Wednesday, January 14, 2009

Congress' and The Fed's Roles In The Crisis

George Mason economist Walter Williams: The Federal Register, which lists new regulations, annually averaged 72,844 pages between 1977 and 1980. During the Reagan years, the average fell to 54,335. During the Bush I years, they rose to 59,527, to 71,590 during the Clinton years and rose to a record of 75,526 during the Bush II years. Employees in government regulatory agencies grew from 146,139 in 1980 to 238,351 in 2007, a 63 percent increase. In the banking and finance industries, regulatory spending between 1980 and 2007 almost tripled, rising from $725 million to $2.07 billion.

So here are my questions: What are we to make of congressmen, talking heads and news media people who tell us the financial meltdown is a result of deregulation and free markets? Are they ignorant, stupid or venal? What kind of assumptions do politicians and news media make about the intelligence of Americans to expect us to buy the idea that our current mess results from deregulation and free markets? I do not find that assumption flattering.

Stanford economist John Taylor (NBER paper "The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong," $5 cost to download):

What caused the financial crisis? What prolonged it? Why did it worsen so dramatically more than a year after it began? Rarely in economics is there a single answer to such questions, but the empirical research I present in this paper strongly suggests that specific government actions and interventions should be first on the list of answers to all three. I focus on the period from the start of the crisis through October 2008 when market conditions deteriorated precipitously and rapidly. I draw on research papers, speeches at central banks, and congressional testimony I have given on the crisis during the past two years.

In this paper I provide empirical evidence that government actions and interventions caused, prolonged, and worsened the financial crisis. They caused it by deviating from historical precedents and principles for setting interest rates, which had worked well for 20 years. They prolonged it by misdiagnosing the problems in the bank credit markets and thereby responding inappropriately by focusing on liquidity rather than risk. They made it worse by providing support for certain financial institutions and their creditors but not others in an ad hoc way without a clear and understandable framework. While other factors were certainly at play, these government actions should be first on the list of answers to the question of what went wrong.

According to Taylor, what specifically started the financial crisis?

The classic explanation of financial crises, going back hundreds of years, is that they are caused by excesses—frequently monetary excesses—which lead to a boom and an inevitable bust. In the recent crisis we had a housing boom and bust which in turn led to financial turmoil in the United States and other countries. I begin by showing that monetary excesses were the main cause of that boom and the resulting bust.

MP: Taylor uses a different graph in his paper, but the St. Louis Fed graph above illustrates his point that the 27% increase in the money supply from 2001 to 2005, along with an unprecedented 5.5% reduction in the Fed Funds rate from 6.5% in 2001 to only 1% in 2003, created the monetary excesses that fueled the real estate boom and bust, and then started the financial crisis.


At 1/14/2009 11:47 AM, Anonymous Anonymous said...

You can't overlook pricing. Government encouraged companies to take on excessive risk at too low a price that didn't take into account risks. The current situation is a direct result of those pricing errors. Example, if the sub-prime mortages had been properly priced at 15% to 20% that they should have had, many fewer would have been made.

At 1/14/2009 4:53 PM, Blogger zephyr said...

Greenspan's low rate policy was gas on the fire, driving the asset bubble. The market was awash with liquidity, driving yields down.

Investors (professional and amateur) became exuberant and overconfident. Accordingly, they placed very little value on risk, and rushed to invest into the market momentum - ignoring risk.

The pricing of risk spreads diminished significantly, further stimulating the asset bubble in a feedback loop.

At 1/15/2009 12:34 PM, Anonymous Mika said...

<" . . .increase in the money supply . . .along with an unprecedented 5.5% reduction in the Fed Funds rate . . . created the monetary excesses that fueled the real estate boom and bust, and then started the financial crisis."i>

Please help me understand this: So the reckless writing of thousands and thousands of mortgages for people who creditors knew couldn't afford them, had little to do with this crisis? Ergo, the bankers who recklessly misused and wrongly invested the money, and irresponsibly extended credit, bear little or no responsibility, but, in fact, it's the government's fault for making money more freely available to them? . . . So, if I increase my son's allowance for his college expenses, it's entirely my fault - not his - if he spends it foolishly?


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