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Getting Off Track
How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis
By John B. Taylor
Hoover Institution PressCopyright © 2009 Board of Trustees of the Leland Stanford Junior University
All rights reserved.
What Caused the Financial Crisis
The classic explanation of financial crises, going back hundreds of years, is that they are caused by excesses — frequently monetary excesses — that lead to a boom and an inevitable bust. In the recent crisis we had a housing boom and bust, which in turn led to financial turmoil in the United States and other countries. I begin by showing that monetary excesses were the main cause of that boom and the resulting bust.
Loose-Fitting Monetary Policy
Figure 1 was published in The Economist magazine in October 2007 as a simple way to illustrate the story of monetary excesses. The figure is based on a paper  that I presented at the annual Jackson Hole conference at which central bankers from around the world assembled in August 2007. It examines Federal Reserve policy decisions — in terms of the federal funds interest rate — from 2000 to 2006.
The line that dips down to 1 percent in 2003, stays there into 2004, and then rises steadily until 2006 shows the actual interest-rate decisions of the Federal Reserve. The other line shows what the interest rate would have been had the Fed followed the type of policy that it had followed fairly regularly during the previous twenty-year period of good economic performance. The Economist labels that line the Taylor rule because it is a smoothed version of the interest rate one gets by plugging actual inflation and gross domestic product (GDP) into the policy rule that I proposed in 1992. When he was president of the Federal Reserve Bank of St. Louis, William Poole presented a similar chart, covering a longer period and without the smoothing, in an essay called "Understanding the Fed," published in the Federal Reserve Bank of St. Louis Review in 2007. The important point is that this line shows what the interest rate would have been had the Fed followed the kind of policy that had worked well during the period of economic stability called the Great Moderation, which began in the early 1980s.
Figure 1 shows that the actual interest-rate decisions fell well below what historical experience would suggest policy should be. It thus provides an empirical measure that monetary policy was too easy during this period, or too "loose fitting," as The Economist puts it. This deviation of monetary policy from the Taylor rule was unusually large; no greater or more persistent deviation of actual Fed policy had been seen since the turbulent days of the 1970s. This is clear evidence of monetary excesses during the period leading up to the housing boom.
The unusually low interest-rate decisions were, of course, made with careful consideration by monetary policy makers. One could interpret them as purposeful deviations from the "regular" interest-rate settings based on the usual macroeconomic variables. The Fed used transparent language to describe the decisions, saying, for example, that interest rates would be low for "a considerable period" and that they would rise slowly at a "measured pace," ways of clarifying that the decisions were deviations from the rule in some sense. Those actions were thus essentially discretionary government interventions in that they deviated from the regular way of conducting policy in order to address a specific problem, in particular a fear of deflation, as had occurred in Japan in the 1990s.
The Counterfactual: No Boom, No Bust
In presenting this chart to the central bankers in Jackson Hole in the late summer of 2007, I argued that this extra-easy policy accelerated the housing boom and thereby ultimately led to the housing bust. Others had made similar arguments. The Economist magazine wrote, in the issue then on the newsstands, that, "by slashing interest rates (by more than the Taylor rule prescribed) the Fed encouraged a house-price boom."
To support the argument empirically, I provided statistical evidence showing that the interest-rate deviation in Figure 1 could plausibly bring about a housing boom. I did this by using regression techniques to estimate a model of the empirical relationship between the interest rate and housing starts; I then simulated that model to see what would have happened in the counterfactual event that policy had followed the rule in Figure 1. In this way I provided empirical proof that monetary policy was a key cause of the boom and hence the bust and the crisis.
Figure 2 summarizes the results of this empirical approach. It is a picture of housing starts in the United States during the same period as Figure 1; it is drawn from that same 2007 Jackson Hole paper. The jagged line shows actual housing starts in millions of units. Both the housing boom and the housing bust are clear in this picture.
The line labeled "counterfactual" in Figure 2 is what a statistically estimated model of housing starts suggests would have happened had interest rates followed the rule in Figure 1; clearly there would have not been such a big housing boom and bust. Hence, Figure 2 provides empirical evidence that the unusually low interest-rate policy was a factor in the housing boom. One can challenge this conclusion, of course, by challenging the model, but by using a model and an empirical counterfactual, one has a formal framework for debating the issue.
Not shown in Figure 2 is the associated boom and bust in housing prices in the United States. The boom-bust was evident throughout most of the country but was worse in California, Florida, Arizona, and Nevada. The exceptions were in states such as Texas and Michigan, where local factors offset the monetary excess stressed here.
Although the housing boom was the most noticeable effect of the monetary excesses, the effects could also be seen in more gradually rising overall prices: inflation based on the consumer price index (CPI), for example, averaged 3.2 percent annually during the past five years, well above the 2 percent target suggested by many policy makers and implicit in the policy rule in Figure 1. It is always difficult to predict the exact initial impacts of monetary shocks, but housing was also a volatile part of GDP in the 1970s, another period of monetary instability before the onset of the Great Moderation. The more systematic monetary policy followed during the Great Moderation had the advantages of keeping both the overall economy stable and the inflation rate low.
Competing Explanations: A Global Saving Glut
Some argue that the low interest rates in 2002–4 were caused by global factors beyond the control of the monetary authorities. If so, then the interest-rate decisions by the monetary authorities were not the major factor causing the boom. This explanation — appealing at first glance because long-term interest rates remained low for a while after the short-term federal funds rate began increasing — focuses on global saving. It argues that there was an excess of world saving — a global saving glut — that pushed interest rates down in the United States and other countries.
The main problem with this explanation is that there is no actual evidence of a global saving glut. On the contrary, as Figure 3 shows in simple terms, there seems to have been a saving shortage. This figure, produced by staff at the International Monetary Fund in 2005, shows that the global saving rate — world saving as a fraction of world GDP — was low in the 2002–4 period, especially when compared with the 1970s and 1980s. Thus, this explanation does not stand up to empirical testing using data that have long been available.
To be sure, there was a gap of saving over investment in the world outside the United States during 2002–4, which may be the source of the term saving glut. But the United States was saving less than it was investing during this period; it was running a current account deficit, implying that saving was less than investment. Thus, the positive saving gap outside the United States was offset by an equal-sized negative saving gap in the United States. No extra impact on world interest rates would be expected. As implied by simple global accounting, there is no global gap between saving and investment.
Monetary Policy in Other Countries: Central Banks Looking at Each Other?
Nevertheless there are possible global connections to keep track of when assessing the root cause of the crisis. Most important is the evidence that interest rates at several other central banks also deviated from what historical regularities, as described by the Taylor rule, would predict. Even more striking is that housing booms were largest where the deviations from the rule were largest. Three economists at the Organization for Economic Cooperation and Development (OECD), Rudiger Ahrend, Boris Cournède, and Robert Price, provide a fascinating analysis of the experiences in OECD countries during this period in their working paper, "Monetary Policy, Market Excesses and Financial Turmoil," of March 2008. They show that the deviations from the Taylor rule explain a large fraction of the cross-country variation in housing booms in OECD countries. For example, 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, Spain, had the biggest housing boom, measured by the change in housing investment as a share of GDP. The country with the smallest deviation, Austria, had the smallest change in housing investment as a share of GDP. That close correlation is shown in Figure 4, which is drawn from their OECD working paper. It plots the sum of deviations from the policy rule on the horizontal axis and the change in housing investment as a share of GDP on the vertical axis from 2001 to 2006.
One important question, with implications for reforming the international financial system, is whether the low interest rates at other central banks were influenced by the decisions in the United States or represented an interaction among central banks that caused global short-term interest rates to be lower than they otherwise would have been. To test this hypothesis, I examined the decisions at the European Central Bank (ECB) in a paper  prepared for a talk in Europe in June 2007. I studied the deviations of the ECB's interest-rate decisions from the same type of policy rule as in Figure 1 but with Eurozone inflation and GDP data. The interest rate set by the ECB was also below the rule; in other words, there were negative deviations. To determine whether those deviations were influenced by the Federal Reserve's interest-rate decisions, I examined the statistical relation between them during 2000–2006 and the federal funds rate shown in Figure 1. I found that the effect of the federal funds rate was statistically significant.
Figure 5 shows how much of the ECB's interest-rate decisions could be explained by the Fed's interest-rate decisions. It appears that a good fraction can be explained in this way. The jagged-looking line in Figure 5 demonstrates the deviations of the actual interest rates set by the ECB from the policy rule. (I have not smoothed out the high-frequency jagged movements as was done in Figure 1.) By this measure, the ECB interest rate was as much as 2 percentage points too low during this period. The smoother line shows that a good fraction of the deviation can be "explained" by the federal funds rate in the United States.
The reasons for this connection are not clear from this statistical analysis, and they are a fruitful subject for future research. Indeed it is difficult to distinguish statistically between the ECB following the Fed and the Fed following the ECB; similar statistical analyses show that there is also a connection the other way, from the ECB to the Fed. Concerns about the exchange rate, or the influence of the exchange rate on inflation, could generate such a relationship, as could third factors, such as changes in the global real interest rate.
Monetary Interaction with the Subprime Mortgage Problem
A sharp boom and bust in the housing markets would be expected to affect the financial markets, as falling house prices led to delinquencies and foreclosures. Those effects were amplified by several complicating factors, including the use of subprime mortgages, especially the adjustable-rate variety, which led to excessive risk taking. In the United States such risk taking was encouraged by government programs designed to promote home ownership, a worthwhile goal but overdone in retrospect. During 2003–5, when short-term interest rates were still unusually low, the number of adjustable-rate mortgages (ARMs) rose to about one-third of total mortgages and remained at that high level for an unusually long time. This made borrowing attractive and brought more people into the housing markets, further bidding up housing prices.
It is important to note, however, that the excessive risk taking and the low-interest monetary policy decisions are connected. Evidence for this connection is shown in Figure 6, which plots housing price inflation along with foreclosure and delinquency rates on adjustable-rate subprime mortgages. The figure shows the sharp increase in housing price inflation from mid 2003 to early 2006 and the subsequent decline. Observe how delinquency rates and foreclosure rates were inversely related to housing price inflation during this period. In the years of rapidly rising housing prices, delinquency and foreclosure rates declined rapidly. The benefits of holding onto a house, perhaps by working longer hours to make the payments, are higher when the price of the house is rapidly rising. When prices are falling, the incentives to make payments are much less and turn negative if the price of the house falls below the value of the mortgage. Hence, delinquencies and foreclosures rise.
Mortgage underwriting procedures are supposed to take into account actual foreclosure rates and delinquency rates in cross-section data. Those procedures, however, would have been overly optimistic during the period when prices were rising unless they took into account the time series correlation in Figure 6. Thus, there is an interaction between the monetary excesses and the risk-taking excesses. This illustrates how unintended things can happen when policy deviates from the norm. In this case, the rapidly rising housing prices and the resulting low delinquency rates likely threw the underwriting programs off track and misled many people.
More Complications: Complex Securitization, Fannie, and Freddie
These problems were amplified because the adjustable-rate sub-prime and other mortgages were packed into mortgage-backed securities of great complexity. The rating agencies underestimated the risk of these securities because of a lack of competition, poor accountability, or, most likely, an inherent difficulty in assessing risk due to the complexity. These complex mortgage-backed securities led to what might be called the "Queen of Spades problem," as in the game of Hearts. In the game of Hearts, you don't know where the Queen of Spades is and you don't want to get stuck with it. The Queens of Spades — and there are many of them in the mortgage game — were the securities with the bad mortgages in them and people didn't know where they were. People didn't know which banks were holding them eighteen months ago, and they still don't know where they are. That risk in the balance sheets of financial institutions has been at the heart of the financial crisis from the beginning.
In the United States other government actions were at play. The government-sponsored agencies Fannie Mae and Freddie Mac were encouraged to expand and buy mortgage-backed securities, including those formed with the risky subprime mortgages. Although legislation, such as the Federal Housing Enterprise Regulatory Reform Act of 2005, was proposed to control those excesses, it was not passed into law. Thus the actions of those agencies should be added to the list of government interventions that were part of the problem.
Excerpted from Getting Off Track by John B. Taylor. Copyright © 2009 Board of Trustees of the Leland Stanford Junior University. Excerpted by permission of Hoover Institution Press.
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Table of Contents
ContentsList of Figures,
1. What Caused the Financial Crisis,
2. What Prolonged the Crisis,
3. Why the Crisis Worsened Dramatically a Year after It Began,
4. What Went Right in the Two Decades before the Crisis,
5. Why a Black Swan Landed in the Money Market in August 2007,
Frequently Asked Questions,
About the Author,