Taylor's analysis of the crisis

John B. Taylor of Stanford has an analysis of the financial crisis as an op-ed in today's Wall Street Journal. He is so anxious to prove that government action caused the crisis that he ends up not making  a lot of sense.

He claims the first mistake was excessive monetary ease during 2003-05, which created the housing bubble. Later on, he says it was a mistake to ease monetary policy after August 2007, a move he says created the short-lived bubble in oil prices in 2008. (How these bubbles get burst remains mysterious.) In standard monetary theory, excessive monetary ease is supposed to create inflation, i.e., a general rise in the price level, NOT a change in relative asset prices. General inflation remained remarkably tame throughout the decade. I hesitate to blame the Fed for bubbles it could not have reasonably foreseen.

Taylor also asserts that the problem in the markets was not liquidity, but rather counterparty risk. Therefore, he claims that adding vast amounts of liquidity to the system was the wrong approach. He seems to think there are two kinds of financial crisis that call for different policy approaches. I think he is wrong. All financial crises start off as a concern about the risks of dealing with certain counterparties. As the dominos fall and the list of toxic assets lengthens, the demand for liquidity increases, and things spiral downward from there. No matter how the crisis began, the demand for liquidity has to be satisfied before confidence can be restored and risky assets can begin trading at appropriate prices again.

I think he is also wrong about the low interest rates of the mid-aughts leading to excessive risk-taking. The standard theory of financial crisis suggests that high interest rates, not low ones, lead to greater risk. Moreover, the housing bubble contributes to the problem. 

But the main thesis--that the crisis was not caused by "any inherent failure or instability of the private economy"--is undercut by his own list of "complicating factors": the overuse of subprime and adjustable rate mortgages, excessively complex mortgage-backed securities, and irresponsible behavior by the ratings agencies. Add that to the unpredictable market bubbles in residential real estate and oil, and you have the recipe for disaster.