How Bad Policy Has Whipped the Economy


We've been through a decade of boom and bust, from the dot-com bubble to the housing bubble to the Great Recession today.

There are all kinds of explanations for the chaos, from greedy banks to shortsighted consumers. But what role has government policy played in the boom-bust cycle?

Last week I sat down with Stanford economist John Taylor. He served as Undersecretary for International Affairs under President George. W. Bush and was recently an advisor to Mitt Romney. He's also been one of the most influential monetary-policy economists of recent history.

Here's what Taylor had to say when I asked him about policy's role in the crisis (transcript follows):

Morgan Housel: We have been through more than a decade of boom and bust cycles, from the dot-com bubble of 2000. As soon as that crashed, we immediately went into the housing bubble, which that crashed and now we've been in the Great Recession for the past four or five years. What role has policy played in that boom-bust cycle?

John Taylor: I think it's a big role. Here I would point to monetary policy, especially in the '03, '04, '05 period of regulatory policy. On the monetary-policy side, both the episodes, there was a period where rates were brought down and the first one, because of the Russian financial crisis and long-term capital management, rates were cut by about 75 basis points, and it took a while for the Fed to put that back in. And that was the period where you had excesses in the markets.

But much more serious was 2003, '04, and '05, where the Fed held the rates much lower than they would have if they were following the policies from most of the '80s and '90s. And that accentuated the housing boom, search for yield, risk-taking, took the banks and other financial institutions in positions they couldn't, shouldn't have been in, and that's where I think the regulatory side of this comes in. Fannie Mae and Freddie Mac were supposed to be regulated. They were given lots of leeway in terms of risk-taking, and for that matter, I think the commercial banks, a lot of regulators sitting on the premises and they were able to take risks they probably shouldn't have been taking.

Morgan Housel: Do you think we've learned anything from the past decade or do you think we're doomed to keep making the same mistakes again?

John Taylor: Well, on the monetary policy side, I think we're kind of doing the same thing. I would say it's very interventionist. It's hard to predict what the Fed will do with the quantitative easing, with the forward guidance. You don't know how rates could be zero through 2015, and so that I think adds uncertainty and sort of the same kind of mechanism that we saw in the other episodes that you're seeing.

I think on fiscal policy, in a way all the uncertainty about the stimulus packages, the cash for clunkers, the first-time homebuyers, the temporary reduction of payroll tax, and now the same things that are being considered now, I think are things we learned in the past we shouldn't be doing, and we're doing them again. So learning has yet to show up in policy.

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