In 1993 Stanford economics professor John B. Taylor developed the Taylor rule which is now the generally accepted formula on how a central banks should set interest rates. Recently he did some good forensic analysis: The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong (pdf)
Here is my short summery of his paper, pimped up with a conspiracy theory.
The problem that led to the crisis started with the deflation scare in 2002/3 when Greenspan set the interest rates far too low (1%) and for far too long (1 year). He broke the Taylor rule.
Too low interest rates led to the housing boom and a credit bubble – this in parts of the Euro area as well as in the United States. Taylor proves that there never was a "global savings glut", i.e. Greenspan's explanation of the boom is false. Mainly the low central bank rates created the bubble.
Through 2005 to 2006 the interest rate climbed back up to 5.25%. This pricked the housing bubble. New home sales declined sharply. In April 2007 mortgage lender New Century declared bankruptcy. On August 6 American Home followed.
The credit crisis started for real on August 9 2007 when suddenly the London Inter Bank Offer Rate jumped higher than other rates it normally follows and stayed elivated. LIBOR is calculated daily from reports and guestimates of rates on interbank loans by 16 major banks. Instead of the normal 0.1% difference between LIBOR and OIS the difference was suddenly at 1%. This threatened to develop into a monetary shock as $300 trillions of loans and derivatives have their interest rate bound to LIBOR.
The relevant policy actors reacted. But they misdiagnosed the underlying problem and therfore used the wrong tools. They assumed that the LIBOR spread showed that there was a liquidity crisis and that pumping money into the markets would help. The Fed opened the Term Auction Facility to give billions of additional cheap loans to the banking system. It did not help. The Bush administration sent checks to taxpayers. That money was not spend for consumption but saved. Interest rates were lowered sharply (again too low.) But all these did not influence the problem obvious in the LIBOR-OIS spread.
The crisis was a solvency and trust crisis. People knew that there were many bad assets out there but did not know who owned how many of them. Banks mistrusted their counterparts and that was the reason they demanded a higher risk premium when lending – thus the LIBOR distortion.
Meanwhile the sharp decrease of U.S. interest rates to 2% in 2008 had led to a deeper decline in the value of the dollar and a sharp rise in the price of oil. The high oil prices sent the 'real' economy into a recession.
Fourteen month into the crisis the problem visible in the LIBOR spread exploded.
Lehman Brothers failed on September 15 2008. This is now usually seen as the event that brought the system down. But Taylor shows that this view is wrong. Lehman's bankruptcy in itself did not have bad consequences. Indeed markets reacted quite calmly. But the shit really hit the fan a week later when, as Taylor assumes, policymakers screwed up.
Taylor writes:
[I]t is plausible that events around September
23 actually drove the market, including the realization by the public that the intervention plan had not been fully thought through and that conditions were much worse than many had been led to believe. At a minimum a great deal of uncertainty about what the government would do to aid financial institutions, and under what circumstances, was revealed and thereby added to business and investment decisions at that time.
So policy makers fucked up because they, instead of spreading calm and confidence, added uncertainty and thereby risk.
That is indeed a plausible explanation. But there are other plausible explanation for the much watched and remarked on spread increase.
On September 23 Paulson offered a $700 billon taxpayer gift to the big banks – the very friends he had worked with all his life. The common people and congress were very much against giving away that money. The house even voted it down. Pressure needed to be applied to congress and the public for the banks to get their hands on the money. They reported too high interbank lending rates and drove up LIBOR and thereby the much watched and reported on risk spread until on October 3 congress gave in and Paulson, on October 13, started to hand out the money in a way they liked.
The banks abused LIBOR to manipulate public opinion and congress to get the money. Call it the greed theory.
Can I prove that banks abused LIBOR to get hundreds of billions in taxpayer money?
No.
LIBOR is a rate that is calculated daily from phone-in reports and guestimates from 16 big banks. There is no way for me to verify that those big banks did not report correctly and did not collude in what they report.
To really prove manipulations one would have to shuffle through all the real interbank deal records of all major banks at that time and to find out if the interest rates they really payed each other were the same they reported for LIBOR.
In spring 2008, by using some other measures, a Wall Street Journal investigation found it likely that several banks, Citibank in the lead, reported too low rates to LIBOR to hide their credit problems.The day after the WSJ first published on the issue, LIBOR rates corrected upwards. (I wrote about possible LIBOR manipulation on October 13 2008. The very next day LIBOR started their decline. But I admit that those were likely independent events – the WSJ circulation is still a bit higher then ours.)
From the WSJ investigation we know that LIBOR can be manipulated by the banks and was manipulated in spring 2008. It is hard to prove manipulation without the actual records. The British Banker's Association is supervising the LIBOR reporting and calculation. But what interest would it have to really find problems with it?
One thing is sure. In October 2008 banks had a huge incentive to report too high rates as it furthered the pressure to hand them over hundreds of billions. Simply ask yourself: What would you do to get a 100 billion dollar gift?
Taylor may be right with his explanation. I may be right to suspect manipulation. Indeed we both could be right.
Taylor concludes:
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.
This is not a call for less government action and intervention. Only for the right ones.
The paper is dated November 2008. Some acting policy persons have changed since then but unfortunately not the policies with regards to the financial crisis. Policy makers still misdiagnose the problem and apply the wrong tools.
The issue is to restore trust into the banking system. The only way to do that is to take them over, clean them up and then privatize them again with a clean bill of health into a strict regulatory environment. Only when that is done can the repair of the real economy begin.