What Caused the Financial Crisis

5. Monetary Policy, Economic Policy, and the Financial Crisis: An Empirical Analysis of What Went Wrong

Chapter 5 Monetary Policy, Economic Policy and the Financial Crisis: An Empirical Analysis of What Went Wrong JOHN B. TAYLOR What caused the financial crisis? What prolonged it? Why did it worsen so dramatically more than a year after it began? Rarely in economics is there a single answer to such questions, but the empirical research presented in this chapter strongly suggests that specific government actions and interventions should be first on the list of answers to all three. The period from the start of the crisis through October 2008, when market conditions deteriorated precipitously and rapidly, is the focus. 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—which lead to a boom and an inevitable bust. In the 2008 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. Monetary Policy, Economic Policy, and the Crisis 151 Figure 5.1. Loose-fitting monetary policy. Economist, October 18, 2007. Reproduced by permission of the author. Loose-Fitting Monetary Policy Figure 5.1 is a simple way to illustrate the story of monetary excesses. The figure is based on Taylor (2007), presented at the annual Jackson Hole conference in August 2007.1 It examines Federal Reserve policy decisions—in terms of the federal funds interest rate—from 2000 to 2006. The line that dips 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 if the Fed had followed the type of policy 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 obtains by plugging actual inflation and GDP into a policy rule that I proposed in 1992.2 But the important point is that this line shows what the interest rate would have been if the Fed had followed the kind of policy that had worked well during the historical experience of the ‘‘Great Moderation’’ that began in the early 1980s. Figure 5.1 shows that the actual interest rate decisions fell well 152 John B. Taylor below what historical experience would suggest policy should be and thus provides an empirical measure that monetary policy was too easy during this period, or too ‘‘loose fitting,’’ as the Economist put it. This was an unusually big deviation from the Taylor rule. There has been no greater or more persistent deviation of actual Fed policy since the turbulent days of the 1970s. So there is clearly 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 can interpret them as purposeful deviations from the ‘‘regular’’ 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,’’ which were ways of clarifying that the decisions were deviations from the rule in some sense. These actions were thus effectively discretionary government interventions in that they deviated from the regular way of conducting policy in order to address a specific problem—in particular, fear of deflation, as had occurred in Japan in the 1990s. The Counterfactual: No Boom, No Bust In presenting Figure 5.1 in 2007, I argued that this extra-easy policy was responsible for accelerating the housing boom and thereby ultimately leading to the housing bust. To support such an argument empirically, I provided statistical evidence that the interest rate deviation shown in the figure could plausibly bring about a housing boom. I did this by using regression techniques to estimate a model of the empirical relationship between the interest rate and housing starts; I then simulated that model to see what would have happened in the counterfactual event that policy had followed the rule shown in Figure 5.1. In this way, an empirical proof was provided that...