Arnold Kling  

John Taylor: The Fed Done It

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He is a leading macroeconomist, and he is out with a serious paper, in which he blames the Fed for excessively low interest rates from 2002-2004. Pointer from James Hamilton, who does not agree. Hamilton writes,


I feel he overstates the role of the Fed in directly causing all the problems. I would instead point to inadequate regulation of key financial institutions as the single most important factor...The Fed tried too hard to fight the jobless recovery of 2002-2004 with monetary stimulus, and that ended up making the severity of the subsequent downturn in housing that much worse.

I agree with Jim that the blame placed on the Fed is a bit simplistic.

Taylor writes,


There was no greater or more persistent deviation of actual Fed policy since the turbulent days of the 1970s.

He is measuring monetary policy relative to the "Taylor rule" for GDP and inflation. However, as I have pointed out a number of times (most recently in my 65h lecture on macroeconomics), the period from 2002-2006 was very unusual in that productivity growth was quite rapid. As a result, GDP was high relative to employment. My guess is that if one were to estimate a "Taylor rule" using employment and inflation, monetary policy was not that unusual. In simple terms, we had a jobless recovery with low inflation, and it made sense for the Fed to follow an easy-money policy.

Taylor scores a point here:


within Europe the deviations from the Taylor rule vary in size because inflation and output data vary from country to country. The country with the largest deviation from the rule was Spain, and it had the biggest housing boom, measured by the change in housing investment as a share of GDP. The country with the smallest deviation was Austria; it had the smallest change in housing investment as a share of GDP.

He talks about the rise in interest rates for inter-bank borrowing.

market turmoil in the interbank market was not a liquidity problem of the kind that could be alleviated simply by central bank liquidity tools. Rather it was inherently a counterparty risk issue, which linked back to the underlying cause of the financial crisis. This was not a situation like the Great Depression where just printing money or providing liquidity was the solution; rather it was due to fundamental problems in the financial sector relating to risk.

...it certainly appears that the increased spreads in the money markets were seen by the authorities as liquidity problems rather than risk. Accordingly, their early interventions focused mainly on policies other than those which would deal with the fundamental sources of the heightened risk.

Taylor argues that consequently policy responses from late 2007 through the early summer of 2008 were ineffective. These included the Fed's Term Auction Facility to expand bank reserves and its easing of the Fed Funds rate.

He goes on,


on Tuesday September 23, Federal Reserve Board Chairman Ben Bernanke and Treasury Secretary Henry Paulson testified at the Senate Banking Committee about the TARP, saying that it would be $700 billion in size. They provided a 2-1/2 page draft of legislation with no mention of oversight and few restrictions on the use. They were questioned intensely in this testimony and the reaction was quite negative, judging by the large volume of critical mail received by many members of the United States Congress. As shown in Figure 13 it was following this testimony that one really begins to see the crises deepening, as measured by the relentless upward movement in Libor-OIS spread for the next three weeks. Things steadily deteriorated and the spread went through the roof to 3.5 per cent.

His point is that Bernanke and Paulson created uncertainty, thereby exacerbating the counterparty risk. People simply did not know who was going to be rescued, or on what terms.


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COMMENTS (11 to date)
TA writes:

I don't buy it that job growth was any slower, nor productivity growth any faster, in the recession that started after 2000 than in the one that started after 1990. I take 1990Q1 and 2000Q2 as the last really good quarters before the economy flattened out and eventually dipped some. Counting forward 6 years in each case, the trajectories of GDP and jobs were both virtually identical in the two cases. Thus all-economy productivity trajectory likewise same.
I use the household survey of jobs, not the establishment survey.

You may disagree with this, but assuming for the moment that I'm right, then what would you say about monetary policy after 2000?

ionides writes:

Is this a non-sequitor?

"I feel he overstates the role of the Fed in directly causing all the problems. I would instead point to inadequate regulation of key financial institutions as the single most important factor...The Fed tried too hard to fight the jobless recovery of 2002-2004 with monetary stimulus, and that ended up making the severity of the subsequent downturn in housing that much worse."

He starts by defending and ends by blaming the Fed.

Gary Lammert writes:

Not too many macroeconomists predicted the events of the last few years or the severity of the current nonlinear transition. Perhaps the constructs and tools they have used and are using need refinement.

Jacob Oost writes:

I think monetary instability allows otherwise small waves to turn into tsunamis, and bad regulation or inadequate regulation (i.e. procedure-based regulation rather than result-based regulation, and regulations designed to achieve a desired end rather than simply avoid market failures) keep the market from being flexible enough to handle gluts quickly enough to avoid a recession.

Dr. T writes:

"He starts by defending and ends by blaming the Fed."

Ionides misreads the blog. Blaming the Fed for worsening the downturn in housing is not the same as blaming the Fed for the other components of the economic collapse.

I assign some blame to the Fed, a lot of blame to Paulson who promoted panic selling of stocks, a moderate amount of blame to the financial institutions who bought or sold but didn't understand mortgage security derivatives, and some blame to lenders and borrowers involved with high risk mortgages. There's plenty of blame to go around, but that hardly matters now. The main issue now is how badly will the federal government screw up with its attempts to 'fix' the economy. Judging from the past two months, it looks like the government is doing almost as bad as possible. (I suppose it could screw up more by printing a few trillion dollars, so I'll cross my fingers.)

David Beckworth writes:

Arnold:

The fact that productivity growth was so robust in 2003-2004 is the very reason the Fed was too loose during this time. The natural--or neutral--rate of interest is comprised of intertemporal preferences, population growth, and productivity growth. If we assume the first two components did not change dramatically during this time, then the rapid gains to productivity imply the natural interest rate should have been increasing. The Fed, however, was decreasing the real federal rates. This was a sure recipe for creating economic distortions.

In 2003 there was a deflation scare and this was a key reason for the Fed pushing rates so low. The assumption the Fed was making was that the deflationary pressures of the time were the result of weak aggregate demand. If this assumption were correct, then the low rates made sense. However, the data points to the productivity gains as culprit. So, the Fed was adding stimulus at the same productivity gains were adding stimulus. Throw in securitization, the geek vs. suits issue, poor governance, etc. and you have the stage set for the largest housing boom-bust cycle in history. I have an article coming out in the CATO Journal that touches on some of these issue, but in the meantime see here and here for some empirical evidence on this view.

Let me close by asking you a question: what would it take to convince you that the Fed did play a significant role?

fundamentalist writes:

These discussions highlight methodological problems. Everyone has their favorite data set that they use to explain the crisis, but each data set is just one small piece of the puzzle. As a result, macro economists look very much like the three blind mend trying to describe an elephant. One felt of the tail and decided an elephant is like a snake. Another felt of a leg and said an elephant is like a tree. The third felt of the ear and decided an elephant was like another animal.

The point is, everyone can hold up their pet data sets and claim the economy works like the data set indicates. What real understanding requires is a unifying theory that encompasses and explains all of the data and all of the pet theories. Modern macro does not have that. It has nothing but people looking at very small pieces of the puzzle and extrapolating to the whole.

Gary Rogers writes:

"In simple terms, we had a jobless recovery with low inflation, and it made sense for the Fed to follow an easy-money policy."

Interest rates affect more than just jobs and inflation, though that is the stated dual mandate of the fed. Low interest rates also discourage savings, which is also bad. Poor policies for the last 40 years have created our current situation where the immediate problem is consumers defaulting on sub-prime loans, but the underlying problem is that consumers have been stimulated to the point where there is no more money to spend for houses and cars. I think fed policies along with government fiscal policies are the primary reasons for our current situation, though not just Greenspan policies. I also suspect the Taylor rule keeps interest rates too low.

"I agree with Jim that the blame placed on the Fed is a bit simplistic."

I do agree with you here. I think that the tremendous debt and additional unfunded promises our government has built up over the years has more effect than it is given credit for. This creates a need to continuously borrow money to keep our house of cards from collapsing and that distorts the economy. I was fascinated by the event that occurred in August 2007 and suspect it has to do with our borrowing and one of the countries holding our debt (probably China) making a change in their policies.

Another phenomena that is not talked about much, but which should be considered is the demographics of baby-boom retirements. Right now there is a tremendous amount of retirement money invested in IRAs and 401Ks that needs to be earning money. This has to have some effect on what is happening in the financial systems. Could it be that the entire financial system is a Ponzi scheme and payouts so far have been made by boomers investing in their retirement funds but the money to make the payouts over the next 20 years does not exist. In other words, Bernard Madoff may not be alone in what is going on. In any case this would account for the tremendous growth in the financial industry.

Greg Ransom writes:

There's an academic literature by very, very smart people on the nature of explanation. It might be helpful if economists read it.

Most explanations are, in technical terms, over determined.

Different things focus our attention on different items of explanation.

What are we interested in? What can we control? Can anyone be held accountable? What things are totally obvious "background information". What is surprising or presumptively contested prior to analysis?

The current crisis is overdetermined.

But certainly the role and behavior of the Fed has to rank up there as 1) interesting 2) under human control 3) beyond mere background information 4) surprising in its effects to many "scientists" and "experts" and 5) presumptively contested prior to analysis.

The regulatory regime and the behavior of various economic actors also meets many of these criteria.

But we should allow different economists with different skills and different interests look at different parts of the puzzle.

And then a hand full of economists can attempt to look at the whole thing.

This will take time. And it will take some courage and tenacity to go up against the "idiot savants" with guild power and a mathematical or political ax to grind.

But I trust is won't take as long as the Hoover-Roosevelt depression to get some good answers.

Gary Rogers writes:

After doing some checking, I would say the August 9, 2007 "Black Swan" date corresponds very well to the time banks would be looking at the November 15, 2007 FAS 157 deadline. It was definitely the time when sub-prime mortgages came to everyones attention. If the news leaked out into the financial markets that all banks with sub-prime paper would have to write down the assets by November 15, it would cause an event similar to what we saw. I will change my theory on the cause of our financial crisis to the following:

1. The underlying cause of the problem is overstimulation of the economy over the last 40 years, which has resulted in too many insolvent consumers and a lack of savings.

2. The trigger was the November, 2007 FAS 157 deadline, the effects of which were recognized in August.

3. Easy monetary policy in the early 2000's was a contributing factor, as was the belief that making home loans with no down payment was doing low income homeowners a favor.

4. The demographics of the baby boom generation just before retirement is also a contributing factor and may turn out to be a primary factor when everything shakes out.

5. Taylor is right that most of what the fed and treasury is doing is actually making the problem worse.

Greg Ransom writes:

Unfamiliar with George Selgin's work on money and productivity? Prices should benignly deflate in a high productivity environment.

"the period from 2002-2006 was very unusual in that productivity growth was quite rapid. As a result, GDP was high relative to employment. My guess is that if one were to estimate a "Taylor rule" using employment and inflation, monetary policy was not that unusual. In simple terms, we had a jobless recovery with low inflation, and it made sense for the Fed to follow an easy-money policy."

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