Thursday, April 24, 2014

A Review of John Taylor's "Getting Off Track: How Government Actions . . . Worsened the Financial Crisis"

         In his small and incisive book Getting off Track:  How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis, John B. Taylor argues that, contrary to the period called “the Great Moderation,” which began in the early 1980s, monetary policy in the early 2000s became too loose, too easy.  This easiness led to the housing boom and, eventually, to the housing bust.  That policy, Taylor explains, was “essentially discretionary government interventions” (p. 3) and those interventions “deviated from the regular way of conducting policy” (p. 4).  “[B]y slashing interest rates . . . the Fed encouraged a housing price boom,” he says (p. 5).
         According to Taylor, other nations mimicked the Fed’s eccentric interest policies, which encouraged the problems we later faced to surface elsewhere also, in places like Spain and Greece.  Among the problems we eventually faced were falling house prices, delinquencies, and foreclosures, which had their expected deleterious effect on financial markets.   The bottom line, Taylor argues, is that a strong connection exists between monetary excesses and risk-taking excesses:  “the rapidly rising housing prices and the [initially] low delinquency rates likely threw the underwriting programs off track and misled many people” (p. 13).  But, as housing prices fell, folks began to wonder of it was worthwhile to continue making payments on houses not worth what was still owed on them.  Too many borrowers decided they were not, and simply stopped paying.  Government backed agencies like Freddie Mac and Fannie Mae instituted policies that made balance sheets even worse.  Securitization, meant to be a source of financial strength and stability, served more to undermine the whole system.  As is often the case with government programs, they were more a part of the problem than of the solution.
         Taylor argues that three types of government intervention served only to prolong the crisis rather than to cure it: (1.) the term auction facility, introduced in December 2007, designed to increase the flow of credit; (2.) temporary cash infusion of 100 billion dollars to the American public in February 2008 intended to jump start consumption and spending, but which was hoarded instead; and (3.) cutting interest rates, which led to a decline in the value of the dollar (pp. 19-24).
         But, as Taylor tells it, the crisis not only got prolonged, by October 2008 it got worse.  To Taylor, it worsened “by a factor of four” and became “a serious credit crunch with large spillovers” (p. 25).  TARP’s $700 billion, Taylor says, were by no means adequately overseen, the entire bill reaching only to 2 ½ pages, thus lacking sufficient oversight, restrictions, and structure.  The result of this lack of foresight and structure was widespread public uncertainty and the reluctant and timid investment that normally follows it.
         After delineating what went wrong, and why, in the 2008 financial crisis, Taylor examines what went right in the two decades preceding it.  “Getting economic policy on track,” he says, “is never easy” (p. 31).  Accomplishing it included “changes in monetary policy,” (p. 35), crisis prevention, primarily by means of a flexible exchange rate and predictability of policy (p. 39), and preventing the forces of globalization from reversing previous local accomplishments (p. 43).
         To Taylor, because banks and government misdiagnosed the problem as one of liquidity rather than uncertainty, their policies not only proved ineffective but actually prolonged and deepened the crisis.  The Fed provided liquidity to ease the problem, yet the financial cancer grew.  Not all economists fell into the diagnostic trap.  Some saw the real problem early on; Taylor was one.  His colleague John Williams was another.  They focused on three things, Taylor says: (1) credit default swaps -- the probability of banks defaulting on their debts; (2) Libor-Tibor spreads -- roughly a counterparty risk measurement between yen and dollar based banks; and (3) Libor-Repo spreads -- a comparison of risk between secured and unsecured lending in the interbank market (p. 53-55).
         Taylor affirms strongly that we “should base our policy evaluations and conclusions on empirical analyses, not ideological personal, political, or partisan grounds” (p. 63), seeming not to recognize the ideological basis of believing that such data and analysis can ever constitute (or arise from) an ideology-free zone.
         Taylor rightly warns us against thinking that frequent and large government actions and interventions are the only answer to our current economic problems” (p. 62).  They are not.  By thus declaring himself, Taylor stands against both George W. Bush and Barack Obama, Bush’s successor.  The former said that he abandoned free market principles in favor of government intervention in order to save the free market.  The latter said that only government can break the vicious cycles that cripple our economy.
         In opposition to them both, Taylor declares (and this quotation serves as a suitable summary of his book’s argument:  “Government actions and interventions caused, prolonged, and worsened the financial crisis.  They caused it by deviating from historical precedents and principles for setting interest rates that had worked well for twenty years.  They prolonged it by misdiagnosing the problems in the bank credit markets and thereby responding inappropriately, focusing on liquidity rather than risk.  They made it worse by supporting certain financial institutions and their creditors but not others in an ad hoc way, without a clear and understandable framework” (p. 61).
         Taylor’s quotation above obviously shows that he is not against all government involvement in such matters.  Perhaps he ought to be more so.  But at least he is not dazzled by the expertise of the reputed experts, whose track record says that they are better at getting things wrong than at getting them right. 
        One last point:  the question and answer session at the end of the book is so good that it alone is worth the price of entry.                 

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