First, Rein In Government-Induced Systemic Risk

Government – not the market – played the dominant role in creating the systemic risk we now face, and the government poses a greater systemic risk in the future. “Reining in this risk should be the highest priority, higher than creating a new systemic risk regulator,” says economist John Taylor.

By Robert Stowe England

May 13, 2009

In the ongoing debate about whether the market or the government played a larger role in the ongoing financial crisis, Stanford University economist John B. Taylor places the greater share of blame on the government.

Taylor, a Treasury undersecretary from 2001 to 2005, laid out his case last night (May 12) in a dinner keynote speech at the Federal Reserve Bank of Atlanta’s Conference on Financial Innovation and Crises at Jekyll Island, Georgia.

Taylor cites a number of government mistakes. At the top of the list is the Federal Reserve’s decision to keep interest rates too low too long in the period from 2002 to 2005.

Taylor faults policy makers for a misdiagnosis of the cause of the money market turbulence in the summer of 2007, which Taylor contends was a counterparty risk problem. The Fed wrongly assumed the trouble was caused by a lack of liquidity and therefore increased liquidity in the financial markets, he said.

“Hence, liquidity was pumped into the system and interest rates were slashed too rapidly which caused the dollar to depreciate and oil prices to skyrocket, a severe hit to the economy, especially the automobile sector,” Taylor said.

Taylor is author of the recently-published Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis.

The Stanford economist does not believe the aftermath of the decision to let Lehman Brothers fail strengthens the case for government regulation.

“Many in government now argue that the cause of the panic in the fall of 2008 was the failure of the government to intervene and prevent the bankruptcy of Lehman. This view gives a rationale for continued extensive government intervention—starting the very next day with AIG—and to proposals for a more expansive resolution process, whether in the hands of a new systemic risk regulator or the FDIC,” Taylor said.

“However, in my view the problem was not the failure to bail out Lehman Brothers but rather the failure of the government to articulate a clear predictable strategy for lending and intervening into a financial sector. This strategy could have been put forth in the weeks after the Bear Stearns rescue, but was not,” he said.

“Instead market participants were led to guess what the government would do in other similar situations. The best evidence for the lack of a strategy was the confusing roll out of the TARP plan, which, according to event studies of spreads in the interbank market, was a more likely reason for the panic than the failure to intervene with [Lehman Brothers],” Taylor said.

He also sees systemic risks in the huge run-up in federal deficits, a raft of bailouts and rescues from Treasury, the Fed and the FDIC, and a huge run-up in the Fed’s balance sheet.

Taylor also faults a leaked report from the Fed written up in the Financial Times (Krishna Guha, “Fed Study Puts Ideal Interest Rate At -5%,” Financial Times, April 27 2009).

The cited Fed article argued that the Fed’s Taylor rule calculations show that the interest rate should be -5 percent.

According to Wikipedia, “in economics, a Taylor rule is a monetary-policy rule that stipulates how much the central bank will or should change the nominal interest rate in response to divergences of actual GDP from potential GDP and of actual inflation rates from target inflation rates.” See more at this link:

“I have not seen the report and I do not know how the calculations were made, but they imply that the Fed may think it has plenty of time before positive interest rates and a reduction in reserve balances are required,” Taylor said. However, the calculations are “way off,” he added.

If one follows the Taylor rule, however, it would yield a plus 0.5 percent interest rate rather than a -5 percent rate in the leaked Fed article, according to Taylor.

“My calculation implies that we may not have as much time before the Fed has to remove excess reserves and raise the rate. We don’t know what will happen in the future, but there is a risk here and it is a systemic risk,” Taylor said.

What should be done now? Taylor’s remedy: “The emphasis should be on proposals to stop the systemically risky budget deficits projected as far as the eye can see, to exit from the extraordinary monetary policy actions, and to end the bailout mentality that is taking the federal government further and further into the operations of businesses and threatens the rule of law.”

“New legislation could then focus on preventing the monetary actions of the kind that led us into this crisis—perhaps a requirement that the Fed focus on the instruments of monetary policy and be accountable and transparent about it,” he added.

“First, state the objective of the monetary policy instruments—including each of the new instruments and facilities,” he told the conference attendees. “Second, say how they will be evaluated to determine whether the policy is meeting the objective; third report the results of evaluation.”

“More generally, government should set clear rules of the game, stop changing them during the game, and enforce them. The rules do not have to be perfect, but the rule of law is essential,” Taylor said.

Taylor’s complete remarks are available at the Atlanta Fed’s web site at this link:

Copyright 2009© by Robert Stowe England


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