Taylor Rules and the Credit Crunch Cause

I recently highlighted some KC Fed research on monetary policy that concluded that Fed policy was too loose in the period 2001-05.

Now, David Papell, Professor of Economics at University of Houston writes a guest-post for Econbrowser titled Lessons from the 1970s for Fed Policy Today that discusses many of the same issues.

He brings to my attention a speech by John Taylor himself, presented at a FRB Atlanta conference:

One view is that “the markets did it.” The crisis was due to forces emanating from the market economy which the government did not control, either because it did not have the power to do so, or because it chose not to. This view sees systemic risk as a market failure that can and must be dealt with by government actions and interventions; it naturally leads to proposals for increased government powers. Indeed, this view of the crisis is held by those government officials who are making such proposals.

The other view is that “the government did it.” The crisis was due more to forces emanating from government, and in the case of the United States, mainly the federal government. This is the view implied by my empirical research and that of others. According to this view federal government actions and interventions caused, prolonged, and worsened the financial crisis. There is little evidence that these forces are abating, and indeed they may be getting worse. Hence, this view sees government as the more serious systemic risk in the financial system; it leads in a different direction—to proposals to limit the powers of government and the harm it can do.

Dr. Taylor takes the opportunity to tout his new book, Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis, Hoover Press, Stanford, California, 2009, and why not?

I argue that the primary initial cause was the excessive monetary ease by the Fed in which the federal funds rate was held very low in the 2002-2005 period, compared to what had worked well in the past two decades. Clearly such an action should be considered systemic in that the entire financial system and the macro economy are affected. My empirical work shows that these low interest rates led to the acceleration of the housing boom and to the increased use of adjustable rate mortgages and other risk-increasing searches for yield. The boom then resulted in the bust, with delinquencies, foreclosures, and toxic assets on the balance sheet of financial institutions in the United States and other countries.

The questions about the role of government in the crisis go well beyond the initial impetus of monetary policy. The gigantic government sponsored enterprises, Fannie and Freddie, fueled the flames of the housing boom and encouraged risk taking—chain reaction style—as they supported the mortgage-backed securities market. Moreover these agencies were asked by government to purchase securities backed by higher risk mortgages. Here I have no disagreement with Alan Greenspan and others who tried to rein in these agencies at the time.

… in my view the problem was not the failure to bail out Lehman Brothers but rather the failure of the government to articulate a clear predictable strategy for lending and intervening into a financial sector. This strategy could have been put forth in the weeks after the Bear Stearns rescue, but was not. Instead market participants were led to guess what the government would do in other similar situations. The best evidence for the lack of a strategy was the confusing roll out of the TARP plan, which, according to event studies of spreads in the interbank market, was a more likely reason for the panic than the failure to intervene with Lehman.

Assiduous Readers will remember that on November 12 I referenced previous predictions that TARP (the asset-buying part) would fail for the same reason that MLEC failed. Shamed by PrefBlog’s criticism, Paulson abandoned the idea that day. The latest resurrection of this old zombie is the Public-Private Partnership Fund which has attracted the usual roster of well-connected firms and so far looks like a fizzle.

Back to Dr. Taylor:

Some argue that the reason banks have been holding off and demanding a higher price for their toxic assets than the market is offering is the expectation that federal funds will be forthcoming to assist private purchases. If so, this may be an explanation for the freezing up of some markets and the long delay in the recovery of the credit markets.

But mistakes occur in all markets and they do not normally become systemic. In each of these cases there was a tendency for government actions to convert non-systemic risks into systemic risks. The low interest rates led to rapidly rising housing prices with very low delinquency and foreclosure rates, which likely confused both underwriters and the rating agencies. The failure to regulate adequately entities that were supposed to be, and thought to be, regulated certainly encouraged the excesses. Risky conduits connected to regulated banks were allowed by regulators. The SEC was to regulate broker-dealers, but its skill base was in investor protection rather than prudential regulation. Similarly, the Office of Thrift Supervision (OTS) was not up to the job of regulating the complex financial products division of AIG. These regulatory gaps and overlapping responsibilities added to the problem and they need to be addressed in regulatory reform.

Going forward, he sees reckless government spending as being the number one systemic risk:

To understand the size of the risk, consider what it would take to balance the budget in 2019? Income tax revenues are expected to be about $2 trillion, so with a deficit of $1.2 trillion, a 60 percent tax increase across the board would be required. Clearly this will not and should not happen. So how else can debt service payments be brought down as a share of GDP? Inflation will do it. But how much inflation? To bring the debt to GDP ratio down to the level at the end of 2008, it will take a doubling of the price level. That one hundred percent increase will make nominal GDP twice as high and thus cut the debt to GDP ratio in half, back to about 40 from around 80 percent. A hundred percent increase in the price level means about 10 percent inflation for 10 years. And it is unlikely that it will be smooth. More likely it will be like the 1970s with boom followed by bust with increasingly high inflation after each bust. This is not a forecast, because policy can change; rather it is an indication of the systemic risk that the government is now creating.

A second systemic risk is the Fed’s balance sheet. Reserve balances at the Fed have increased 100 fold since last September, from $8 billion to around $800 billion, and with current plans to expand asset purchases it could rise to over $3,000 billion by the end of this year. While Federal Reserve officials say that they will be able to sell the newly acquired assets at a sufficient rate to prevent these reserves from igniting inflation, they or their successors may face political difficulty in doing so. That raises doubts and therefore risks. The risk is systemic because of the economy-wide harm such an outcome would cause.

The Fed’s calculation reported in the Financial Times has both the sign and the decimal point wrong. In contrast my calculation implies that we may not have as much time before the Fed has to remove excess reserves and raise the rate. We don’t know what will happen in the future, but there is a risk here and it is a systemic risk.

In my view the increasing number of interventions by the federal government into the operations of private business firms represents a systemic risk. The interventions are also becoming more intrusive and seemingly capricious whether they are about employee compensation, the priority of debt holders, or the CEO. Many of these actions reverse previous government decisions, and they involve ex post changes in contracts or unusual interpretations of the law. We risk losing the most important ingredient to the success of our economy since America’s founding—the rule of law, which will certainly be systemic.

It does my heart good to hear somebody talk about “the rule of law” and mean it. In most people’s mouths it means “Crack down on people I don’t like.”

David Papell concluded his post on Econbrowser with the warning:

In the 1970s, the Fed “stabilized” overly optimistic inflation forecasts and responded too strongly to output gaps, lowering interest rates too much — especially during and following the 1970-1971 and 1974-1975 recessions, resulting in frequent recessions and the Great Inflation. What are the lessons from the 1970s for Fed policy today?
  • •The Fed should respond to inflation, not inflation forecasts, especially in an environment where large negative output gaps are causing forecasted inflation to fall.
  • •The Fed should not tinker with Taylor’s output gap coefficient of 0.5.

Using the rule with Taylor’s original coefficients, the experience of the 1970s suggests that, even if it could, the Fed should not lower its interest rate target below zero. If the incipient recovery takes hold and inflation stays the same or rises, it may need to raise rates sooner than many people think.

5 Responses to “Taylor Rules and the Credit Crunch Cause”

  1. […] predict future economic conditions; some of these even believe that if they don’t do it better than the Fed, it must be because they are either corrupt or incompetent and probably both. DBRS has today […]

  2. […] interplay between monetary policy and housing bubbles has been discussed on PrefBlog before; e.g. Taylor Rules and the Credit Crunch Cause, with David Pappell warning The Fed should respond to inflation, not inflation forecasts, […]

  3. […] biggest danger the capital markets now face is over-regulation (as alluded to in a speech by John Taylor). Until performance becomes a serious consideration when placing assets for management (with risk […]

  4. […] assertions have been discussed on PrefBlog, for example Taylor Rules and the Credit Crunch Cause; the seminal paper was discussed on Econbrowser, The Taylor Rule and the Housing Boom. But Bernanke […]

  5. […] really know whether it’s strictly kosher to reverse engineer the Taylor Rule, but if we use a Taylor output gap coefficient of 0.5 then a tightening due to capital costs of 63bp means the output gap will grow by 126bp. And […]

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