John B Taylor on the Economic Crisis
John B. Taylor, Economics professor at Stanford University, talks about the causes for the market’s panic
John B Taylor on the Economic Crisis
Question: In what ways could policy measures have been more predictable in
John Taylor: There's several ways policy could have been more predictable in
this crisis. I think first of all, by sticking to the predictable policy
that worked well in the '80's and '90's with respect to the setting of
interest rates. That's something that I think we have a lot of
evidence for, it was unpredictable, a surprise if you'd like, to take
rates too low for so long even though there was an effort to explain
it, it was hard for people to understand how long that was going to
be. Was it a new policy of actual low interest rates, or not? So
that's an element of unpredictability that I think has caused
I think a second thing I would stress is the response to the
problems in the financial institutions. First of all, misdiagnosing it
as a liquidity problem, so more liquidity was pumped into the
economy, new facilities were set up. That added unpredictability
rather than looking at the evidence that there was a problem in the
banks due to the mortgages and the other toxic assets.
And then I'd say the third element of unpredictability, and probably
the most important for the severe panic. And I would go back to,
for example, the Bear Sterns intervention. Let's just take as a
given, although it is debatable that that was the right thing to do in
the heat of the moment, very difficult under pressure. I have been
in policymaking jobs. I know what that's like. So, the decision was
to intervene and bailout Bear Sterns creditors.
It seems to me that that was the moment, as clear as possible, about
what would be the policy in case another institution had some
problems to articulate it, but there was very little description of it
and in fact, policies tended to vary from case to case. You had the
IndyMac, you had WaMu, you had of course the Lehman Brothers,
AIG, Fannie and Freddie, and in each case there was a difference
and each one seemed to be approached independently, if you like,
ad hoc without an overall strategy.
That's probably the biggest degree of unpredictability. Equity
holders, preferred equity holders, debt holders, bank holding
company versus bank, various kinds of senior creditors,
counterparties, there was a huge amount of uncertainty about how
they were going to be treated. And of course, when the ultimate
policy was port forth, the so-called TARP was put forth in a way
that was quite confusing. The Treasury Secretary just had 2 ½
pages , testified with the Chairman of the Fed of the Banking
Committee, and couldn't answer, in my view, the questions very
well. A huge irate response from the Congress at that point and it
really then became very clear, I think, that there wasn't really
policy. They had not been thinking about it, at least as evidenced
from the testimony and the other actions. And so, that was
probably the most unpredictable, most damaging part of this whole
Question: Did the financial panic come about because of the Lehman
Brothers’ bankruptcy, or was it the government response?
John Taylor: This is a question about the timing of the panic and whether it was
associated with the Lehman Brothers bankruptcy, or with the
responses of the government more generally. Basically, as soon as
that occurred, I looked at the data and I saw much more evidence
that the panic in the markets were associated with the government's
responses a week or ten days later. That's the time that say, the
S&P 500 fell by nearly 30%, 10 times greater than what happened
at the time of Lehman. The S&P 500 was higher the Friday after
the Lehman bankruptcy than the Friday before.
And there's lots of other data to look at to show you that. There is
much more investigation. For example, not one counterparty,
derivative counterparty to Lehman, filed for bankruptcy after the
Lehman case. The major creditors who did not fail. So it's hard to
find a direct knock on effects from that in the data. The more I
look at it, the more it seems to me the other explanation makes
Now, I'd say, now you need to think about what the counter factual
would have been. And I guess I'd go back to something I've
stressed before that if there had been a clear policy put forth
whereby people could have expected the possibility at least of
Lehman being put through bankruptcy, then there could have been
some preparation. There wasn't any. The day of the announcement
in September, 2008, people were just beginning to think about how
it works. It was really, I think, a surprise that had been no
preparation. And so, it was a jolt. Let's be sure, it was a jolt. But it
seems to me that the direct connections that people talk about with
expect a cascading and domino effects were not there and it really
occurs later. There's more evidence for this. John Cochran, Louie
0542 at Chicago have put more out. I think the former FDIC Chair,
Bill Isaac has studied it and has come to the same kind of
So, while it was originally controversial when I put this idea forth,
over a year ago actually in a speech at the Bank of Canada, in
November, 2008, was viewed as controversial. But I was just
looking at the data then, but more and more you look at what
happened, internally talk to people, and study the aftermath, it
seems to me there is at least as much -- let me put it evenly, at least
as much evidence that the panic was caused by the response as
distinct from that particular event at Lehman Brothers. And I think
it is more evidence, it's actually becoming overwhelming, but this
is still controversial, and it will be looking at it more and more.
Looking at the data carefully, at spreads in the markets at what's
happening to the equity markets and also looking at what's
happening in the aftermath of the bankruptcy of Lehman Brothers,
those are the kinds, if you like, nitty gritty details that we need to
be studying to understand what happened. We're doing that work
here at Stanford at the Hoover Institution. A lot of focus on, we
have a whole working group that's delving into it. We've talked to
people, former policymakers, and also people in the private sector
to try to understand this and match it up with the data. And I think
that's the most important thing to do now. Come to some
conclusion about what actually happens so that we can then take
the appropriate remedies, reforms, to make sure it doesn't happen
Question: Why have you disapproved of the stimulus of the large counter
cyclical Keynesian policies?
John Taylor: Why have I disapproved of the stimulus of the large counter
cyclical Keynesian policies? Because I don't think we have ever
had much evidence that they work. So, let me try to be specific.
The first stimulus was in early 2008, and that was largely in the
form of one-time rebate checks sent to individuals. A lot of money
went out and basic economic theory would tell you that that would
not jump start consumption. People would save most of that.
So, unlike what was advertised, it shouldn't stimulate the economy
and in fact, if you go back and look at it carefully. Look at the
numbers as I have done, you don't see an impact. You see that big
rebate just went into people's pockets and didn't touch on jump
start consumption. In fact, consumption is going the other way at
And then you had this stimulus of 2009 to the extent that that was
based on sending checks to people. You see exactly the same thing
happening. One-time payments, temporary tax cuts don't stimulate
spending or consumption. And again, we knew that for years and
years. That's why policy in most of the '80's and '90's didn't take
those kinds of approaches.
And so that brings you to the question about government
purchases, can that be more effective? Well, yes, in principle, it
can be if it's timed right, if it's done in time. But this stimulus
package of 2008, the government purchase is part of it, is spread
out over a long period of time, most of them haven't even come in
line yet. The government purchases side. So, I don't see that that's
stimulating the economy. The rebound in the economy has been
due to things like inventory changes, recognition that the panic is
over in investment side, and so you can't find the impacts of it.
And it's unfortunate because that means that we’ve got a huge
increase in our debt and that's ultimately harmful. We didn't get
much out of it in terms of stimulus. So, I'm convinced -- what I
like to do is not just look at the models. I looked at a new
Keynesian model, I looked at a model I built many years ago, I
looked at other people's models. And they're good for assessing
impacts, but ultimately what we need to do now that we've had
these packages, is to look at what happened. You go away from the
models, look at what happened, did jump start -- did consumption
get jump started, I say no. Was the recovery due to the stimulus? It
seems not because it was in the form of investment.
So, I think, ultimately, we can learn from this experience, I don't
know exactly why we moved away from the policies that were
working, which is really aversion to these large countercyclical
policies. It began in early 2008 and has continued and it may
continue further. And I think let's start learning from what
happened and not be ideological about this. Not consider what
school went in, but look at the facts. When I look at the facts, I
don't see much impact of these policies.
Question: How responsible is Wall Street for the financial crisis?
John Taylor: I'd say the responsibility of Wall Street in this crisis, and it still
hasn't been resolved is the dependence of the financial institutions
on the government for bailouts and interventions. In other words,
the institutions had become large enough and complicated enough
that at least that led people to say we needed to have these bailouts,
these interventions. Each time it was -- people said there would be
systemic risk it was like saying there was fire in the theater, crying
fire in the theater, and it led to these responses which I say were
quite chaotic and not systematic. They really led to problems.
So, I think what has to happen in the future is, Wall Street, the
large firms, have to find a way to say, "We are not going to depend
on the government for bailouts." Just like a startup firm out here in
Silicon Valley, if it fails it's not going to be bailed out by the
government. The same should be true for the large financial
institutions. They should find a way to do that. It seems to me that
in some sense they are responsible for doing that. They want to be
But I think, in the meantime, government needs to find a way for it
to get out of this bailout business. There's an example I would
point to where there has been a change. In the 1990's, the IMF did
a lot of bailouts. The United States participated in some of those in
the case of Mexico. But it got quite chaotic in the case of the
Southeast Asia crisis. They were sometimes in and sometimes not
in. In the case of Russia, they were in for a while and they pulled
out and, of course, we had a lot of contagion globally. But it wasn't
until maybe 2002, 2003 that the policy became more predictable
and more understandable.
The IMF led out some procedures called The Exceptional Access
Framework. It clarified what their operations would be. So, the
expectation of a bailout of a country in this case, sovereign debt,
was reduced substantially. And I think you saw a huge
improvement in the emerging markets. Some of them made an
extra effort to build up their reserves, some of them reduced their
deficits, they made the adjustments and they've been stronger as a
result. And that shows you what can happen if the policy becomes
more predictable and less expected bailouts there are in the system.
John B Taylor on the Economic Crisis
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