The BBVA Foundation Frontiers of Knowledge Award in Economics, Finance and Business Management has been awarded in its thirteenth edition to Ben Bernanke (The Brookings Institution, Washington DC), Mark Gertler (New York University), Nobuhiro Kiyotaki (Princeton University) and John Moore (University of Edinburgh). The jury has awarded him “for his fundamental contributions to understanding how imperfections in financial markets can amplify macroeconomic fluctuations and generate deep recessions “, according to the minutes.
“In the last 15 years”, as the jury relates, “advanced economies have been hit by strong macroeconomic shocks that have arisen from the financial sphere. In 2008, driven by excess liquidity from emerging countries and lax supervision, many financial institutions in advanced economies had pursued a strategy of short-term benefits and took big risks: Investing in real estate bubbles with short-term loans and exposing yourself to undercapitalized financial institutions. Governments and central banks had to rescue a financial sector that was on the verge of imploding and would not have been able to perform its main functions: serving retail depositors, lending to small and medium-sized businesses, and managing a fluid payments system.
The jury highlights that “what the Great Recession, the European debt crisis and the current Covid recession have in common are weak balance sheets” in companies, financial and non-financial. “The macroeconomic effects of weak balance sheets had been largely ignored before the 1990s, even though their importance is crucial.”
This importance was made clear in the paper by professors Ben Bernanke and Mark Gertler “Agency Costs, Collateral, and Business Fluctuations”, published in 1989 in the prestigious American Economic Review. In it they develop a model that shows that if a company must go out to raise financing in the market, the state of its balance sheet is key: if the company has a weak financial situation, the premium that it must pay for financing will increase, This will reduce your ability to acquire loans and, therefore, your investment and, crucially, your productive activity. This reduction in activity will drag down the cash flows and the price of its assets and capital, which will lead to a further deterioration of the balance sheet. In this way, a “fatal loop” is produced, in terms of the jury, which causes that small initial shock in the financial statements of companies (due to an adjustment in production, for example) to lead to feedback that can trigger a crisis.
“Preliminary discussions on this article started in 1983,” Professor Gertler recounted shortly after hearing the news of the award. “Ben and I met during a summer in which we shared a residence in a large house that a mutual friend had found. He was a great connoisseur of the Great Depression and his ideas led us to ask ourselves how the financial sector could be a factor that propagates economic cycles, the interaction between both planes. Thus they began to write the article, in which they described that “Adverse feedback loop”, in their own words, which they gave the name of financial accelerator.
In their subsequent work, Bernanke and Gertler (nominated by Joaquín Maudos, Professor of Economics at the University of Valencia and Deputy Director of Research at the Valencian Institute for Economic Research) introduced the credit channel, the amplifying effect that loan dynamics of the Banks add to this negative loop: when evaluating a transaction, banks take into account the value of the investments to be financed, but also the economic cycle and the financial statements of the companies that request the loans. The balance sheets of companies, therefore, already deteriorated by the impact of the crisis extended to the real economy, make it difficult to finance companies in the banking channel, adding that new feedback multiplier effect. This channel, as detailed in the jury’s minutes, “shows how weak banks lead to a credit crisis, in which fragile companies (small and medium-sized companies) that depend on their relationship with the banks suffer.”
The Kiyotaki-Moore model
In those early eighties when professors Bernanke and Gertler met, the latter carried out an action that he defines as “one of the best professional decisions I have ever made”, hiring Nobuhiro Kiyotaki.
Shortly afterwards, Professor Kiyotaki (nominated by Teresa García Milá, professor at Pompeu Fabra University and director of the Barcelona Graduate School of Economics) moved to the United Kingdom, to carry out a stay at the London School of Economics, where he met the professor Moore (also nominated by Professor García Milá and József Sakovics, Acting Director of the School of Economics at the University of Edinburgh): their offices were side by side. “I had already finished all the syllabus before the end of the course and it occurred to me that I could ask Professor Kiyotaki for some material. My students were dazzled by his work, ”recalls Professor Moore.
Moore, who had so far focused his research work on microeconomic aspects, especially contract theory and industrial economics, was going through an experience that was decisive for the collaboration between him and Kiyotaki: professional reasons forced him to move to Scotland, so that he had to sell his house in the British capital in the midst of a major housing market crisis (in the early nineties). The price that the market was willing to pay for your home was falling, but the mortgage credit he had was not diminishing, so he was forced to sell in an environment that would make him surface large capital losses.
Precisely, by placing assets at the center of the model, its great contribution emerges: the well-known Kiyotaki-Moore model, and the multiplier effect of collateral. When companies go to the market to finance themselves, they must use an asset as collateral, that is, as a guarantee for the lender in the event of a worsening of financial conditions that may lead to default. The feedback effect appears here in a new way: if the assets that companies use as collateral (investment in machinery, real estate …) deteriorate, this makes their access to financial markets even more complicated in order to carry out new productive activities that allows them to improve their balance sheets.
The key, the record illustrates, “resides in the dual role of capital, as a productive asset and as collateral.” “The effect,” he continues, “is persistent: as companies invest less, the value that the market discounts from future profits is reduced, further reducing their net worth. This intertemporal channel further deteriorates the value of the collateral, creating a loop that further amplifies the initial recession.
Both pairs of researchers – Bernanke and Gertler on the one hand, Kiyotaki and Moore on the other – continued to open research paths in which they put their model in relation to transfers to and from the financial system and how monetary policies could correct these imperfections . The first two carried out a series of papers in the late nineties which, in the words of the jury, have shaped “what has become the standard model for business cycle analysis and monetary policy.” For their part, Professors Kiyotaki and Moore focused on liquidity and its effects on the system.
As the jury notes, the work of the four winners promoted “a vast literature that expanded especially quickly after the great financial crises of 2008 clearly demonstrated the relevance of their ideas. Thanks to their contributions, today it is common for economists to analyze the implications that company balance sheets have on monetary policy, for capital controls, to understand the role of shadow banking – and its associated dangers – and to prudential regulatory reforms ”.
All this investigative work served as an argumentative support for the unorthodox quantitative easing measures that were applied to fight against these crises. Professor Kiyotaki assures that they gave “academic support to explain why this policy (known as quantitative easing) would not make governments lose money, but could generate income, in addition to improving or mitigating the crisis.”
This is corroborated by the person who, at that time, presided over the US Federal Reserve and had to face the devastating effects of the economic mechanisms that, along with the other three winners, had described in his models years before, Professor Ben Bernanke. “Yes absolutely, [nuestra investigación sirvió de apoyo académico a las decisiones que tomé cuando era presidente de la Reserva Federal]. Now we no longer remember, but there were many people during that crisis who argued that this was a problem for Wall Street, that it was not a problem for the rest of the economy. I was convinced that great instability in the financial system, including the collapse of a large company, would be destructive not only for investors and companies on Wall Street, but also would have huge implications for the entire economy». A perception, he concludes, based on his research work, that “underlined the importance of trying to stabilize the financial system to avoid the implications for the economy in general, which we actually saw when the crisis worsened in 2008. So this was a beginning. very important that I tried to put into practice.
In the current crisis derived from the Covid-19 pandemic, one of the problematic sources is once again in the weakness of the balance sheets of some companies and, as the jury notes, “it worries that they cannot survive without a prolonged injection of money for governments and central banks.
For Mark Gertler, the key will be how long the shock lasts: «Dealing with the current crisis is, fundamentally, dealing with the virus: that vaccination continues to advance, that there are guarantees that masks are used and the rest of preventive measures … In this sense, we are clearly seeing signs of progress in both the United States and the Eurozone. Now, with interest rates at zero, and even below, both in the short and long term, it seems clear that there are limits to how much more monetary policy can stimulate the economy ””.
In this regard, Professor Moore agrees that “this Covid-19 crisis is even more severe than the financial crisis. What it shares with it is the erosion of balance sheets and the damage this does to investments, and in general, to all economic activity. But in addition, it is simultaneously a shock to the supply of many products and services, and at the same time slows down demand, because people are locked up and cannot spend, or they have lost purchasing power and therefore spend less. For all these reasons, I believe that the Covid crisis will be like a test bed for macroeconomic thinking and models for many years to come.