Taylor Rule and Fed Witches’ Brew

February 17, 2009

By Chidem Kurdas

Bubble, bubble, toil and trouble—that’s an apt metaphor for the Federal Reserve policies meticulously dissected by Stanford professor John Taylor, in the Wall Street Journal and other places.  He shows that the Fed set the financial crisis in motion and then made it worse.

Relative to the pattern that held since 1987 – a standard that has come to be known as the Taylor Rule – the Fed kept interest rates exceptionally low in 2002-2006.  Easy credit got real estate prices bubbling, which convinced folks that property prices go only one way and concealed the risk of price declines. Hence homeowners, developers and banks over-extended themselves.

Once the credit bubble collapsed in 2007, the excessive debt became rancid. Taylor argues that the Fed mis-diagnosed the problem as a lack of liquidity. Once again opening the spigot and cutting US rates, it brought down the US dollar. The price of oil, being denominated in dollars, consequently went through the roof. That wrecked household budgets and people responded by curtailing consumption. Thus economic conditions worsened.

Funny, the Fed did something similar in the1920s and 30s. Back then, Hayek argued that monetary policy distorted interest rates and Mises observed that political pressure for cheap money caused unwarranted credit expansion, according to a study presented by Lawrence White to the Colloquium last week.

That early-20th century policy debacle led to a massive expansion of government spending, programs and regulation. The current witches’ brew concocted by the Feds looks to have the same result. In both of these eras, the government messed up the economy big time and then come to the rescue by fattening itself.

The first time was definitely tragedy; the second time should be farce, going by Marx’s quip—but no, most likely what we’re seeing is the making of another tragedy. In any case, Taylor’s National Bureau of Economic Research paper detailing Fed actions and their effects is well worth a careful read—unless you prefer to get his book.

One Response to “Taylor Rule and Fed Witches’ Brew”

  1. John Tyler Says:

    Let me start with an oblique angle. It is not true that oil prices shot up because of easy credit, it was because of the reasonable fear of war against Iran.

    Similarly, it is not true that asset bubbles are caused by easy credit. And tight credit is certainly not the way to bust a bubble. It is in the nature of durable assets that capital gains are possible. Once prices start going up, the capital gains tend to keep the price rising. The same is true on the downside. Asset bubbles end the same way they began, naturally. The end of an asset bubble reacts on the financial system, leading to a Minsky moment. Asset bubbles are natural, autonomous events, and it is difficult to see any way of eliminating or controlling them.


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