Risks of straying from the prudent path

Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis

By John B. Taylor

(Hoover Press, $14.95)

The literature on the causes of the economic breakdown will soon be vast. Amid the stacks, this new book by John Taylor, Stanford professor and author of the celebrated Taylor rule of monetary policy, is worth noticing. It combines seriousness, brevity and accessibility – and it advances a distinctive argument. Its theme is that monetary policy errors, rather than “any inherent instability of the private economy”, first caused the crisis and then made it worse.

Unsurprisingly, the Taylor rule has a central role in the analysis. The author has long expounded the view that predictable, rules-based economic policy gets better results than an approach that surprises economic agents or leaves them guessing about what the government intends. The Taylor rule was originally intended as a recommendation to central banks about the conduct of monetary policy and later recognised as a way to predict how central banks actually behave.

The rule says central banks should set the short-term interest rate equal to one-and-a-half times the inflation rate; plus half of the gap between actual and trend gross domestic product; plus one. For example, if the inflation rate is 5 per cent and the output gap 3 per cent, the Taylor rule says make the interest rate 10 per cent: one-and-a-half times 5, plus a half of 3, plus 1. The rule is derived from monetary-policy models that describe how the economy reacts to changes in interest rates. By the late 1980s and early 1990s, the US Federal Reserve was observed to be following the rule, with notable success.

The crisis that began in 2007 and worsened in 2008 was caused, Taylor says, because the Fed abandoned the rule earlier in the decade. Between 2002 and 2004 interest rates were cut even though the rule required them to be raised. In 2004 and 2005 the gap between the actual and the recommended interest rate was between two and three percentage points. Taylor describes a model simulation in which interest rates followed the Taylor-rule path during this period instead of diverging from it so markedly. The housing boom would have ended in 2003 instead of 2006, he says; house prices and levels of mortgage debt would not have risen so high. In short, monetary policy was the primary cause of the boom and subsequent bust.

The Fed had good reasons – or thought it had – for pushing rates lower even though the rule that it had followed up to that point recommended the opposite. But discretion can be dangerous. Keeping monetary policy on auto-pilot would have yielded far better results. Once the crisis had begun, the book argues, misdiagnosing the problem as one of lack of liquidity rather than heightened counterparty risk prolonged it.

Lack of predictability again played the key role when the crisis suddenly worsened in 2008. Allowing Lehman Brothers to fail was not the decisive moment, in Taylor’s view: the market took that in stride. What sparked panic, he says, was the announcement of the troubled asset relief programme several days later – a plan for massive government outlays, with no clear rationale for their use and no provision for effective oversight. At that moment, uncertainty peaked.

Getting Off Track is concise to a fault. The main text is barely 60 pages long; an epilogue, references and a section of frequently asked questions pad it out to a still slender 92 pages. The book gives little or no space to issues it sees as incidental to its main theme.

Subprime mortgages, for instance, get short shrift. The author sees them as a result more than as a cause, and at most as an amplifier rather than a driver. “There is an interaction”, he writes, “between the monetary excesses and the risk-taking excesses”. In the same way, he mentions mortgage securitisation and the role of Fannie Mae and Freddie Mac in expanding the market for securitised subprime loans only briefly: they are merely “more complications”. As for the idea that a global savings glut was the underlying cause, the book dismisses this out of hand.

So nobody could describe this terse study as comprehensive or exhaustive. Instead, it is a short, sharp statement of what Mr Taylor sees as the principal policy mistake and the errors that flowed from it. Most commentary on the crisis glides by this issue without even noticing it, so intent are most analysts on blaming deregulation and the fatal flaws of Anglo-American capitalism.

Taylor is having none of that, and at the very least Getting Off Track is a bracing corrective to this tendency. Failures of regulation played their part, no doubt; there was undue faith in the market, maybe. But Taylor persuasively argues that at the root of it all was a humdrum failure of the Fed to abide by its own tried and tested approach to setting interest rates.

The writer is an FT columnist

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