John Taylor on the causes and treatment of the crisis
This essay by Stanford's John Taylor is well worth reading.
In this paper I have provided 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.
What are the implications of this analysis for the future? Most urgently it is important to reinstate or establish a set of principles to follow to prevent misguided actions and interventions in the future. Though policy is now in a massive clean-up mode, setting a path to get back to these principles now should be part of the clean-up. I would recommend the following:
First, return to the set of principles for setting interest rates that worked well during the Great Moderation.
Second, base any future government interventions on a clearly stated diagnosis of the problem and a rationale for the interventions.
Third, create a predictable exceptional access framework for providing financial assistance to existing financial institutions. The example of how the International Monetary Fund set up an exceptional access framework to guide its lending decisions to emerging market countries is a good one to follow.