Exclusive Book Excerpt: Getting Off Track

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

Professor Taylor’s contrarian perspective crisis holds that the primary cause of the financial crisis was a botched monetary policy by the Federal Reserve under Alan Greenspan along with government efforts, such as promoting home ownership among the poor. For Taylor the government is more part of the problem than part of the solution.

Professor Taylor's book uses a a combination of research and essays to provide an empirical analsys of what went wrong. Looking ahead, he suggests a set of principles to follow to prevent similar misguided actions and interventions.

Excerpted from Getting off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis, by John B. Taylor, published by Hoover Press, Copyright © 2009

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PREFACE 

What caused the financial crisis? What prolonged it? What worsened it dramatically more than a year after it began? Rarely in economics is there a single answer to such questions, but the empirical research I present in this book strongly suggests that specific government actions and interventions should be first on the list of answers to all three. I focus on the period from the start of the crisis through the fall of 2008, when market conditions deteriorated precipitously and rapidly. Simply put, when policy started getting off track—especially when compared with the period of good performance during the previous two decades—financial and economic conditions turned sour.

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Chapter One: What Caused the Financial Crisis 

THE CLASSIC EXPLANATION OF FINANCIAL CRISES, going back hundreds of years, is that they are caused by excesses— frequently monetary excesses—that lead to a boom and an inevitable bust. In the recent crisis we had a housing boom and bust, which in turn led to financial turmoil in the United States and other countries. I begin by showing that monetary excesses were the main cause of that boom and the resulting bust. 

Loose-Fitting Monetary Policy  (chart, to the right below) was published in The Economist magazine in October 2007 as a simple way to illustrate the story of monetary excesses. The figure is based on a paper that I presented at the annual Jackson Hole conference at which central bankers from around the world assembled in August 2007. It examines Federal Reserve policy decisions—in terms of the federal funds interest rate—from 2000 to 2006.

The line that dips down to 1 percent in 2003, stays there into 2004, and then rises steadily until 2006 shows the actual interest-rate decisions of the Federal Reserve. The other line shows what the interest rate would have been had the Fed followed the type of policy that it had followed fairly regularly during the previous twenty-year period of good economic performance. 

The Economist labels that line the Taylor rule because it is a smoothed version of the interest rate one gets by plugging actual inflation and gross domestic product (GDP) into the policy rule that I proposed in 1992. When he was president of the Federal Reserve Bank of St. Louis, William Poole presented a similar chart, covering a longer period and without the smoothing, in an essay called “Understanding the Fed,” published in the Federal Reserve Bank of St. Louis Review in 2007. The important point is that this line shows what the interest rate would have been had the Fed followed the kind of policy that had worked well during the period of economic stability called the Great Moderation, which began in the early 1980s.

The chart  shows that the actual interest-rate decisions fell well below what historical experience would suggest policy should be. It thus provides an empirical measure that monetary policy was too easy during this period, or too “loose fitting,” as The Economist puts it. This deviation of monetary policy from the Taylor rule was unusually large; no greater or more persistent deviation of actual Fed policy had been seen since the turbulent days of the 1970s. This is clear evidence of monetary excesses during the period leading up to the housing boom. 

The unusually low interest-rate decisions were, of course, made with careful consideration by monetary policy makers. One could interpret them as purposeful deviations from the “regular” interest-rate settings based on the usual macroeconomic variables. The Fed used transparent language to describe the decisions, saying, for example, that interest rates would be low for “a considerable period” and that they would rise slowly at a “measured pace,” ways of clarifying that the decisions were deviations from the rule in some sense. Those actions were thus essentially discretionary government interventions in that they deviated from the regular way of conducting policy in order to address a specific problem, in particular a fear of deflation, as had occurred in Japan in the 1990s. 

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Chapter Two: What Prolonged the Crisis 

THE FINANCIAL CRISIS became acute on August 9 and 10, 2007, when the money market interest rates rose dramatically. Figure 7(on right, below)  illustrates this using a measure that has since become the focus of many studies. That measure is the spread between the three-month London Inter-bank Offered Rate (Libor) and the three-month overnight index swap (OIS). The OIS is a measure of what the markets expect the federal funds rate to be over the three-month period comparable to the three-month Libor. Subtracting OIS from Libor effectively controls for expectations effects, which are a factor in all term loans, including the three-month Libor. The difference between Libor and OIS is thus due to things other than interest-rate expectations, such as risk and liquidity effects. 

If you look at the lower left of the figure on the right,  you see a spread of about 10 basis points (0.1 percentage point). If you extended that to the left, you would see a similar level of about 10 basis points. On August 9 and 10, 2007, this spread jumped to unusually high levels and has remained high ever since. In our research on this episode, John Williams and I called the event “A Black Swan in the Money Market” because it appeared to be so unusual. Figure 7 focuses on the first year of the crisis; the worsening situation in September and October 2008 is covered in the next chapter.

In addition to being a measure of financial stress, the spread affects the transmission mechanism of monetary policy to the economy because trillions of dollars of loans and securities are indexed to Libor. An increase in the spread, holding the OIS constant, will increase the cost of such loans and have a con- tractionary effect on the economy. Bringing this spread down therefore became a major objective of monetary policy, as well as a measure of its success in dealing with the market turmoil.

Diagnosing the Problem: Liquidity or Counterparty Risk? 

Diagnosing the reason for the increased spreads was essential, of course, to determining the necessary policy response. If it was a liquidity problem, then providing more liquidity by making discount window borrowing easier or opening new windows or facilities would be appropriate. But if the issue was counterparty risk, then a direct focus on the quality and transparency of the banks’ balance sheets would be appropriate, by requiring more transparency, by dealing directly with the increasing number of mortgage defaults as housing prices fell, or by looking for ways to bring more capital into the banks and other financial institutions. 

In the fall of 2007 John Williams and I embarked on what we thought would be an interesting and possibly policy-relevant research project to examine the issue. We interviewed traders who deal in the interbank market and we looked for measures of counterparty risk. The idea that counterparty risk was the reason for the increased spreads made sense because it corresponded to the Queen of Spades theory and other explanations for uncertainty about banks’ balance sheets. At the time, however, many traders and monetary officials thought it was mainly a liquidity problem. 

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Chapter 3: Why the Crisis Worsened Dramatically a Year after it Began 

The figure below, using the same Libor-OIS measure of tension in the financial markets as above, shows how dramatically the financial crisis worsened in October 2008. Recall that in our research paper on the subject, John Williams and I called the jump in spreads in August 2007 “A Black Swan in the Money Market.”

The October 2008 events were even more unusual. Not only was the crisis prolonged for more than a year, but it worsened, according to this measure, by a factor of four. It became a serious credit crunch with large spillovers, seriously weakening an economy already suffering from the lingering impacts of the high oil price bout and the housing bust. Notice the close correlation in Figure 12 between our measure of counterparty risk and the Libor-OIS spread, demonstrating convincingly that all along the problems in the market were related to risk rather than to liquidity. 

Many commentators have argued that the crisis worsened because the U.S. government (specifically the Treasury and the Federal Reserve) decided not to intervene to prevent the bankruptcy of Lehman Brothers over the weekend of September 13 and 14. It is difficult to bring a rigorous empirical analysis to this important question, but researchers must do so because future policy actions depend on the answer. Perhaps the best empirical analyses we can hope for at this time are event studies that look carefully at reactions in the financial markets to various decisions and events. Such an event study, summarized below, suggests that the answer is more complicated than the decision not to intervene to prevent the Lehman bankruptcy and, in my view, lies elsewhere. 

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Chapter 4: Why a Black Swan Landed in the Money Market in August 2007

The Fed has gone about as if the problem is a shortage of liquidity. That is not the basic problem. The basic problem for the markets is that uncertainty that the balance sheets of financial firms are credible. —Anna J. Schwartz interviewed in the Wall Street Journal, October 18–19, 2008. 

THE FAILURE TO DIAGNOSE the financial crisis early on as mainly due to increased risk rather than to liquidity is a key reason that the policy responses were inappropriate and that the crisis was prolonged, as explained in Chapter 2. As with a medical patient, say with cancer, if you misdiagnose the disease and see it as a digestive disorder, then you will prescribe the wrong treatment. By not attacking or removing the cancer you let it grow, and the treatment for a nonexistent digestive disorder could make the patient even sicker. Ironically, during the Great Depression, a crisis to which the current one is often compared, there was a liquidity shortage, and the Fed did not provide liquidity, as Milton Friedman and Anna Schwartz showed in their Monetary History of the United States. In this crisis the Fed did provide liquidity, but the problem was not a shortage of liquidity—the doctor prescribed the wrong treatment. 

A legitimate and important question, however, is whether such a diagnosis was possible early on. In this chapter I examine this question. I explain how one goes about making such a diagnosis in the case of economic illnesses, and I examine some actual diagnoses made in real time in 2007 and 2008, including the one by John Williams and me mentioned in Chapter 2. 

Early Signs Signs of severe trouble first flared up on Thursday, August 9, 2007, when traders in New York, London, and other financial centers around the world faced a dramatic and sudden change in conditions in the money markets. Interest rates on mediumterm interbank loans, measured, for example, by the threemonth Libor (London Interbank Offered Rate) surged, compared with the interest rate on overnight interbank loans (the federal funds rate), which the Fed targets. The turmoil did not disappear. The term interbank rates did not come down at all and indeed moved up further on Friday. Rates on such term lending seemed to disconnect from the overnight rate and thereby from the Fed’s target for interest rates. Because interest rates on trillions of dollars of loans and securities are linked to Libor, bringing the spread down became a major concern of policy officials at the Federal Reserve. 

After many years of comparative calm, traders, bankers, and central bankers found these developments surprising and puzzling. But that Thursday and Friday of August 2007 turned out to be just the beginning of a remarkably long period of tumult in the money markets, with the difference between the threemonth Libor and overnight loans remaining unusually high and volatile, reminiscent of the highly extraordinary events described by Nassim Taleb in his popular book The Black Swan: The Impact of the Highly Improbable. But why did that black swan land in the money markets? 

Possible Diagnoses Right from the beginning of the crisis, bankers, economists, and others offered various explanations. One explanation, referred to as “counterparty risk,” was that banks became reluctant to lend to other banks because of the perception that the risk of default on the loans had increased and/or the market price of taking on such risk had risen. Lending between banks in the Libor interbank market is unsecured; there is no collateral to claim in the case of a default. Many banks were writing down their loans and securities because they had either been downgraded or were backed by mortgages with delinquent payments or foreclosed properties. Clearly, the continuing decline in housing prices and the slowing economy raised the chances of a further deterioration of banks’ balance sheets. Moreover, the realization of the risks of securities backed by subprime mortgages triggered doubts 

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Epilogue

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. Although other factors were certainly at play, those government actions should be first on the list of answers to the question of what went wrong.

To hear a replay of Professor Taylor's recent Webinar on How Government Caused, Prolonged, and Worsened the Financial Crisis, click here. 

If the link does not immediately take you to the Webinar registration, please scroll down the page.

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John B. Taylor is the Bowen H. and Janice Arthur McCoy Senior Fellow at the Hoover Institution and the Mary and Robert Raymond Professor of Economics at Stanford University. He served as senior economist on President Ford  and President Carter’s Council of Economic Advisers and as a member of President George H.W. Bush's Council of Economic Advisers. He was Under Secretary of the Treasury for International Affairs from 2001 to 2005 and is currenetly a member of the California Governor's Council of Economic Advisors. 

Getting off Track can be purchased from Hoover Press.