Monetary Policy

What Caused the Crisis?

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Most pundits and politicians will tell you that the ongoing financial crisis is the result of too little regulation and that we need a heavy dose of government intervention to restore prosperity. But according to the Stanford University economist John B. Taylor, a member of the president's Council of Economic Advisers under both Gerald Ford and George H.W. Bush, the exact opposite is true. In his new book Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis (Hoover Institution Press), Taylor argues that the government bears the most responsibility for creating and sustaining the current crisis. And if we're to come out of it, he adds, we need a lot less federal interference, not more.

Senior Editor Michael C. Moynihan spoke with Taylor in February.

Q: What is the basic premise of Getting Off Track?

A: The conventional wisdom is that markets screwed up and we need more regulation. Rarely is the government mentioned as maybe having caused this mess. What I did was look at the data, and what kept popping up in each case was government intervening too much and making things worse.

Q: What did you identify as the cause of the current financial crisis?

A: Monetary excesses. The Federal Reserve took the interest rate down to very low levels, which generated a housing boom, which inevitably brings a bust.

Q: What prolonged the crisis?

A: Misdiagnosis. They thought it was just a liquidity problem—not enough money. But it was a problem in the banks. The banks had problems on their balance sheets and wouldn't lend to each other. I looked at the data at the time and saw that it was a risk problem, not a liquidity problem. So it was treated incorrectly: We had a stimulus package, a sharp cut in interest rates, and special facilities to provide more money.

Q: Give an example of how the government made the situation worse.

A: The easiest example is last fall, when you had this panic and the markets crashed. The government comes forth with a $700 billion package. The secretary of the treasury and the chairman of the Federal Reserve go to the banking committee with only two pages of legislation and talk the economy down in order to attract interest. I think that had a lot to do with the lack of confidence. People realized the government didn't have much of a plan.

Q: And what about the billions of dollars in bailout money?

A: It's more of the same. Instead of looking at what happened with these previous government interventions, we're just doing it some more. The stimulus package will do little to stimulate the economy. We tried that last year, and it didn't work. And now we are doing it again.

Q: You explain in Getting Off Track that many things went right in the two decades before the crisis.

A: Economists call this period the "great moderation" or the "long boom." We had long expansions and short recessions. The early 1980s through today were very smooth times. And in this period you didn't have much intervention; government took a hands-off policy in many respects. Monetary policy was following clear guidelines. There was much deregulation, which freed up markets, and lower tax rates. All of those things generated a consistently strong economy.

Q: So if the government has misdiagnosed the problem, what does that say about the solutions it is offering?

A: President Obama talks about the only solution being government. So I'm worried, quite frankly, that we are going to be doing the wrong thing for a while, and it's going to take longer to get back on track. Because it's going to take effort and communication to show people that there is nothing wrong with the market system and a lot of intervention caused these problems.