Smith Faculty Opinion Article

By Dr. John A. Haslem, Professor Emeritus of Finance E-MAIL WEB SITE

The 30 Seconds Outlook
June 15, 2009

TAYLOR’S RULES RULE

There must be established a set of guiding principles to prevent repetition of the mistakes made during this crisis. First, there must be return to the principles for setting interest rates that were followed during the Great Moderation that began in the early 1980s. Second, future government crisis interventions must be based on a clear and transparent diagnosis of problems as well as rationale for any intervention. Third, there must be established a “predictable exceptional access framework” for providing assistance to financial institutions in crisis.

DIAGNOSIS OF THE FINANCIAL CRISIS

1. Monetary excesses were the main cause of the crisis. Application of the “Taylor Rule” indicates Fed fund rates were well below what they would have been if the Fed had followed the interest rate policy of the Great Moderation—a period of low inflation and a stable economy. The result of “loose” money during the lead up to the housing boom.

2. The loose monetary policy accelerated the housing boom and bust. The Taylor Rule results applied to housing starts indicates loose monetary policy was the most important cause of the housing boom, bust, and the crisis. CPI inflation was also well above the two percent target rate implicit in the Taylor Rule analysis.

3. An alternative explanation for low Fed fund rates was a “global savings glut” between savings and investment. The U.S. had a current account deficit with savings less than investment. However, the savings glut outside the U.S. was offset by the domestic savings deficit. The alternative explanation is wrong.

4. The boom and bust in the housing markets would be expected to impact financial markets. During the boom, mortgage lenders became lax in their lending standards because they did not anticipate the housing bust, when falling prices led to great numbers of delinquent mortgages and foreclosures. These effects were accentuated by adjustable rate sub-prime mortgages that led to excessive risk taking, and when housing prices fell below the value of mortgages, the incentives for borrowers to hold on became negative.

5. The boom and bust in the housing markets were amplified by sub-prime mortgages but also by packaging these loans into mortgage backed securities of great complexity with inadequate transparency. To make matters worse, Congress encouraged Fannie Mae and Freddie Mac to expand sub-prime loan programs to borrowers who did not meet traditional lending standards.

6. The financial crisis became more serious in 2007 when money market interest rates increased dramatically. To determine if the cause was increased risk, the spread between the three months Libor (rate) and the three months Overnight Index Swap was examined. This spread also impacts the transmission mechanism of monetary policy as huge amounts of loans and securities are indexed to Libor. An increase in spread due to Libor will increase interest rates and dampen the economy.

7. To determine if the increase in money market rates was due to increased risk, risk measures were examined to test their correlation with the spread noted above. Differences in rates on secured and unsecured overnight interbank loans (Repos) were examined. Subtracting Repo rates from Libor provides a measure of risk. The computed impact of this risk on the Libor spread indicated it could explain much of the variation in spread. This analysis identified counterparty risk. Therefore, the focus of public policy should have been on the quality and transparency of bank balance sheets, either by requiring more transparency, dealing directly with increased mortgage defaults, or increasing the capital of financial institutions.

8. The analysis also showed that increased Repo rates were not due to liquidity shortages, which are treated by the Fed’s use of monetary tools. This was the treatment during the Great Depression when printing money or providing liquidity was the solution. Unfortunately, in the current crisis public officials thought increased spreads in the money market were caused by liquidity problems, and the crisis continued.

John A. Haslem