What Lebanon can learn from Nobel economists

Bernanke, Diamond and Dybvig’s research on financial crises could help Lebanon navigate its catastrophic banking crisis


What Lebanon can learn from Nobel economists

Three US economists shared the 2022 Nobel Memorial Prize in Economic Sciences for their research on banks and financial crises.

They were Ben S. Bernanke, a distinguished fellow at the Brookings Institution and former chairman of the US Federal Reserve from 2006 and 2014; Douglas W. Diamond, professor of finance at the University of Chicago Booth School of Business; and Philip H. Dybvig, professor of banking and finance at Washington University.

Although carrying the hallmark name of Alfred Nobel, this prize was not directly endowed by the legendary Swedish chemist. For 121 years, his name has been bestowed on scientists and peacemakers from around the world, who have conferred the greatest benefit on mankind.

Nobel knew little about economics and abhorred it being listed as a science, preferring to keep that classification to medicine, physics, chemistry, literature, and the most famous of all his prizes: peace.

The prize being shared by the three American economists is called “The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel.” Although administered by the Nobel Foundation, the prize was established by Sweden’s central bank to commemorate its 300th anniversary.

Ben Bernanke

Bernanke earned the 2022 laureate for his cutting-edge research of the Great Depression — the worst economic crisis in modern history — which on Thursday, 24 October 1929, witnessed a major drop in the price of inflated stock and bonds on the New York Stock Exchange.

Over the next couple of days, the world economy famously lapsed into a recession that lasted 10 years, during which hundreds of banks and financial institutions went bankrupt, incurring huge loss on depositors.

Professor Bernanke attributes the exacerbation of the 1929 crisis to “bank panic,” where depositors became overwhelmingly afraid of losing their savings. This, along with the news of the so-called Black Tuesday crash, then triggered a run on banks and a massive withdrawal of funds.

This behaviour deepened and eventually prolonged the financial catastrophe — particularly with the continued adoption of deflationary monetary policies that had a devastating effect on the world economy. In his 1983 article, Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression (The American Economic Review, volume 73, No. 3), Bernanke detailed how people’s reluctance to deposit their savings in banks prolonged recession and allowed it to drag on for almost an entire decade.

Bernanke also noted that from that point, banks were reluctant to offer long-term loans, fearing that they would be exposed, once again, to stressing emergency withdrawals.

Bernanke’s wealth of research, both on the Great Depression and the Japanese banking crisis of the 1990s, gave him plenty of knowledge, which he put to good use when serving as chairman of the US Federal Reserve in 2008.

It helped in solving the mortgage crisis that rocked the US during his tenure, which began when low-income families were incapable of refinancing loans that they had obtained to purchase their homes.

That triggered panic among mortgage dealers, which, in turn, led to the faltering of financial services, subsequently causing an economic deflation that froze the global financial system.

Under Bernanke, the Federal Reserve System intervened swiftly to maintain and secure adequate liquidity, preventing the collapse of commercial banking by dropping the benchmark interest rate to zero and launching an intensive purchase of debt securities from the markets — a policy that later came to be known as quantitative easing, or QE.

Bernanke succeeded, avoiding a freeze of the credit system which potentially might have triggered another depression. Some of the negative side effects of his success was rising inflation of speculative bubbles and the exacerbation of inequality in wealth.

Both, however, were contained by Bernanke.

Diamond and Dybvig

Bernanke’s fellow laureates, Douglas Diamond and Philip Dybvig, earned their place in history for formulating a theory to explain the logic behind the very existence of banks, their vital importance in society, and the reasons for their vulnerability.

The two economists worked on a mathematical model carrying their name, known as the Diamond–Dybvig Model, which measures both panic and fear among depositors. They tackled specific cases, such as the spread of negative rumours about the status of banks and their liquidity, which causes clients to rush to withdraw their deposits.

The raison d'être behind the existence of banks, Diamond and Dybvig believed, spells out the very reason for their vulnerability. Depositors, they said, prefer obtaining liquidity, not only on the dates specified in their deposit contracts but also at any time they need their savings.

Meanwhile, borrowers from banks need time to pay off their debts or collect their return on investments. Theoretically, this means that banks are constantly at risk of liquidity shortage — a situation that will likely be exacerbated by pressure that necessitates deciding to share the risks associated with this structural situation of liquidity. Precautionary measures to handle the risk of liquidity shortage may include restricting the right of depositors to withdraw funds by day, week, or month. Such restrictions should be approached with great caution, since they can have serious impacts on depositors.

A mechanism for exceptions ought to be found, including humanitarian and/or medical cases, like the need for life-saving surgery. Setting a fair maximum for withdrawal limit is not easy. Diamond and Dybvig believe that overcoming this hurdle can be achieved through activating the role of the central bank as a “lender of last resort” to private banks or by adopting a system of deposit insurance with the “possibility” of setting a maximum limit.

Diamond and Dybvig believe that overcoming this hurdle can be achieved through activating the role of the central bank as a "lender of last resort" to private banks or by adopting a system of deposit insurance with the "possibility" of setting a maximum limit. 

That was the case in the European Union after 2009, when insurance was limited to €100,000/depositor. This system greatly reassures individual depositors, if not investment funds as well. 
A catastrophic crisis 

All the above, along with the findings of the three professors, were seemingly missed by banking officials in Lebanon — a country experiencing a banking crisis that has been described by the World Bank as one of the most severe worldwide since the mid-19th century. 

Banks around the world, Lebanon included, have made massive transfers abroad for the benefit of political leaders and privileged individuals living overseas. In Lebanon's case, these transfers amounted to no less than three or four times the value of the loan that Lebanese officialdom has been negotiating with the International Monetary Fund (IMF).  

The Lebanese constitution guarantees "economic freedom" but that was ignored so that banks could practice the exact opposite. Under directives of the Central Bank of Lebanon (CBL), there are now low ceilings for bank withdrawals, coupled with haircuts that exceed 75% for accounts in foreign currencies. 
Adding insult to injury, the CBL has recently authorised private banks to accept opening new accounts in fresh dollars — unrestricting new funds in foreign currency, all coming from abroad. All this does is encourage political leaders and influential figures to move a fraction of the money that they transferred abroad over the past three years, returning it to Lebanon as "fresh dollars."  


Politicians are presently deliberating what they describe as a better version of capital control — a law that would maintain their self-interests rather than expose them to legal prosecution for exacerbating the banking crisis. 
These politicians should all read the works of this year's Nobel economics laureates to help them learn how similar problems were solved in the not-too-distant past.  

Perhaps in such case studies they will find a solution to the banking problem in Lebanon.  

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