was based on my reaction. Oh, stop it. University of. The Chicago professor gets awarded the Nobel prize in Economics, and that was his reaction. 

Sascha: [00:12:39] Welcome back to the dive. I'm Sascha Kelley, your host. And today we're talking about the Nobel prize for economics. Let's get back into my conversation with Thomas from comedian versus economist. So because you're talking about the fact that that we're in a time of turmoil currently, do you think that this decision will make bank runs and banking failures less likely in the future? Or will it take us another four decades to kind of understand the impacts we might be looking at another Nobel prize for economics in four decades that completely transforms economic theory. 

Thomas: [00:13:12] Yeah, I think so. I mean, it's really useful. Like, it's good it's good. What I think the three winners have given us is some good stories to understand how things play out right here and right now in the current settings. But those settings are not this where it differs from the physical sciences. We're not talking about gravity. We're not talking about a set of institutions that has been given to us by God that says that atoms should interact this way with other atoms and these sort of things. All those policy settings are just institutions that we have created and are up for change. And so as those institutions change, then we start to re revisit those stories. And so it's quite possible that in 40 years, we have a policy framework that makes all of this work redundant. It just doesn't apply anymore. But for the moment, I think it does give us a good handle on what's happening and does point to the way forward of that where we need to do more work. And I think like the moral hazard and that sort of thing, that's definitely more work to be done then. 

Sascha: [00:14:09] I guess my last question out of curiosity is, is there a significance to the Nobel prize for economics within the economic community? You know, does it give you huge clout? Will this really make your career? We did talk about the prize money earlier that it's significant, but I'm just curious about where it sits in terms of other economists' knowledge and the fame within that circle. 

Thomas: [00:14:33] Yeah. I mean, it's yeah, it's massive is massive like it in it's where it's where you sort of cut across. You can launch yourself from being famous in the economics discipline to just being generally famous. Yeah. So, you know, it is massive, but it, it, it does come, it tends to be awarded at the end of a career. Like you look at Diamond 68, 67, I think blank is about the same mark. It sort of comes at your end of the career. You're already famous, you're already a tenured professor, wherever you are. So it's not going to have a massive change on your career trajectory, I don't think. But yeah, it definitely makes you mark and they would be chuffed. They'd be stoked to be getting this award for sure.

Sascha: [00:15:13] And solidifying work that they've done 40 years ago. So, you know, in the middle, if you're in your sixties, you know, in your mid-twenties. So that's pretty, pretty incredible there for sure. Well, Thomas, let's leave it there for today. I think you've got me up to speed, though, with the Nobel prize for economics. I really appreciate it. Got to give you a shout out. You also released an episode for CVE this week. First Fan Fest has a special guest in the studio. My colleague Alec Linehan and I've just finished listening to it. Lots of laughs. It was a really great episode. So also got to give you a plug and say go have a listen to CVE as well. 

Thomas: [00:15:47] Thanks, Sascha. 

Sascha: [00:15:48] All right. Talk to you soon.