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John B. Taylor is the Mary and Robert Raymond Professor of Economics at Stanford University and the George P. Shultz Senior Fellow in Economics at the Hoover Institution.  He formerly[…]

The market’s panic wasn’t due to the institution’s bankruptcy; it was more about the government’s response a week later.

Question: In what ways could policy measures have been more predictable in this crisis?

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 damage.

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 episode.



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 sense.

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 ***** in Chicago have put more out. I think the former FDIC Chair, Bill Isaac has studied it and has come to the same kind of conclusion.


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 again


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 that point.


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 responsible citizens.


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 become more predictable and less expected bailout there are in the system.




 Recorded on December 21, 2009