Getting Off Track: A Review

John B. Taylor’s recent book on the financial crisis of 2008 provides an objective look at how Federal Reserve monetary policies and Treasury mismanagement played a key role in the crisis, and could have been averted.


Many articles and tomes have been written this year about the 2008 Financial Crisis, but few have approached the subject with an analytic-based story as compelling as John Taylor’s [1]. As we celebrate the one-year anniversary of that rocky week in September 2008, marked by major bailouts, bankruptcies and mergers of distressed financial institutions, massive Federal Reserve injections of money into the banking system, and a major economic and market contraction, we ask ourselves: how could it have been prevented? According to Taylor: by acknowledging as early as the Fall of 2007 that the root of the problem was counterparty risk dislocations and not liquidity problems, and by not shocking the system with excessive monetary easing or government intervention.

“We should base our policy evaluations and conclusions on empirical analyses, not on ideological, personal, political, or partisan grounds.” -John B. Taylor

Taylor focuses on specific interest rate spreads [2] to diagnose that the early problem (Summer 2007) was with the risk associated with bank balance sheets, causing banks and other institutions to contract their lending, including inter-bank lending, resulting in skyrocketing adjustable rate mortgage (ARM) and consumer interest rates, which in turn acutely affected the broader economy. His analysis also documented that had the Federal Reserve followed an “automatic policy rule” for setting interest rates in the early part of this decade (particularly 2002-2004, a period of excessive easing), that a housing bubble would likely not have developed, that a more gradual rise and fall in housing starts would have been realized, and that mortgage delinquencies would not have been as severe.

Importantly, Taylor’s analysis shows that there was a global correlation between interest rate spreads; i.e., that the spreads denominated in dollar-euro-sterling tracked each other quite nicely, indicating that the balance sheet risk issues were widespread among U.S., European and British banks, but not as coupled with Japanese banks. Similarly, many central banks in the U.S. and Europe (OECD countries) appear from the data to have ignored the use of a sound automatic policy rule for setting interest rates, placing rates artificially too low from 2002-5. This set a global environment for sharply rising housing investment as a percent of gross domestic product (GDP), amid a historically low global savings as a percent of world GDP.

Central bank liquidity programs (the Fed’s Term Auction Facility) and federal government Keynesian-style stimulus infusions (the 2008 U.S. tax rebates) had little effect in bringing down elevated interest rate spreads in 2008, according to Taylor’s analyses. Had those solutions been replaced by a targeted solution aimed at bank balance sheet issues, which evidently appear to have been driving the risk premium in the spreads, we might have seen a very different outcome. As Taylor notes, other measures of counterparty risk, such as credit default swap (CDS) premiums and the spread between interest rates on unsecured and secured lending in the inter-bank market became elevated and correlated in time with short-term mortgage/consumer-related rate spreads [2]. Transparency into bank balance sheets was needed early.

To his character, Taylor generally refrains from talking about specific personalities involved in the policy decisions that led to, and prolonged, the crisis. Instead, he offers solid suggestions for policy reform, which include the global adoption and maintenance of principles (such as an automatic rule) for setting interest rates, diagnosed rationale for government intervention, and a predictable framework for government assistance to distressed financial institutions.

Clearly Taylor was not a casual observer during the crisis. After trying to convince colleagues early (Summer/Fall 2007) of the nature of the problem, he was repeatedly ignored. One might wonder upon the alternate history had he been Chair of the Fed.

References and Endnotes

[1] “Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis,” John B. Taylor (2009 Hoover Institution Press, Stanford University).

[2] The fundamental metric used in Taylor’s analysis is the 3-month “Libor-OIS Spread,” or the difference between the London Inter-Bank Offer Rate with a 3-month maturity and the Overnight Index Swap with the same maturity. Most ARMs and consumer interest rates in the U.S., Europe and Britain are tied to 3-month Libor, while the OIS is a market measure of federal funds rate expectations. As Taylor points out, factoring out interest rate expectations allows for further analysis of the dependence of the spread on risk and liquidity, two other important measures. The Libor-OIS Spread jumped a whopping 17x its usual standard deviation in August 2007, and remained relatively elevated until jumping another 100x in October 2008. Taylor has termed this phenomenon as a “Black Swan in the Money Market.”

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