Throughout the current recession, John Taylor has exemplified what an economist should be. He continuously provides careful and thoughtful commentary on the financial crisis and the recession — both in scholarly papers and on his blog. Taylor’s recent post on the stimulus package highlights precisely what I am talking about.
In late November the NYT had a piece on the stimulus package which showed that certain forecasts of GDP were shown to be much higher with the stimulus package than those forecasts would have been without the stimulus package. However, Taylor reminds us of an important point:
It’s been nearly a year since the stimulus package of 2009 was passed. Unfortunately most attempts to answer the question “What was the size of the impact?” are still based on economic models in which the answer is built-in, and was built-in well before the stimulus. Frequently the same economic models that said, a year ago, the impact would be large are now trotted out to show that the impact is large. In other words these assessments are not based on the actual experience with the stimulus. I think this has confused public discourse.
I would take this criticism one step further. As I have mentioned before, there are major fundamental differences between the New Keynesian and Old Keynesian models. What’s more, our priors should be based on the model that we believe to be the best description of reality and subsequently adjusted accordingly. While there is certainly much to quarrel with in New Keynesian models, I find it difficult to believe that we should elevate the Old Keynesian models in light of these potential shortcomings.
As we emerge from the financial crisis, it is important to develop a framework for dealing with failing institutions. In particular, the nature of the doctrine of “too big to fail” must be addressed and re-examined. Recently, John Taylor and Larry White have spoken out about the need for a rule of law rather than a discretionary authority. Their comments and my thoughts are below the fold.
Why didn’t anyone tell me that John Taylor is blogging?
In any event, Taylor does some of the best work in the profession — thoughtful, careful, and persuasive. Definitely check out the blog.
If I could only recommend one economist to read on the current financial crisis, I would choose John Taylor. His latest paper details the causes of the financial crisis as well as the subsequent policy responses (and failures). Here are some highlights:
- He presents evidence that the Federal Reserve significantly deviated from its historical behavior (the Taylor Rule), which created the boom-bust scenario in housing.
- He presents counter-factual evidence through the use of simulation that suggests the housing boom would have been avoided had the federal funds rate not deviated from the Taylor rule.
- He rejects the global savings glut hypothesis.
- The behavior of other central banks similarly deviated from the Taylor rule and those with the largest deviations also had the largest housing booms.
- There is a connection between excessive monetary policy and risk-taking.
- The subprime mortgage market exacerbated the problem.
- The financial crisis was (is) not a liquidity problem, but rather a counter-party risk problem.
- There is a strong correlation between the sharp cuts in the federal funds rate and the price of oil.
- Credit spreads increased in the aftermath of the announcement of the TARP. (Taylor blames this on the uncertainty surrounding the vague discretionary power of the Fed/Treasury in implementing the plan.)
- From his conclusion:
“In this paper I have provided empirical evidence that 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, which had worked well for 20 years. They prolonged it by misdiagnosing the problems in the bank credit markets and thereby responding inappropriately by focusing on liquidity rather than risk. They made it worse by providing support for certain financial institutions and their creditors but not others in an ad hoc way without a clear and understandable framework. While other factors were certainly at play, these government actions should be first on the list of answers to the question of what went wrong.”
I am teaching Money and Banking again this semester and this paper will undoubtedly be required reading.
Here is a non-gated link to the paper.