April 13, 2009


Taylor Rules: In a new book, economist John Taylor explains the cause of the crisis.: a review of (David R. Henderson, 03.24.09, Forbes)

Taylor, one of the leading New Keynesian economists in the U.S.--and, indeed, in the world--is a senior fellow at the Hoover Institution and an economics professor at Stanford University. He carries serious credentials as a practitioner of economic policy: From 2001 to 2005, he was Bush's Undersecretary of the Treasury for International Affairs. Virtually all of his impressive academic papers have been in macroeconomics, many of them on monetary policy.

And how many economists besides Taylor can claim that a rule for conducting monetary policy has been named after them? Answer: none. The famous Taylor rule is one that a large percent of macroeconomists of various persuasions agree should guide a central bank's monetary policy, assuming that a central bank is a good idea. So when John Taylor speaks or writes, people should listen or read.

Taylor writes that the Federal Reserve Bank, Fannie Mae (nyse: FNM - news - people ) and Freddie Mac caused the crisis, the Bush administration misdiagnosed the problem, and, because of the misdiagnosis, the bailout made the problem worse.

Throughout 2007 and 2008, Fed Chairman Ben Bernanke and others in policy-making positions assumed that the problem was that the financial system lacked liquidity, and virtually all their actions were calculated to inject more liquidity. But Taylor gives evidence, which he garnered with economist John Williams, that liquidity was not a problem. The problem, writes Taylor, was "counterparty risk." Taylor compares finance to the game of Hearts. In Hearts, you don't want to get stuck with the queen of spades. The queens of spades in finance, he writes, "were the securities with bad mortgages in them" and "people didn't know where they were." Increasing liquidity by increasing the money supply does nothing to solve that problem.

...for markets to function efficiently the cards have to be on the table. Even the Queen is valuable, so long as you know which card she is.

Posted by Orrin Judd at April 13, 2009 7:03 AM
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