Stanford economics professor John Taylor has a new paper in which he takes aim at recent economic policy, and fires with both barrels, concluding that “government actions and interventions caused, prolonged, and worsened the financial crisis.”
Taylor begins with an argument he articulated at the 2007 Jackson Hole conference that excessively loose U.S. monetary policy in 2002-2005 was a factor contributing both to the housing boom and subsequent housing bust. The solid line in the figure below shows the actual path that the fed funds rate followed over this period, with the dashed line reflecting what Taylor believes would have been closer to the optimal response.
Taylor’s counterfactual simulations suggest that these excessively low interest rates set by the Fed were a key factor causing the unsustainable housing boom, the consequences of whose collapse we are still trying to recover from.
Taylor also challenges the claim that the low interest rates of 2002-2004 could be attributed to a global savings glut, noting that total world savings was in fact an unusually low fraction of GDP.
Taylor also reviews the evidence that interest rate differentials such as the LIBOR-OIS spread reflected default risk rather than liquidity shortages. In Taylor’s view they did, in which case the new Fed measures such as the Term Auction Facility could have done little to affect the targeted interest rate spreads.
Taylor further offers support for the proposition that by cutting interest rates too quickly at the start of 2008, the Fed aggravated the commodity price boom which in turn was one factor contributing to the recession of 2008.
Although Taylor makes a number of valid points, I feel he overstates the role of the Fed in directly causing all the problems. I would instead point to inadequate regulation of key financial institutions as the single most important factor that brought us where we are today. I read Taylor’s evidence as providing further support for the view that when we ask too much of monetary policy, it can do more harm than good. The Fed tried too hard to fight the jobless recovery of 2002-2004 with monetary stimulus, and that ended up making the severity of the subsequent downturn in housing that much worse. The Fed tried too hard to prevent a downturn by bringing interest rates down so quickly at the beginning of 2008, and that ended up aggravating the oil price shock and ultimately making the hit to the auto sector in the first half of 2008 that much worse. And the Fed tried too hard in a futile effort to narrow default-risk premia, leaving itself with awkward balance sheet problems that will be tricky to resolve without aggravating our problems even further.
“You can’t blame a guy for trying,” the saying goes. But one reading of Taylor’s evidence is that we might be quite justified in doing just that.