Was the financial crisis caused by monetary policy? Comments on a speech by John B. Taylor

Comments on a speech by John B. Taylor

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[I was asked to comment on a presentation by John B. Taylor in a panel discussion of central bank independence at the AEA meeting In San Diego last week. In his talk, Taylor wondered whether legislated rules could improve Fed independence. PJW]

Before getting to the subject of Fed independence in general, I’d like to address the suggestion—raised in John’s paper--that Fed monetary policy between 2003 and 2005 was possibly responsible for the huge housing price bubble that developed before 2007.

By common agreement, the deflation of that bubble was the precipitating cause of the 2008 financial crisis. As John suggests, low interest rates between 2003 and 2005 could have caused investors to reach for yield by taking greater risk on subprime mortgages and mortgage-backed securities based on them.

However, the data provides little support for this idea.

The real return on the Treasury bills between 1995 and 2002 fluctuated between 2.5 and 3.0 percent. From 2002-2005 it was negative by an average of about 1.5 percent. That would have been the period that fostered the bubble under this theory.

Here is a chart of Shiller’s data on real housing prices between 1970 and 2010. It shows two bubbles around 1979 and 1989, and a third gigantic bubble beginning in 1997 and extending through 2007.  The vertical lines show what real housing prices were in the relevant years.
Here’s a close-up of just the years 1985-2007:

As you can see, by 2000 the housing price bubble was already larger than any previous bubble. And by 2003—the first of the years in which most observers believe real interest rates were too low—the housing bubble was already almost three times the size of the biggest previous bubble.

So it seems highly likely that something other than interest rates or the reach for yield caused the great housing bubble, and thus highly unlikely that monetary policy could have been the cause of the bubble. The bubble was already well-established and growing fast before real interest rates turned negative.

My nominee for the cause of the crisis, as John noted in his paper, is US government housing policy, which reduced underwriting standards and poured enormous sums of money into the housing market, beginning in the mid-90s, to stimulate more home ownership among low and moderate income Americans.

For a time this worked. Home ownership rose from 64 percent in 1995—where it had been for 30 years—to almost 70 percent in 2004.  But by 2007, half of all mortgages in the US—28 million loans—were subprime or otherwise weak. 74 percent of these weakmortgages were on the books of government agencies or others subject to government requirements. When the bubble deflated, these mortgages defaulted in unprecedented numbers, dooming Fannie and Freddie and causing the financial crisis. 

Turning now to the question of the independence of the Fed and whether a legislated rules-based system would make it more independent—my answer is yes and no.

First, why do we value Fed independence?

In my view, Fed independence is important because welfare is maximized when the markets believe that the Fed’s decisions are made on the basis of economic policy—and not what the political organs of government think that policy should be.

If the markets believe that the Fed is not independent, they will interpret its signals in ways that do not maximize welfare.

For example, there is the classic conflict between lenders and borrowers. Lenders like stable money, borrowers like inflation.  The ideal monetary policy, many believe, allows the money supply to grow along with the economy. That maximizes welfare.

A monetary policy that is too tight favors lenders; one that’s too loose favors borrowers. This is a political struggle, not an economic question. If market participants believe that the Fed is responding to the politicians and favoring one group over another, they will act accordingly.

If the Fed’s thumb is on the scale in favor of lenders, then market participants will assume that interest rates will remain higher than they need to be, and reduce their borrowing, restricting economic growth. On the other hand, if the belief is that the Fed is favoring borrowers, market participants will assume that inflation is in the future and act accordingly, stimulating the inflation they expect and again restricting economic growth.

So the reason we want an independent Fed is to improve the chances that its decisions are based on economic fundamentals, even though there might not be complete agreement among economists about what those decisions should be. The important point is that these decisions appear to be independent of politics because they were based on economic analysis, not political considerations. That’s why the Fed has looked most independent in during the Paul Volcker and Alan Greenspan eras.

During the Volcker period, its prescription ran directly counter to what the politicians clearly wanted. Reagan’s willingness to take the heat for tight money policies in 1982—from both Republicans and Democrats—allowed Volcker to succeed as far as he did.  Volcker’s policies drove interest rates up, but eventually persuaded the markets that the Fed would remain independent of the politicians and was serious about combating inflation.

Under Greenspan, the maestro had such prestige among the population, the economics profession, and the media that the politicians couldn’t challenge him.

So the Fed in both cases was seen as making policy on the basis of sound economic analysis and for that reason was seen as independent. This is de facto independence, the only sound basis for considering a central bank to be independent of the government.

Where are we now?

The Fed has said it will hold interest rates at near zero for years—when it couldn’t possibly know whether that will be the right economic or monetary policy even 6 months from now. Holding interest rates at near zero until unemployment reaches 6.5 percent certainly doesn’t look like monetary policy-making on the basis of economic analysis.

Instead, it looks like a political decision—the kind of policy that the Obama administration would like the Fed to follow in order to revive the economy. And coming after the unprecedented cooperation with the Bush Treasury during the fall of 2008, and the Fed’s receipt of substantial new powers in the Dodd-Frank Act—giving the agency virtual control of the financial system—the Fed looks more and more like a political body. Its de facto independence seems to be at a low point in modern history. 

The Fed, of course, will argue that in a crisis of the kind that overcame the economy in 2008 its failure to act in mitigating the crisis and aiding the recovery would have threatened its independence rather than preserved it. This is a plausible argument, but a counterfactual one; we’ll never know whether it was necessary for the Fed to do what it has been doing since 2008.

This, then, takes us back to the question raised by John’s paper on legislated rules as a way to improve or even assure the Fed’s independence. There’s no question that legislated rules that channel Fed decision-making would aid Fed independence, but if any set of rules were always applicable we wouldn’t need the Fed.

I don’t think hard and fast rules, without exceptions, are workable for the same reason that a constitutional amendment requiring a balanced budget under all circumstances is not workable. There are too many situations in which the rules—whatever they are—would not be the right policy. There must be exceptions. The Fed will then make use of the exceptions—arguing in cases where it is under political pressure that it had to violate the applicable rule in order to preserve its independence.

In other words, while rules like the Taylor Rule have proven to be valuable and should be followed, the only way they will really be useful in preserving the independence of the Fed is if following the rule turn out to produce good results.

So John and others who believe in the Taylor Rule are back where they started—having to persuade as many of you as possible that the Taylor Rule should be followed because it produces the best economic policies for the country over the long term.

If that idea is widely shared in the economics profession—and it seems to have widespread support—it will function as a powerful support for the Fed’s natural desire to maintain its independence. And will be much more effective for this purpose than legislated rules.

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Peter J.

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