Frontiers Award to Bernanke, Gertler, Kiyotaki and Moore for establishing the interrelation between financial markets and the real economy

The four winners´ investigations have produced extensive literature that grew especially fast after the great financial crisis of 2008, which added to the relevance of their ideas. The award jury wanted to highlight that "what the Great Recession, the European debt crisis and the current Covid recession have in common are “weak balance sheets'' in companies, whether financial or not. “The macroeconomic effects of weak balance sheets had been largely ignored before the 1990s, even though their importance is crucial.”

Ben Bernanke (United States, 1953) and Mark Gertler (Canada, 1951) showed that a negative loop is established within a company's balance sheets, its investments and their productive capacity, which can propagate until giving rise to a macroeconomic crisis. A relevance that was made clear in the paper ‘Agency Costs, Collateral, and Business Fluctuations,’ published in 1989 in the prestigious magazine American Economic Review.

“We began to talk around the subject of the paper as early as 1983, ” Professor Gertler explained after hearing about the award's ruling. “Ben (Bernanke) had a vast knowledge of the Great Depression and his ideas led us to speculate on how the financial sector might  be a factor in propagating business cycles, by how it interacts with the real sector,” he commented.

In their later work, they introduced the credit channel, which explains the amplifying effect bank loan dynamics add to that negative loop. This channel shows how weak banks lead to a credit crisis, in which fragile companies (small and medium-sized companies ) that depend on their relationship with banks suffer.

The Kiyotaki-Moore model

Professors Nobuhiro Kiyotaki (Japan, 1955) and John Moore (Germany, 1954) later introduced a new amplifying effect of the negative loop: the double condition of the assets that companies use as collateral against possible loan defaults (as a productive asset and as collateral).

The key, the jury's record illustrates, “lies in the double role of capital as a productive asset and collateral wealth. The effect is persistent: since firms invest less, the discounted value of future profits declines, further reducing their net worth. This intertemporal channel strengthens the initial erosion of collateral, creating a loop that further amplifies the initial recession.”

Both pairs of researchers continued to open investigative paths by using their model regarding transfers to and from the financial system to study how monetary policies could correct these imperfections. The research Bernanke and Gertler conducted in the late 1990s would shape what has become the standard model for monetary policy and business cycle analysis. For their part, Professors Kiyotaki and Moore focused on liquidity and its effects on the system.

Application of the models in the Covid crisis

In the current crisis derived from the pandemic, one of the problematic sources is yet again in the weakness of certain companies´ balance sheets. For Gertler, the key lies in the duration of that shock: “First and foremost, I think dealing with the economic crisis involves dealing with the virus, getting people vaccinated, making sure they are wearing masks and so on, and we are definitely seeing signs of progress in the U.S. and it seems that is the case in the euro area as well. Now, it is also true, given interest rates are at zero or even lower, and not only short-term rates but long-term rates as well, it does seem there are limits to what monetary policy can do to further stimulate the economy.”

Moore agrees that “this Covid crisis is even more severe than the financial crisis. What it shares with it is the erosion of balance sheets and the bad effects that it has on the scale of investment, and overall economic activity. At the same time, it is also a shock to supply because of the need for lockdown; supply has been severely hampered for many goods and services, and at the same time the crisis has put the damper on demand, either because people are locked down and unable to spend more or they have lost income and spend less as a result. So I think the Covid crisis will end up being a sort of test bed for macroeconomic modelling and thinking for years to come.”