An empirical analysis of what went wrong

Via Paul Krugman, a paper by John Taylor (he of the Taylor rule fame) from last November examining the early part of the credit crisis in the US. It is somewhat technical but still readable by a layman, it’s worthwhile ploughing through because he takes a look at the policies pursued by the US Government and their outcomes. His assertion that the Lehman bankruptcy didn’t matter as much as convential wisdom would have it has been challenged but I think there is something in the idea that inconsistent action has excaberated problems:

    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. While other factors were certainly at play, these
    government actions should be first on the list of answers to the question of what went wrong.

    What are the implications of this analysis for the future? Most urgently it is important to
    reinstate or establish a set of principles to follow to prevent misguided actions and interventions
    in the future. Though policy is now in a massive clean-up mode, setting a path to get back to
    these principles now should be part of the clean-up.

One final thing — there is a blink and you’ll miss it reference to the Republic. Check out the eye popping location of “IRL” on the chart on page 6.

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