Michael Hanson
Business in Review

Getting Off Track

By, 05/25/2010
I had every intention of winding down my reading on the crisis, but it just seems to keep going—books from worthy authors are still arriving weekly on the topic. So, let us press forward, then, with John Taylor's Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis. 

This dainty 92 page book is not light reading, nor will it appear on any bestseller lists. But actually, these scant few pages are as cogent and clear as any I've encountered in describing the mechanics of the financial problems that caused the panic. 

John Taylor is a noted economist of this era in his own right, but is most often referred to as a friend of Milton Friedman (provocative because he's critical of Uncle Alan in this book). Taylor's pedigree includes stints (as either a student or professor) at Princeton, Stanford, and Columbia. In the early 90s he coined the Taylor Rule (more on this momentarily), and he's been a part of many prestigious economic counsels (as economists with sterling pedigrees are wont), including multiple presidential administrations. 

Taylor's book makes a very clear and pointed proposition: The government caused the financial and market ills of 2008, and played a key role in exacerbating those problems. He is right to blame the government for worsening the panic, but wrong to point such a strong finger for causing it. Or, rather, when he blames the government for causing it, he tends to blame the wrong parts. Let me explain. 

Taylor Rule for Everyone! 

The Taylor Rule is a "guide" to central banks on how to determine interest rates. It tracks inflation, output, and employment, recommending a higher interest rate when inflation is above comfortable levels and/or when full employment and capacity is reached. When inflation and/or output are low, the rule argues for a low interest rate. (There's plenty of mathematics to this, which we'll abstain from here.) 

Much of this book is a case study articulation of the theory. Specifically, that the rule was ignored for much of the last decade (Greenspan kept interest rates too low for too long). This inaction was a principal cause of the overheated boom and bust in housing, which eventually caused the panic and recession. Taylor might be a little bit right in this, but it's far too bombastic a claim. It's much more reasonable to say perhaps monetary looseness exacerbated some of the frothiness. Taylor is more right in pointing a finger at the moral hazard atrocities that are (and continue to be) Freddie and Fannie. 

Still, amazingly, there's no mention of FAS 157 and the dubious features of Sarbanes-Oxley. These two causes alone so obviously account for so much of Financials' problems that it boggles the mind we don't hear about them more often. If we are to successfully assign government blame for the origins of the downturn, we must go there, and prominently. Taylor doesn't. 

More importantly, such hard and fast economic equations as Taylor's often fail in practice, and blind adherence to them is a recipe for chaos. Taylor readily cops to the fact that we cannot put our faith in a theory, and that we must be versatile and aware of the peculiarity of each circumstance. But this is the problem with all rigid quantitative economics—in practice it works until it doesn't, at which point there you are, stuck with an equation that's somewhat mercurial in its forecasting power, and ultimately still requires a qualitative decision. Whether such equations help those decisions or obfuscate them is debatable. 

Risk versus Liquidity 

Although Taylor sometimes mis-assigns blame for the origins of Financials' problems, he gets as close to correctly assigning causality for the latter stages of the panic as anything I've so far read. He makes an important distinction about the crisis, one that few have drilled down to: The problem wasn't liquidity in the beginning—first it was risk and then liquidity.   

What does this mean? Differentiating between risk and liquidity might seem like hair-splitting. Certainly, in the marketplace risk and liquidity can be siblings, and at times seem nearly interchangeable. We're better off calling late 2008 a period of  "uncertainty" instead of risk. 

Why? Economist Frank Knight illuminated this issue brilliantly. He said that risk and uncertainty are two different things. Risk is what happens when you know the odds. If you flip a coin, there's a 1 in 2 chance of coming up heads. That's risk—you know the probabilities and can make a bet on it. But uncertainty is totally incalculable: these are situations where there is no way to know the odds—the probability of an outcome is just a wild guess. 

Indeed, the Fed and its cohorts innovated tremendously to provide liquidity to banks, but never actually took uncertainty off the table until way late in the game. In fact, they probably increased uncertainty by acting so haphazardly—each inconsistent reaction creating mounting uncertainty over the latter half of 2008. Who would they save? Who would they watch fail? What tactics would they use? Each reaction was different (from Bear Stearns to AIG and all in between) and thus, by the time we got to September ‘08, uncertainty about what happens next was at all-time highs. This is deadly poison for markets, which always look ahead. When even the next few hours are opaque, liquidity dries up. No one is willing to put money on the line when the government seems to be making the rules up as they go. And there you have your panic.

As with any event in a hugely complex global economy, there are multiple reasons for the cause of everything—the best we can do is figure out how much each factor mattered. Of course, that will always be a matter of opinion, hence the never-ending debate on such issues. With this book, Taylor does better than most at sluffing off the inane tendency to blame "greed" and stupidity for the panic. In an era when we seem to keep looking to the government for answers, this is an important perspective about its ills. But if this book proves anything, it's that the very causes of this era in financial history are still very debatable and in doubt in the public forum, and will be for decades to come.

*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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