Taylor on Policy as a Cause of the Financial Crisis

John Taylor is another macroeconomist on everyone’s short list for a Nobel Prize. He as also an undersecretary of Treasury in the Bush administration, which means that a lot of politicians and pundits in D.C. are currently more inclined to dismiss him than they ought to be.

His piece entitled “How Government Created the Financial Crisis” in the February 9 issue of The Wall Street Journal makes the point that – like all recessions – this one was caused by a number of things we’ve seen before, just not in this combination.

One mistake was that most past financial crises have been about liquidity, while this one was about solvency.

Early on, policy makers misdiagnosed the crisis as one of liquidity, and prescribed the wrong treatment.

The Bush Treasury and the Bernanke Federal Reserve didn’t “do nothing”, rather they did several things that weren’t right. Then they made it worse:

After a year of such mistaken prescriptions, the crisis suddenly worsened in September and October 2008.

Many have argued that the reason for this bad turn was the government's decision not to prevent the bankruptcy of Lehman Brothers over the weekend of Sept. 13 and 14. A study of this event suggests that the answer is more complicated and lay elsewhere.

While interest rate spreads increased slightly on Monday, Sept. 15, they stayed in the range observed during the previous year, and remained in that range through the rest of the week. On Friday, Sept. 19, the Treasury announced a rescue package, though not its size or the details. Over the weekend the package was put together, and on Tuesday, Sept. 23, Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson testified before the Senate Banking Committee. They introduced the Troubled Asset Relief Program (TARP) …

The two men were questioned intensely and the reaction was quite negative … It was following this testimony that one really begins to see the crisis deepening and interest rate spreads widening.

The realization by the public that the government's intervention plan had not been fully thought through, and the official story that the economy was tanking, likely led to the panic seen in the next few weeks. And this was likely amplified by the ad hoc decisions to support some financial institutions and not others …

It’s worth remembering that Taylor is probably on a first name basis with all the principals in the story. He isn’t blaming anyone, but he is trying to do some forensics to figure out what they did wrong.