In the classic Disney film “Mary Poppins”, George Banks, a prominent London financier, takes his son, Michael, to the bank to convince him to deposit his tuppences instead of using them to feed the birds. After a song (and a stilted dance) by the bank’s board of directors, the president takes Michael’s money, creating a ruckus when Michael shouts. All customers assume that the bank must be short of money and demand their deposits. The bank reacts by closing its doors and going out of business, which only creates more panic in London as a large crowd forces themselves inside.
The scene, while hilarious, highlights one of the fundamental weaknesses in our global financial system – how banks can cause a financial crisis – which was the subject of research that won the Nobel Prize in Science awards this year, awarded on Monday.
Sweden’s Riksbank awarded the prize to former Federal Reserve Chairman Ben Bernanke, along with fellow Americans Douglas Diamond and Phillip Dybvig, for their work on the role of central banks in preventing or managing financial crises. The award was for research published in 1983 and 1984 that remains alarmingly relevant nearly four decades later.
Bernanke is a household name in politics and economics, having served as Chairman of the Federal Reserve from 2006 to 2014. Appointed by Presidents George W. Bush and Barack Obama, Bernanke led the Fed through the 2008 financial crisis. Ironically, Bernanke wrote his doctoral dissertation on how the Federal Reserve made the Great Depression worse by reducing the money supply and raising the interest rate as the stock market crashed. As a professor at Princeton, Bernanke researched economic history, showing that liquidity in the face of toxic assets – hard-to-sell investments – was essential to preserve the banking system.
In developed economies, fractional banking is key to long-term private capital investments, such as expanding factory space or building research labs. Since these projects require billions of dollars upfront, banks serve as key intermediaries taking the relatively smaller savings of ordinary workers and channeling the funds to improve and build the economy. Unlike Scrooge McDuck, Bankers don’t swim in gold coins in a giant safe, but rather save a fraction of each deposit as a reserve and lend the rest. These loans cause a chain reaction that ripples through the entire financial system, with companies using the cash to hire workers who then put their savings in a bank that lends again and so on.
However, if the assets that investors have bought lose value or if participants in the financial system lose confidence, then the whole apparatus can collapse like a house of cards. Bernanke’s research on the Great Depression showed that bickering among regional bank presidents, as opposed to quick and decisive action to increase the money supply in the face of the crisis, crippled credit and increased the economic quagmire.
In the fall of 2008, Bernanke applied those lessons by cutting interest rates, then advocating an all-time low. Normally, when the Fed increases the money supply, it does so by buying risk-free government savings bonds. This action injects liquidity into the financial system and lowers interest rates while maintaining the same risk on the Fed’s balance sheet. Bernanke instead opted to buy mortgage-backed securities, making the banking system more liquid while removing toxic assets from the market. This bold move may have halted the collapse in asset prices and allowed markets to stabilize.
Bank runs, however, are psychological. If all the depositors withdraw their savings at the same time, the bank will lose its reserves quickly and close. Diamond and Dybvig have shown that prevention is the best cure. If policymakers can keep fear from spreading through the system, angry depositors (like the bank’s kids) won’t even show up.
Utah banker and former Fed Chairman Marriner Eccles reportedly slowly paid depositors in small bills and silver dollars or drove a truck with cash-lined windows, among other strategies, to signal liquidity. However, the consistent way to signal confidence is for the government to provide deposit insurance (like the FDIC). These programs reassure borrowers that their savings are safe and there is no reason to withdraw en masse.
Who should create money, how to use it, and how to ensure its value has always fascinated humans since commerce has existed. Central banking is a young science, but these researchers have expanded our understanding of our relationship with money and finance in illuminating and sometimes controversial ways. Understanding the effects of monetary policy is vital to the strength of money, the trust we place in ourselves, and our relationships in an interconnected world.
Michael S. Kofoed, @mikekofoed on Twitter, is an associate professor of economics at the US Military Academy and a research fellow at the Institute of Labor Economics. A native of Utah, he holds degrees in economics from Weber State University and the University of Georgia. These opinions are those of the author and do not represent the United States Military Academy, the Department of the Army, or the Department of Defense.