Mr. Bernanke and the Taylor Rule

A favorite game at my school was “lets you and him fight” whereby A would tell B that C had been talking trash about him and would often tell C the same thing about B. It was hard for B and C to avoid getting sucked in.

I sat beside Gentle Ben Bernanke at the FOMC table until I retired from the Fed in November 2004. He was a gentleman and a scholar. I can’t imagine him deliberately picking a fight with anyone—certainly not John Taylor over the Taylor Rule.

When I hurriedly read his remarks at the American Economic Association meetings, my impression was that he chose his topics to suit a more academic audience than he usually addresses in his speeches. Discussing monetary policy in that context was, in my humble opinion, his hat tip to the professors who would have heard of the Taylor Rule. I didn’t see any trash talking in the speech.

Let me say for the record that in my time on the FOMC the Taylor Rule, once it appeared on the scene, was mentioned occasionally during the discussions—respectfully I might add. It was usually in the context of a question: “How does current policy comport with the Taylor Rule?” Or, “What would the Taylor Rule have us do?” Not that we would necessarily fall in line, but it was always considered useful information. The problem for me was that, as they were wont to do, the staff had devised a “modified Taylor Rule” and I could never remember exactly how they had modified it, or even exactly how the original Taylor Rule was formulated for that matter. But it was given respect, and knowing whether we were easier or tighter than the Taylor Rule called for, modified or otherwise, was useful information even when the details were vague.

The part of his talk that seemed to rile Chairman Bernanke’s critics the most was his assertion that the housing bust following the boom or bubble was more the fault of inadequate regulation than too easy monetary policy. Frankly, that assertion seems almost self evident to me.

Even if easy money contributed to a housing bubble while the general price level was pretty well behaved, it was not the mere bursting of the bubble that caused the worst financial crisis since the Great Depression. The proximate cause of the financial crisis was the large number of subprime mortgages contained in the mortgage backed securities like time bombs set to go off. Somehow we seem to have forgotten that. Most of the blame nowadays goes to high salaries and bonuses.

Easy money may lead to a boom or a bubble in the housing market. Easy money may lead to too much lending and too high prices, but easy money doesn’t cause unscrupulous lenders to make subprime loans almost certain to go bad; and easy money doesn’t cause investment banks to securitize and sell them all over the world. Those destructive practices obviously should have been stopped through regulation or legislation. Chairman Bernanke accepted Fed failures on the regulatory front even though the Fed was not the regulator of those making the loans or most of those securitizing them.

Unfortunately, the unwritten rule of “not seeming defensive” has led the Fed to take more than its share of flack than I think it deserves. It’s time to end the flack and cut the Chairman some slack.

Comments (2)

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  1. EHROSEN says:

    Excellent and illuminating piece. I am glad you are back at it and hope you had a restful break. If you had wrote Bernanke’s speech, or given him this entry to read aloud, the result would have been healthy for the system. Instead, IMHO, his speech was counterproductive and ineffectual, i.e. anyone smart enough to understand it already knew what he said.

  2. Greg says:

    I agree. Mortgages are priced off of ten year Treasuries, and monetary policy has no control over the prices or yields of ten year Treasuries. I look at FASB 157 and the SEC’s implementation of it in regards to financial companies as the root cause. Had the financial companies not needed to write down the market value of those sub-prime mortgages and instead continued to use the discounted cash flow method I believe the meltdown would not have occurred. We would have had a turndown in housing and possibly the economy, but it would not have been as severe.