he 2022 Nobel Prize for economic sciences has been awarded to three American economists: Ben Bernanke, Douglas Diamond and Philip Dybvig, for their research on banks and financial crises. The Nobel laureates believe that bank failures led to the emergence of the global financial crisis in 2008 and defied a quick recovery as major economies queued up and got into deep recessions.

The global financial crisis of 2008 had many similarities with the Great Depression of the 1930s. The Great Depression paralysed the world’s economies for many years and had lasting adverse social consequences. The global financial crisis of 2008 was arguably the worst after the Great Depression of the 1930s. Research by the 2022 Nobel laureates, according to the Swedish Academy prize committee, has made it possible to manage subsequent financial crises effectively.

Despite the professional stature of the Nobel laureates, their prognosis and proposed solutions do not gain easy traction. It is no secret that the corporate greed of the large investment banks was primarily responsible for creating and precipitating the crisis. Governments worldwide bailed out the banks in 2008 and 2009, while ordinary people suffered. Some of them lost their homes. The Nobel laureates, however, have argued that society as a whole benefitted from the bailouts.

Bernanke was the Federal Reserve chairman when Lehman Brothers collapsed in 2008. Bernanke says that had Lehman Brothers been rescued in time, the crisis might have been much less severe. He argues that there was no legal way to save he bank. So the second best thing for the government was to let the banks fail and use the resources to prevent system-wide failures. The Fed introduced ultra-low interest rates and bought massive assets to pull the economy out of the recession. The approach has been reversed recently after inflation reached one of the highest levels in the United States and some other parts of the world.

Bernanke believes that economic contractions lead to bank failures, but it was the large-scale bank failures that prolonged the crisis. When the banks are not in a position to channel loans towards productive activities, more severe economic crises result. Only banks are strategically positioned to know about the economic health of the businesses; when the banks fail, the knowledge is lost. As the banking system took a long time to recover, the economy performed poorly throughout the period.

Unlike Bernanke, who explained the consequences of bank failures, Diamond and Dybvig explained why banks failed. The banks failed when there was a run on the banks by the depositors. Diamond explained that when people started losing faith in the financial system’s stability, bank runs became a real possibility. What can the banks do in such a situation? According to Diamond, the banks need to ensure that the banking sector is healthy and respond in a calculated and transparent way to any change in the policy regime, including the monetary policy.

In Diamond and Dybvig’s model, banks are intermediaries overseeing the transfer of funds from depositors to borrowers. The deposits are for short periods but the loans are given for long years. It is in this context that the banks provide the maturity transformation function. The banks coordinate the meeting between savers and investors and channel loans towards good projects. This helps the economy grow. Diamond and Dybvig suggested that bank failures could be averted by deposit insurance. This implies a more significant role in the market for governments.

Whether insights from this year’s noble laureates will mitigate the risk of running into more depressions like those of the 1930s and 2008 and make the global economy less vulnerable is anybody’s guess. They will be best judged by history.

Bernanke’s legacy as a policymaker during the 2008 global financial crisis is mixed. While he is lavishly praised for managing the American economy during the financial crisis, many people contend that he had a significant role in precipitating the crisis. Before the crisis, Bernanke was part of the team that kept interest rates low. This fuelled the housing bubble. During the crisis, he developed a monetary stimulus to prevent bank failures that continued to create financial bubbles.

Diamond and Dybvig too are no strangers to controversy. Like them, Sweden’s Sveriges Riksbank economists also believe that deposits lead to loans. However, there is considerable controversy here. The Bank of England researchers found that it is after banks give loans that the money comes back in the form of deposits. In this model, banks are not the intermediaries; they create money. The Reserve Bank of Australia and Bundesbank of Germany are also of the view that bank loans precede saving deposits.

Whether the insights from the three Nobel laureates of this year will mitigate the risk of running into more depressions and make the global economy less vulnerable is anybody’s guess. They will be best judged by history.

The Great Depression in the 1930s is often called a five-sigma event. In terms of a probability distribution, the likelihood of such an occurrence is nearly 0. Nobody could thus have predicted that such a massive depression was around the corner. In hindsight, we can identify a series of events that led to it. Thus the failure on the part of economists to predict it was considered a general failure of the economics discipline.

An important factor contributing to the Great Depression was the instability of Germany. As a result of the Versailles Treaty, Germany had to pay considerable reparations. This made it unstable. A major takeaway is that since the world is much more integrated now than it used to be 90 years ago, it is much more important to watch for the weaker links because problems in one country can create problems in other countries. More recently, the Ukraine-Russia war has led to great volatility in the petroleum prices, a massive increase in the inflation rates and volatility in the value of major currencies all over the world.

Several quirks in the history of Nobel prize make one less inclined to see too much policy value in the insights of Nobel laureates. In the past, individuals have been awarded Nobel prizes for contradictory approaches, sometimes in the same year. The controversy between 2013 Noble laureates Robert Shiller and Eugene Fama is a case in point. Schiller believed that as human beings investors were liable to be swayed by several psychological factors, whereas Fama held that markets were always efficient, and consumers incorporated all available information into the price mechanism. The disagreement reached a point where Schiller publicly stated that Fama may be suffering from “cognitive dissonance”.

The works of 2018 Nobel laureates, Nordhaus and Romer, integrated climate change and technological innovation into macro-economic analysis. The 2019 Nobel laureates Banerjee, Duflo, and Kremer, popularised experimental approaches to alleviate global poverty. The works of these five Nobel laureates had direct relevance for Pakistan. Does the work of Bernanke, Diamond and Dybvig have similar relevance for it?

A large segment of Pakistan’s population refuses to approach banks for loans on account of the prohibition of interest in Islam. Many only reluctantly park their savings in current accounts. Financial literacy is generally low and most people have limited skill levels to capitalise on the opportunities offered by new technologies. Without an effective regulatory and judicial system, the odds of generating a dependable income stream by investing in peer-to-peer Shariah-compliant instruments like Musharika and Modaraba are also very low. The public is largely sceptical about the functioning of the banks that identify themselves as ‘Islamic’. The banking system needs to address the lingering doubts in the public mind to achieve its potential.

The writer is an associate professor in the Department of Economics at COMSATS University Islamabad, Lahore Campus