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Analysis | The 2022 Economics Nobel should come with a warning

The Nobel Prize Committee has rightly recognized three economists—Ben Bernanke, Douglas Diamond, and Philip Dybvig—for their research on a topic critical to human prosperity. If only supervisors would put their insights into practice better.

The research citing the prize revealed a major flaw in the prevailing academic orthodoxy. At the time, the dominant models — used by policymakers to understand and manage the economy — assumed that the financial sector played a minor role in booms and busts, simply operating in the background to turn savings into investments. But Diamond and Dybvig pointed out that short-term borrowing to make long-term investments (i.e. leverage combined with maturity transformation) made banks particularly prone to debilitating panic. And Bernanke showed how these dynamics played a central role in making the Great Depression of the 1930s so bad.

These efforts suddenly proved relevant in 2008, when a bursting mortgage bubble sparked a panic that paralyzed both traditional banks and lenders in the so-called shadow banking sector, leading to the bankruptcy of several major institutions, including Lehman Brothers Holdings Inc. The credit crunch eventually left millions of people out of work and destroyed an estimated $1.4 trillion in economic output in the US alone.

Despite his stock market, Bernanke — who chaired the Federal Reserve from 2006 to 2014 — has been slow to respond to the brewing crisis. As late as 2008, the central bank deemed the largest US financial institutions healthy enough to continue making shareholder payments that reduced their equity capital and increased their leverage. Their capital buffers soon proved woefully inadequate, forcing the Fed and other authorities to deposit trillions of dollars in taxpayers’ money to lift the financial system from the brink of collapse.

Regulators have since responded with stricter capital and liquidity requirements, designed to limit leverage and ensure banks have enough cash to weather a confidence crisis. But even in traditional banks, the level of capital would need to be much higher to be resilient in a severe crisis. And as illustrated by incidents such as the recent trials of UK pension funds and the implosion of Archegos Capital Management, regulators need to do even more to limit leverage between non-bank financial institutions, for example by setting minimum collateral requirements in the credit and derivatives markets. .

The Nobel Prize in Economics usually rewards research that has long been widely accepted and followed up. Not this time. The world is once again in an economic downturn with little confidence that the financial sector will be a source of strength rather than contagion. Let this award serve as a reminder: the task of addressing the vulnerabilities described by Bernanke, Diamond, and Dybvig—and which the 2008 financial crisis exposed—is far from done.

More from Bloomberg Opinion:

• How do we solve Bernanke’s solutions? That’s for a future Nobel laureate: Stuart Trow

• Nobel laureate chemistry wants to shake up her field: Lisa Jarvis

• On Putin’s birthday, the Nobel Peace Prize honors his enemies: Therese Raphael

The editorial board serves on the editorial board of Bloomberg Opinion.

More stories like this are available at bloomberg.com/opinion

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