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