Everyone knows the joke about looking for a lost item under the lamp post instead of where it was actually lost “because the light is better there.”
So, in the financial crisis, it looks like the government,
urged on by the bankers, seems bent on treating the problem as a lack of liquidity
when the real issue is transparency. This matters, because Washington
Stanford economist John Taylor argues compellingly in The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong (Nov. 2008) that the great credit freeze was not because institutions were unwilling to lend but because they lost the ability to assess counter-party risk.In such an environment, simply adding cash does not resolve the crisis because it does not improve the ability of the participants to assess risk.
Still, even if it is hard to figure out how to do the right thing of improving transparency, it would be nice to avoid doing wrong ones, and Taylor “provide[s] three specific examples of the interventions that prolonged the crisis either because they did not address the problem or because they had unintended consequences” (Term Auction Facility; Temporary Cash Infusions; The Initial Cuts in Interest Rates through April 2008).
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.