Taylor vs Bernanke Essay PDF

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An essay examining the Taylor Rule for Macroeconomics...

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Read “The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong” (especially all the subsections of section 1) by John Taylor, and “Monetary Policy and the Housing Bubble” by Ben Bernanke. Briefly summarize Taylor’s main argument and Bernanke’s response. Discuss which of the two thesis you find most convincing and why. It is natural, in the aftermath of such a devastatingly deep, long-lasting and widespread recession as that which the world felt following the financial crisis of 2007-8, that we would want to analyse and discover what it was that had happened. The purposes of such work apply beyond academia – it is vital that we can understand the mistakes that were made so they are not made again, and so that we can learn how to better deal with future crises as and when they arise. Taylor, in his 2009 paper “The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong,” argues that his model, the Taylor Model, was not accurately followed in the monetary policy of the USA in the years 2002-2004, a move which was particularly devastating, by his account. Bernanke, however, rejects Taylor’s analysis, defending the monetary policy of this period, attributing the deviation to external factors beyond the influence of the fed, and pointing out potentially key flaws in the Taylor Model which could account for why it is not to be followed precisely, but rather as a rule of thumb. Taylor’s argument is such that he outlines first his main hypothesis, assesses and re Fig 1 the alternative theories, and then assesses other factors which contributed to the effects of his main hypothesis. First, Taylor blames the crisis on ‘loose fitting monetary policy,’ as shown in figure 1. In this diagram, it is clear to see that, in the years 2002-2004, the monetary policy enacted by the Federal Reserve were such that the interest rates fell far below what could be derived from the Taylor rule. This was a break from the norm, as it was the ‘type of policy [the Fed] had followed fairly regularly during the previous 20 year period of good economic performance.’ Taylor then provides a counterfactual, through which he claims, with reference to the housing market: ‘no Fig 2 boom, no bust.’ By this, Taylor blames the large bust on the failure to control the housing bubble that built before the financial crash. He claims that the ‘extra easy policy’ outlined above ‘was responsible for accelerating the housing boom and thereby ultimately leading to the housing bust.’ Taylor claims that he has provided empirical analysis to show that this is the case by estimating in hindsight what would have happened were his opinions enacted, and interest rates not been so low. The line labelled ‘counterfactual’ in figure 2 shows what ‘a statistically estimated model of housing starts’ predicts, compared to the jagged line of reality and the line with the shorter

dashes, which shows what the same model predicted for the actual interest rates. Taylor believes this serves to show that, were his rule followed, neither boom nor bust would have occurred with such aggression. Taylor then assesses an alternative explanation, that of a ‘global saving glut.’ The argument for such an explanation goes that the low interest rates of the 2002-2004 period were caused not by monetary authorities, but rather by an ‘excess of world saving,’ which reduced interest rates globally. Taylor, however, rejects this thesis as there is little evidence for such a phenomenon. Despite a ‘gap of saving over investment outside the United States during 2002-2004,’ he argues that this was offset by an ‘equal sized negative gap in the United States,’ thus rebuking the argument. Taylor continues by assessing what else contribute Fig 3 e effect of the loose monetary policy. He blames the crisis in part on the ‘several complicating factors including the use of sub-prime mortgages, especially the adjustable rate variety which led to excessive risk taking.’ He believes also that this ‘and the low interest monetary policy decisions are connected.’ He claims, in reference to figure 3, which outlines the delinquency and foreclosure rates on adjustable rate subprime mortgages when compared to housing prices. In addition, he claims that the complexity of the mortgage packages was such that it made it difficult to trace the ‘bad’ mortgages, and thus the risk of the packages was far greater. Making this problem worse, he argues, were the ‘government sponsored agencies Fannie Mae and Freddie Mac,’ which were ‘encouraged to expand and buy mortgage backed securities,’ and failed legislation which should have controlled such excess. In blaming the monetary policy decisions of the Federal Reserve for the financial turmoil that followed, Taylor has made claims that many would find objectionable. Bernanke is one such person, as he was a member of the Board of Governors of the Federal Reserve System for the period that Taylor blames for the crash, 2002-2004. He thus jumps to respond to Taylor’s argument and defend the policy decisions taken in his 2010 speech ‘Monetary Policy and the Housing Bubble.’ He first takes objection with the vagueness of the Taylor rule in general. He gives a form of the rule as shown in figure 4. He notes that, in order to use the Taylor rule, one must ‘specify numerical values for the coefficients a and b, choose appropriate indicators of inflation and output, and specify a target rate for inflation and a measure of potential output.’ Therefore, argues Bernanke, we can reject Taylor’s findings that monetary policy was indeed too loose in the period 2002-2004 if we can find justified objections too either the rule itself or the values that we enter Fig 4 into it. He argues that ‘some empirical and simulation evidence suggests that the responsiveness of policy to the output gap, given by the parameter b in the Taylor rule equation, should be higher than the value of 0.5 originally chosen by Taylor.’ Such a finding would mean that the Taylor rule line in figure 1 is actually above where it should have been. In addition, we have different ways of measuring inflation

and the output gap. For example, when measuring the inflation, Taylor favoured the GDP deflator, whereas the FOMC prefer the use of core PCE inflation, which they claim to be more reliable. The result of using core PCE inflation is that the rates were lower in the periods 2002-2004, which could have led to results that justify the lower interest rates of the period. This analysis is not conclusive, as it is not clear which choice of measure is best. It serves to show, however, that the Taylor rule is not set in stone, and is open to interpretation, and can deliver differing results. Bernanke also takes issue with the fact that the Taylor rule states that ‘monetary policy should depend on currently observed values of inflation and output.’ This is flawed, argues Bernanke, because ‘monetary policy works with a lag,’ and therefore ‘effective monetary policy must take into account forecast values of the goal variables.’ The reasoning for this is that, otherwise, there is no distinction between temporary and longer lasting increases in inflation. In figure 5, Bernanke has analysed what the Taylor rule would have predicted were the estimated inflation rates taken into account rather than the current values for the time. These are lower than those that Taylor pointed to as evidence in figure 1, as Fig 5 shown by the red line on the diagram. He argues that path recommended by the red line, or Taylor’s original suggestion, must be flawed as it suggests too high a rate of interest in 2008 – 7 or 8 percent – ‘a policy decision that probably would not have garnered much support among monetary specialists,’ although he gives liittle justification for this claim. In addition, Bernanke claims that the rise in house prices were not, in fact, caused by the policy decsions regarding interest rates, regardless of how justified such rates may or may not have been. He argues instead that, whilst low interest rates do allow increased borrowing, and thus more people taking out mortgages, the problem in the build-up to the recent financial crash was the ‘increasing use of more exotic types of mortgages and the associated decline of underwriting standards.’ He cooncedes that the interest rates made dome effect on the housing market, but that without such a change in the nature of mortgages, the effect would have been minimal. He claims that economists have found that ‘only a small portion of the increase in house prices earlier this decade can be attributed to the stance of US monetary policy.’ However, it can be argued that it is the role of the Federal Reserve to react to such instrumental changes to the mortgage system, and to therefore create legislation to make changes, and adjust interest rates accordingly. Bernanke admits as much in his conclusion, writing that ‘stronger legislation and supervision aimed at problems with underwriting practices and lenders’ risk management would have been a more effectivee and surgical approach to constraining the housing bubble than a general increase in interest rates.’ This does not, however, rule out that monetary policy was flawed in the period in question, and that such monetary policy led to the boom and bust of the housing market. In addition, the claim that regulatory policies should have been more aggressively enacted is one made by both Taylor and Bernanke, and thus Taylor’s arguments are not undone by Bernanke’s conclusions. Therefore we can say that Taylor was indeed correct in his criticism of the Federal Reserve’s handling of monetary

policy in the period 2002-2004, and furthermore in his criticism of the lack of control and regulation of the housing and mortgage markets during the boom phase of the cycle. Thus we can judge Taylor’s argument to be the more convincing off the two, and Bernanke’s response to be insufficient....