David R. Henderson
When Henry Paulson and Ben Bernanke proposed the $700 billion bailout last September, many mainstream economists who spoke out lined up in favor, although about as many economists were critical. Few--I'm one of the few--were dead-set against it.
Some of us who criticized the bailout were dismissed because we are not macroeconomists. (Macroeconomics is the study of the economy as a whole: GDP, inflation, unemployment, etc.) That dismissal never made much sense because you don't have to be a macroeconomist to understand that the Henry Paulson plan was proposing central planning of the financial markets and, as the late Friedrich Hayek and Ludwig von Mises showed us, central planning doesn't work.
But now comes a book by an economist who criticizes the bailout and who cannot be dismissed on any of the standard grounds. That economist is John Taylor, and his book is Getting Off Track: How Government Actions and Interventions Caused, Prolonged and Worsened the Financial Crisis.
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 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.
Taylor's evidence that the problem was risk, not liquidity, comes from his comparison of two interest-rate spreads. The Libor-OIS spread is the three-month London Interbank Offered Rate (Libor) minus the three-month overnight index swap (OIS). The OIS measures the market's expectation of the federal funds rate over a three-month period. The size of the Libor-OIS spread, therefore, is due to things like risk and liquidity. But how to distinguish between the two? That's where Taylor brings in his second spread, the difference between the Libor and the interest rate on secured loans. Libor loans are unsecured. The size of this spread is due to risk, and the Libor-OIS spread shot up at the same time that the unsecured-secured spread shot up.
Many proponents of the bailout argued that the government's failure to bail out Lehman Brothers made the financial crisis worse. But Taylor, drawing on the well-known finding of financial economists that financial markets adjust within hours or minutes to new information, shows that the Libor-OIS spread did not widen much after the Lehman bankruptcy. Instead, the big widening occurred after Bernanke's and Paulson's Sept. 23 testimony spooked financial markets with their warnings of grim days ahead if the bailout were not passed. This is some of the key evidence that the bailout actually worsened the problem.
Taylor's views that the problem was diagnosed and that the bailout made the problem worse are persuasive. But I disagree with him when he says that the seeds of the housing bubble were in Fed Chairman Alan Greenspan's too-loose monetary policy. To make this case, Taylor relies on the federal funds rate, the rate that banks charge each other for overnight loans and that the Fed reserve targets with its monetary policy. He gives zero data on the growth of the various monetary aggregates. But monetary economist Jeff Hummel and I have shown that after Y2K, the monetary aggregates during the early 2000s were growing modestly.
