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Getting Off Track
By: John B. Taylor


How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis


In this little book, John Taylor pulls together some of his recent research relating to monetary policy and the recent financial crisis.:


In this book I have provided empirical evidence that government actions and interventions caused, prolonged, and worsened the financial crisis. They caused it by deviating from historical precedents and principles for setting interest rates that had worked well for twenty years. They prolonged it by misdiagnosing the problems in the bank credit markets and thereby responding inappropriately, focusing on liquidity rather than risk. They made it worse by supporting certain financial institutions and their creditors but not others in an ad hoc way, without a clear and understandable framework.


In addition to being to being a professor of economics at Stanford University, Taylor served as Under Secretary of the Treasury for international affairs from 2001 to 2005. He has also served on the Council of Economic Advisors in the Ford, Carter, and Bush 41 administrations, and was a member of the Panel of Economic Advisors of the Congressional Budget Office from 1995-2001.


Taylor is best know for what is called the “Taylor Rule” - an empirical relationship that can help a central bank, the Federal Reserve System, set its target Federal Funds rate given data on inflation and the GDP gap, the difference between actual GDP and the trend level of GDP. Arguably, the ideas and research behind the Taylor Rule are given some credit for the reduction in the volatility of both inflation and the growth rate of real GDP, and the reduction in the frequency of recessions between 1980 and 2000. For example, in the 20 years previous to this period there were recessions every 3 to 4 years while during this period there were only two recessions which were 8 years apart. This latter period has been called “the Great Moderation.”


Taylor discusses three specific policy efforts that he contends “should be first on the list of answers to the question of what went wrong” over the past eight years or so. The first policy blunder can be laid at the feet of the Federal Reserve System and its fear that the U. S. economy would drop off into deflation after the recession of 2001. Fed policy was to push the Federal Funds target to very low levels and announce the decision with the statement that interest rates would be low for “a considerable period” and that they would rise slowly at a “measured pace”. For a period of about three years, 2002 through 2004, the Federal Funds rate was kept below 2%.


According to the Taylor policy rule, the Federal Funds rate should have begun rising by the end of 2001 and increased at a relatively steady pace to 5.25% sometime in 2004. Therefore, the Fed deviated from “historical precedents and principles” and inflated the economy, the primary credit bubble coming in the housing sector. One can argue, therefore, that there exists explicit empirical evidence of the over-reaching of the Federal Reserve during this period of time. Similar evidence exists for countries within the European Union.


The second policy blunder was the creation of the Term Auction Facility (TAF) in December 2007. The events leading up to this move by the Federal Reserve actually kicked off on August 9 and 10 of that year. Late in 2006 and early in 2007 delinquencies and foreclosures started to shoot up in the housing sector. These problems became amplified because they connected directly with the adjustable-rate sub-prime mortgage market and mortgage-backed securities. The real difficulty was that there developed a lot of bad mortgages, but it was very, very difficult to identify where the bad mortgages were located. (And they still don’t know where many of them are - see Gretchen Morgenson, “Guess What Got Lost in the Loan Pool?”)


On August 9 and 10, 2007, the interest rate spread between the three-month London Inter-bank Offered Rate (Libor) and the three-month overnight index swap (OIS) jumped from about 10 basis points (where it had averaged for a long time) to a range of roughly 60 to 100 basis points. An argument developed over the reason for this jump. To some, especially in the Fed, the increase in this spread represented a lack of liquidity. To others this increase was because of Counterparty risk: that is, it represented a solvency risk. The Fed created the TAF in December 2007 to resolve a liquidity problem. Taylor argues that this did not solve the problem, the spread remained high, and this move by the Fed only prolonged the crisis.


The final blunder came with the Bernanke panic in the middle of September 2008. The result of this was the Troubled Asset Relief Program (TARP). After providing a two-and-one-half page piece of legislation, Bernanke and Treasury Secretary Paulson testified in front on Congress September 23. Taylor states that “it was following this testimony that the crisis began deepening, as measured by the relentless upward movement in the Libor-OIS spread over the next three weeks.” The spread reached 350 basis points: thus, the policy makers made the situation worse.


(Hoover Institution Press: 2009)