John Taylor Clears the Way for an Informed View of the Financial Crisis 16 comments
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If you’re trying to source our current distress, pick up Professor John Taylor’s recent working paper, The Financial Crisis and Policy Responses: An Empirical Analysis of What Went Wrong.
Taylor examines thoroughly and in great depth, i.e., plumbs, alternative theories for the crisis. He then devises tests to determine which theories are consistent with empirical data. He concludes by observing:
Government actions and interventions caused, prolonged, and worsened the financial crisis. (© 2009 John Taylor, The Financial Crisis And The Policy Responses: An Empirical Analysis of What Went Wrong.)
This article provides my quick summary of Professor Taylor’s work. You should read his original paper for the full story.
Impact of Loose Monetary Policy
According to Professor Taylor, monetary excesses were the main cause of the US housing boom and bust. This can be seen if one compares:
- The actual path for the Fed Funds rate, from 2001 – 2006; with
- An alternative path for Fed Funds that would have been consistent with prior Fed policies that produced good US economic performance.
As indicated in Figure 1, between 2001 and 2006, actual interest rates were well below levels suggested by historical relationships – evidence that monetary policy was “too easy” – the Fed provided too much liquidity. Professor Taylor observes that:
There [had been] … no greater or more persistent deviation of actual Fed Policy [from that implied by the Taylor rule] since the turbulent days of the 1970’s. (© 2009 John Taylor, The Financial Crisis And The Policy Responses: An Empirical Analysis of What Went Wrong.)
Professor Taylor then provides the results of an empirical model that focuses upon what the housing market might have looked like had Fed Funds been higher and followed a path consistent with prior policy. The figure appears below.
© 2009 John B. Taylor, from The Financial Crisis and the Policy Response
In Figure 2, the jagged solid line depicts actual housing starts, and the smooth “Counterfactual” line depicts starts produced by a model using the higher, Taylor Rule, rate path.
Finally, the smooth higher line depicts housing starts produced by a model using the actual Fed Funds path. Professor Taylor believes that this figure provides empirical evidence “that the unusually low interest rate policy was a factor in the housing boom.”
Impact of Monetary Policy and GSE Accommodation Upon Subprime Mortgage Originations
The low interest rates, identified in Figure 1, then contributed to excessive risk taking in the subprime mortgage market through their impact upon mortgage credit.
As suggested by Figure 3, subprime credit varies inversely with home prices. The home price boom contributed both to unusually robust subprime credit performance, and also “threw the [somewhat backward-looking subprime] underwriting programs off track.” This produced loose underwriting policies that became much too lax as the housing boom progressed.
Professor Taylor also singles out the GSEs’ appetite for “risky sub-prime mortgages” as an additional contributing factor. Taylor’s view is shared by Nobel laureate Harry Markowitz, as I observed in One At A Time:
There has been, for a long period of time, considerable pressure by Congress on Fannie Mae to support the objective of low-cost housing. The only way to satisfy that was for Fannie to lower their standards. And once they lowered their standards, others had to do the same to be competitive… (Professor Harry Markowitz, One At A Time, November 2008.)
Event Study: September - October 2008
The most controversial section of the paper may be Professor Taylor’s “event study” – a close examination of market reaction to federal policy announcements from September to October 2008. The event study relies upon a graph (his Figure 13) of short-term credit spreads.
Professor Taylor maps movements in credit sensitive spreads to market events as well as Treasury and Fed policy announcements. The key date appears to be 23 Sep, when a “2-1/2 page draft of [TARP] legislation with no mention of oversight and few restrictions” was released. Credit spreads quickly quadruple. This may reflect:
- Public realization that the intervention plan was not “fully thought through”; and/or
- General public dissatisfaction with the arbitrary and unclear rationale for government market intervention or inaction with respect to failing financial institutions.
Conclusion
Professor Taylor sums up his brief by stating:
- "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, which had worked well for 20 years…;
- They made it worse by providing support for certain financial institutions … but not others in an ad hoc way without a clear and understandable framework…
- These government actions should be first on the list of answers to the question of what went wrong."
© 2009 John Taylor, The Financial Crisis And The Policy Responses: An Empirical Analysis of What Went Wrong
Citing a need for a “massive [policy] clean-up,” Professor Taylor calls for a return to principled and proven interest rate policies, clarity, and predictability with respect to government intervention. Let’s hope that these changes occur.
REFERENCES
- John B. Taylor, NBER Working Paper 14631 - The Financial Crisis And The Policy Responses: An Empirical Analysis of What Went Wrong, Jan 2009.
- The Economist - Fast and Loose, 18 Oct 2007.
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His paper is one that I've referred to myself here on Seeking Alpha (seekingalpha.com/artic...) and your complete analysis of his paper is appreciated.
Thanks for bringing John Taylor‘s working paper to our attention. If loose monetary policy from 2001 to 2006 was one of the primary contributing factors to the current state of affairs, we appear to be committing the same error once again. What are the chances that his findings will now be incorporated into fiscal and monetary policy?
Jack
With respect to what the new Administration needs so it will not continue or repeat prior policy mistakes, I believe that the answer is simply - wisdom and the courage of their convictions.
If they are lacking in either or both, then I'm not sure why we bothered to hold last fall's election.
Many of us who are not economists, and therefor lack his credentials, knew that something awfully stupid was being perpetrated by Dr. Greenspan, and many mainstream publications, including the Economist, saw this disaster brewing, as early as March, 2003:
www.economist.com/surv...
It would have been admirable if mainstream economists at our universities and research institutes had stood up and said something about Greenspan's absurd policies while there was still time to reverse them.
Reminds me of the latter days of the Roman Empire where continual conquests of new lands brought back to the Roman Republic new slaves which were put to work in the fields and which supplanted the effort of "free" peasant farmers which were the backbone of the Republic. The Aristocrats undermined the Roman Republic then, and the financial aristocrats are doing it now to the declining American democracy.
Sad, but the paralllels of history are striking.
Just wait until Congress gets the trillion dollar "stimulus" bill passed. My bet is that it will be pork, pure pork. No use at all in getting the economy to be more productive but great for buying political support, contributions, and votes.
A very nasty situation.
Just wait until the Fed and Treasury try to soak up liquidity as inflation gets started. A credit crash worse than 2008. The Fed and Treasury fear this and won't actually do anything meaningful about inflation until the grass roots political pressure gets intense. The inflation to come, unlike the inflation of the early 1970's, will not be accompanied with meaningful wage and employment increase. People will be really mad, especially those on fixed incomes.
I expect this likely before the end of Obama's first term.
What is really scary now is the parties responsible for the boom and bust are going to "fix" the economy.