Causes of the Financial Crisis

Last October I summarized a trenchant analysis by Anna Schwartz, co-author with Milton Friedman of the seminal A Monetary History of the United States.  She pointed out that Bernanke was solving the wrong problem - in a misguided attempt to replay history and prevent the last Great Depression, he was treating the banking crisis as a liquidity problem when instead it was a solvency problem.   Today in the WSJ the Stanford economist John B. Taylor explains how we got into this mess in How Government Created the Financial Crisis.  For those who do not get the online version of the Journal, let me summarize:

1. Greenspan caused the bubble by holding interest rates too low for too long in 2003-5.
2. Fannie/Freddie exacerbated the problem with subsidized mortgages and relaxed requirements, and the encouragement of excessive risk-taking by backing the securitization of subprime loans.
3. The initial response to the crisis in Aug 9-10, 2007 when money market interest rates rose dramatically was to treat the problem as one of liquidity, so the Fed initiated the Term Auction Facility on Dec07.  The TAF made little difference to the widened spreads. This should have clued them in that the rise in those rates was due to lack of confidence in the solvency of the counter-party (the other side) to money market funds, not liquidity.  
4. The next response was the $100B tax rebate passed in Feb08 to jumpstart consumption. It had little impact since as Milton Friedman had pointed out, only permanent changes in income cause consumers to change their spending behavior, not temporary rebates.  
5. The third response was a large drop in short term rates from 5.25% in Aug07 to 2% in Apr08.  This was sharper than warranted by the Taylor Rule (named after the author).  It caused a sharp drop in the USD and a sharp rise in Oil, exacerbating the crisis.
6. The collapse of Lehman Bros. did not cause the most dramatic leg of the crisis.  Interest rate spreads changed very slightly between the Friday before the bankruptcy (Sep12) and the Monday after (Sep15).
7. The panic was caused by the $700B TARP, the bill that Anna Schwartz had criticized solving the wrong problem.  Panic set in after this bill was debated and the public realized how poorly thought through it was, and how much more serious the problem appeared to be.

Taylor concludes that we should base policy on clearly understood problems and clearly thought-through solutions.  The crisis was misunderstood from the beginning and the plans to fix it have accordingly been poorly designed and largely ineffective.  As to the current Stimulus Bill, which he does not mention, Taylor concludes:

Massive responses with little explanation will probably make things worse  This is the lesson from the crisis so far.