Nobel 2022: Comments

The 2022 Nobel Prize in Economics recognized excellent work in economics. No one will dispute that. However, the Nobel committee did not display the kind of even-handedness we have seen in the past.

I remember when the Diamond-Dybvig model was first put forward. It energized discussion of the role of central banks and supported their role as lender of last resort. Bernanke’s work on monetary policy in the Depression also supported arguments for an active Fed. The Fed’s (that is to say, Bernanke’s) decisions in 2008 are often justified by reference to that research.

However, there is another line of research which focuses on the dangers of Fed activism. In particular, Kareken and Wallace in their papers pointed out that deposit insurance creates a “moral hazard” problem, that is, when depositors are insured against losses a bank has more incentive to make risky loans at high interest rates. In simple terms, heads the bank wins, tails the government loses and depositors don’t care. Another example of this was the “Greenspan put” which is the name of Greenspan’s tendency to use monetary policy to keep stock prices up and also encouraged risky investments.

For a far more serious presentation of these issues, see the interview Tom Sargent gave in 2010.

These issues are as active and relevant today as they ever were. Here at the Hoover Institution I hear a lot about the moral hazard problems and the preference of “Let them fail!” The Nobel Prize committee has come down on one side of the argument. Of course, remember that the “Nobel” Prize in economics is really given by the Bank of Sweden, telling us that central bankers in Sweden gave the prize to an American central banker, and academics whose work supports central bank activism and intervention.

My own views are mixed. Bailing out AIG was profitable for the US Government. They had the assets to cover their liabilities but it was a very bad time to sell assets to raise cash. A no-brainer for anyone with a lot of cash.

Bankruptcies can be messy and take too much time to resolve. I once heard a regulator tell us that one problem with the 2008 bankruptcies is that so many deals were unconventional. Put simply, a couple of investment bankers would see each other in the men’s room and use the available paper to define a novel kind of trade. Bankruptcy procedures had to sort through this mess. The regulator said that his agency was working to mandate that all trades fit on standard forms. My comment was “I thought you were supposed to make financial markets more stable, not just making sure that future autopsies were easier.”

The Bush administration decided to bail out General Motors because it thought that the resulting disruption would be very costly in the environment of late 2008. The US lost money on the investment side of that bail-out but I would like to see a full accounting include the savings in terms of avoided unemployment insurance claims.

The work done by Dybvig, Diamond, John Bryant, Kareken and Wallace in the last 70’s and early 80’s has always been recognized as important. That was 40 years ago, in the days of paper and pens. That generation did great work. Here again is an example of where the economic profession has failed spectacularly in developing important ideas. There is no doubt that both the lender-of-last-resort and moral hazard arguments have some validity in the real world. It is also obvious that the excessively simple models built by a younger generation and used in macroeconomics and finance today, are incapable of analyzing how these considerations interact, and cannot evaluate alternative policies in any serious quantitative manner.

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