What caused the financial crisis?

It was right around this time last year that the financial crisis became a panic that brought down some of Wall Street’s giants and caused market conditions in general to deteriorate so dramatically. Thus, now is good time to consider what caused this crisis.
John Taylor, a senior fellow at the Hoover Institution and a professor of economics at Stanford, tackles this question in a slender book called Getting Off Track. Taylor’s thesis is that government actions and interventions caused, prolonged, and worsened the financial crisis. In this post, I deal only with his analysis of causation.
The classic explanation of financial crises, Taylor observes, is that they are caused by excesses that lead to a boom and an inevitable bust. In this case, “we had a housing boom and bust, which in turn led to financial turmoil in the United States and other countries.”
Taylor argues that the housing boom was caused mostly by monetary excesses. He shows that from mid-2002 until 2005 the Fed rate was substantially below the rate indicated by the “Taylor Rule.” That rule is, so named by The Economist I think, is essentially a model that derives the appropriate interest rate from the inflation rate and GDP using as the benchmark the monetary policy during the 1980s and 1990s when the U.S. economy experienced a period of great stability and growth. Taylor views the Fed’s deviation as purposeful – an attempt to avoid deflation – and thus calls it a discretionary government intervention, i.e., a deviation from the regular way of conducting policy in order to address a specific problem.
Taylor contends that by slashing interest rates more than normal policy would have dictated, the Fed encouraged a housing boom. He bases his case on a model, developed that estimates what housing starts would have been had the Fed set interest rates in a manner consistent with the Taylor Rule. According to his model, housing starts in 2005 would have been approximately 1.6 million units, as compared to the actual figure of approximately 2.1 million.
Monetary policy is not the only culprit in the housing boom and bust. Taylor also blames the use of subprime mortgages. He notes, however, that the excessive risk taking associated with such mortgages was related to the Fed’s low-interest monetary policy. The low interest rates inflated the value of houses, which lowered the foreclosure rate (the benefits of doing whatever it takes to hold on to one’s home are far greater when its price is rising). The lower foreclosure rates, in turn, masked the risk associated with underwriting subprime loans.
The problems were amplified when the adjustable-rate subprime loans were packaged into mortgage-backed securities of great complexity. This phenomenon meant that people didn’t know where the bad mortgages were and which banks were holding them. “That risk in the balance sheets of financial institutions has been at the heart of the financial crisis from the beginning,” says Taylor.
Finally, Fannie Mae and Freddie Mac, both government sponsored entities, were encouraged to expand and buy mortgage-backed securities, including those formed with risky subprime mortgages. Legislation such as the Federal Housing Enterprise Regulatory Reform Act of 2005 were proposed to control these excesses. However, Democrats like Barney Frank made sure they were not passed into law [note-the point about Frank and the Dems is my editorial comment; Taylor is relentlessly non-partisan in his economic analysis] Thus, Taylor concludes, “the actions of those agencies should be added to the list of government interventions that were part of the problem.”
In future posts, I’ll present Taylor’s analysis of what went wrong after the government intervened in response to the crisis.