What this covers
John Taylor of Stanford University and host Russ Roberts trace the origins and conduct of the 2008 financial crisis through the lens of monetary policy. The conversation centers on Taylor's argument that loose Federal Reserve policy—specifically, interest rates held far below historical norms during 2003–2005—created the conditions for the housing boom. Taylor walks through the evidence: the Fed's funds rate stayed at 1% into early 2004, nearly three years after the recession ended; cross-country data show nations whose rates deviated most below his rule had the largest housing bubbles; and low rates transmitted to mortgage demand through adjustable-rate mortgages and the term structure. The discussion then pivots to government response: Taylor contends that ad-hoc, unpredictable interventions—especially the decision not to bail out Lehman Brothers after rescuing Bear Stearns—amplified panic and contagion when clear, rule-based strategy would have steadied markets.
The conversation ranges across the mechanics of policy transmission, the Fed's quantitative-easing purchases, and competing explanations for the crisis. Taylor argues that the Fed's mortgage-backed-security purchases had minimal measurable impact, that the "global savings glut" explanation lacks empirical grounding, and that stimulus packages in 2008 and 2009 arrived too late to matter. Roberts and Taylor also discuss the structural problem of asymmetric incentives facing policymakers—rewarded for intervention but punished for restraint—and debate whether rule-based monetary policy, such as the Taylor rule, can constrain institutions better than relying on individual leadership. The program concludes by addressing longer-term risks: Taylor warns of substantial inflation risk from excess reserves still lodged in the banking system, and both speakers reflect on what the crisis teaches macroeconomics and future Fed behavior.
Taylor argues the 2008 financial crisis was largely policy-induced: the Fed held interest rates far below what its own past behavior (the Taylor rule) prescribed in 2002-2005, fueling a housing boom, and subsequent ad-hoc government interventions worsened and prolonged the panic.
- Fed funds rates in 2003-2005 were well below Taylor-rule levels, stimulating adjustable-rate mortgage demand and housing prices
- OECD cross-country evidence shows nations whose rates deviated most below the Taylor rule had the largest housing booms
- Unpredictable, ad-hoc interventions (e.g. surprise non-bailout of Lehman) created contagion, while clear, rule-based policy would reduce surprises
This asset isn't compiled yet
You're seeing its claims, ranked. Compile it to build the argument threads, weight them, and check each claim against your library — the full view.
Policymakers face an asymmetric incentive structure that biases them toward intervention: there is little reward for saying no when things then work out fine, but a huge penalty if they say no and things fall apart, creating strong pressure to say yes — which reduces short-run damage but causes long-term difficulties and a self-perpetuating bailout mentality.
“you don't get much reward if you say no and things work fine... you get huge penalty if you say no and things do fall apart and so there's a strong incentive to go ahead and say yes”
Good monetary policy under the Taylor rule means the central bank's interest rate adjusts by a sufficient (quantifiable) amount when inflation or GDP rises or falls — rising at least as much as inflation increases, and being cut by specified amounts during recessions — which allows specific measurement and comparison against actual policy.
“The Taylor rule shows that good monetary policy is one in which the interest rate set by the central bank adjusts by a sufficient amount when... inflation Rises or when GDP Rises or Falls”
Monetary policy transmits globally through exports/imports (via exchange rates), capital flows (via interest rate differentials), and a tendency for small open economies to follow large economies' rates — e.g. if the US cuts rates and Sweden's Riksbank does not, the Swedish currency appreciates, pressuring it to follow.
“if the US has a low interest rate it will tend to mean that small open economies British for example or the Swedish will have lower and lower interest rates too”
The US version of quantitative easing was not the general 'inject reserves to drive rates to zero' Japanese variety, but rather targeted purchases of specific securities (medium-term Treasuries, mortgage-backed securities) aimed at affecting their yields directly — evidenced by the fact that balance-sheet expansion began the week of September 17th when the funds rate was still at 2%, before the FOMC even voted to cut rates, and it was the expansion itself that drove the rate to zero.
“the United States version of quantitative easing is not of that variety... there's purchases of certain kinds of securities trying to affect their yields directly”
Taylor's empirical evaluation finds the Fed's mortgage-backed-security purchases had a very small impact: although mortgage rates fell after the purchases, controlling for market perceptions of risk on those securities shows the rate movements were caused by other factors, not the purchases — the same being true of interbank money-market spreads.
“when you bring those risk numbers into account the purchases of the securities by the Fed doesn't do very much at all it's caused by other factors”
You do not want an institution that depends on getting the right person into position; because the political incentives facing the Fed chair will not change, the system remains prone to catastrophic mistakes (like the Great Depression and the recent crisis), so the remedy is to build sound philosophy — such as inflation targeting or rule-based interest-rate guidelines — into the institutions themselves rather than relying on individual leadership.
“you really don't want to have an institution that depends on getting the right person into position”
The fall 2008 panic was probably not caused primarily by the Lehman Brothers bankruptcy: the major market movements (S&P 500 dropping 28% in three weeks, surging money-market spreads, global export collapse) occurred at least 10 days to two weeks after Lehman, coinciding with the government publicly warning of disaster to sell the TARP program, which itself scared markets.
“most of those movements occurred at least ten days or two weeks after the Lehman Brothers bankruptcy and they also occur at time at a time where the US government... is out there saying we need to intervene with a tarp program or the will be disaster”
Much of the financial crisis was caused by excessively loose monetary policy, evidenced by interest rates in 2003-2005 being much lower than would have been expected based on the monetary policy that worked well during the long expansions of the 1980s and 1990s, as measured by the Taylor rule.
“the evidence I focus on is that interest rates were much lower especially 2003 4 & 5 then would have been expected based on the kind of monetary policy that was used during much of the 80s and 90s”
Low rates encouraged excess risk-taking through a self-reinforcing feedback loop: rising housing prices gave borrowers incentive to keep paying and not default, which misled underwriters into thinking investments were less risky, so more investments were made on that assumption — a process that reversed when prices leveled off and delinquencies and foreclosures rose.
“those high inflation rates for housing would give people more incentive to make their payments... so that would mislead if you like underwriters into thinking these are good investments less risky than you'd think”
Traditional money measures like M2 became unreliable because technological and regulatory changes let people make payments without traditional money forms; this is why central bankers and policy rules like the Taylor rule focused on interest rates to stand in for hard-to-measure money growth.
“because of all the technological changes the regulatory changes... money became less reliable the traditional measures became less reliable”
The global savings glut explanation for low long-term rates has factual problems: measured global savings rates in that period were actually lower than in the 70s, 80s, and most of the 90s; Greenspan's fallback to intended-versus-desired savings is essentially unmeasurable and thus an unsubstantiable argument.
“the overall global savings rate was lower than normal in that period... so it's hard to see it excess”
The February 2008 Bush stimulus package and the 2009 stimulus package had very little impact, which is further evidence that the crisis dynamics were largely policy-induced and that markets stabilized long before the fiscal packages were enacted.
“the large interventions starting with the stimulus package in February 2008 which I don't think did much good at all”
Low federal funds rates transmitted to the housing boom through two channels: lowering adjustable-rate mortgage rates (about 30% of mortgages, a rising fraction, often at low teaser rates) which increased housing demand, and through the term structure feeding short rates into the long rates that 30-year mortgages depend on.
“the low interest rate would make the raid on adjustable rate mortgages much lower so about 30 percent of the mortgages during this period were adjustable rate”
Fannie Mae and Freddie Mac played a significant role in the crisis: while not initially bundling subprime mortgages into their own securities, they were a non-trivial portion of demand for subprime mortgage-backed securities (estimates in the hundreds of billions) to satisfy HUD's affordable housing requirements imposed starting in 1992, thereby indirectly supporting the subprime market.
“they were a non-trivial portion of the demand for those securities we're using those to satisfy their affordable housing requirements that HUD imposed on them starting in 1992”
Disruptions in financial markets come from surprises — unanticipated events markets cannot discount; the Lehman problem was that after the Bear Stearns intervention markets expected Lehman to be bailed out too, so the non-bailout was a surprise, whereas a clear strategy articulated right after Bear Stearns would have substantially reduced the impact.
“the problem with Lehman was it was a surprise after the bear intervention... there was a great expectation that Lehman Brothers would be intervened and bailed out and when it wasn't that was a surprise”
The 'conundrum' of long-term rates failing to rise when the Fed began raising short rates was likely because market participants were unsure whether the Fed was permanently abandoning the policies of the 80s and 90s, so much of the long-rate adjustment was a surprise.
“my feeling about the conundrum is that the main reason for this was that people in the markets were somewhat unsure about what the Fed was going to do”
The Fed's accumulation of roughly a trillion dollars in assets — over half of it mortgage-backed securities — has injected an enormous quantity of excess reserves into the banking system, creating a serious risk that when the economy recovers and banks lend it out, substantial inflation will follow unless the Fed successfully removes the reserves in time.
“there's an enormous number of excess reserves into the banks the banking system which would suggest... that when the economy recovers... that money is going to be lent out and we're going to have substantial inflation”
The Fed's claim that it can easily withdraw reserves ('a big mop in the back room') is harder than it sounds, especially because unwinding mortgage-backed securities requires selling them, which people will argue raises mortgage rates, and the Fed's purchase of medium-term Treasuries to keep long Treasury rates low and reduce Treasury borrowing costs raises questions about its independence.
“they talk like they've got a big mop in the back room... much easier said than done and I think one reason is the mortgage-backed securities”
Some form of rule-based thinking about the interest-rate instrument — beyond a pure inflation target, perhaps something specifying movements of the instruments — is a productive way to constrain the Fed; policy rules served as good guidelines historically, don't need to be perfect, but are hard to legislate.
“I do think that some kind of rule based thinking about the interest rate or whoever their interest instrument happens to be when we're out of this it is a productive way to think about things”
The Great Moderation's long expansions and short recessions were the result of good monetary policy and a better understanding of its impact (including the importance of expectations), evidenced by the pattern that bad policy in the 1970s produced bad results, good policy in the 80s and 90s produced good results, and getting off that good policy again produced the recent crisis.
“the Great Moderation was did a good monetary policy... once we got off of that policy things went to hell in a handbasket”
The Fed kept rates excessively low because of well-intentioned efforts to prevent something worse — primarily a fear of deflation and continued worry about the aftermath of 9/11 and the bursting dot-com bubble — not because of bad intentions or incompetence.
“well-intentioned efforts to prevent something worse... like a deflation or like a Japan or major downturn”
Holding the federal funds rate at 1% in early 2004 — nearly three years after the 2001 recession ended, while the economy and inflation were rising — represented a long period where rates were the lowest in the previous 40 years, amounting to injecting too much money into the banking system.
“in 2004 early part of 2000 for the federal funds rate was still at 1 percent... that's really it almost three years after the recession had ended in 2001”
Easy money causes excesses but you cannot predict where they will show up; based on 1960s and 70s experience, monetary policy did induce booms and slumps in housing, making housing a logical place for the excess to occur this time.
“the thing about about easy money if you like is you don't know where it's going to show or what its gonna do”
The proper monetary-policy lesson is essentially technical, not political: the very low rates were an effort to over-fine-tune ('the perfect becoming the enemy of the good') — trying to do even better than the successful 20-year record — and the lesson is to return to the basic fundamentals that worked rather than overdo fine-tuning.
“you could think about the very low rates that I complained about before as an effort to do if you like do too much fine-tuning... it's kind of like the perfect becomes the NAB”
If each central bank simply did what was right for its own country (keeping its inflation low and creating stability), the world would have very good performance overall — meaning much explicit international coordination is unnecessary, though it remains useful to ensure no central bank makes life difficult for its counterparts.
“if each central bank did what was right for its country... then we'd have just a very good world performance”
OECD research found a high correlation across countries between the degree to which a nation's interest rate was below its estimated Taylor-rule level and the size of its housing boom, including Spain and Ireland — providing evidence that the loose-money-causes-housing-boom mechanism works globally, not just in the US.
“they looked at countries whose interest rate was below the Taylor rule as they estimated... and found an amazingly high correlation between the deviations in the housing price boom”
Ad-hoc discretionary policy is structurally appealing to policymakers because announcing a general rule limits flexibility and ties their hands, putting them in positions where their rules require saying no when they want to say yes; this is why rules-based approaches (monetary rules, constitutions) are valuable but politically hard to maintain.
“ad hocs really appealing... announcing a policy that you might set of general rule side limits your flexibility and ties your hands”
A rule of thumb like the Taylor rule — not an ironclad rule but one allowing some discretion — could be effective if deviations from it are punished with shame and embarrassment, enforced by constant 24-hour news scrutiny providing discipline to the process.
“deviations from it would be punished with shame and embarrassment might be effective I think so”
The Fed does not literally set the federal funds rate; it injects or extracts bank reserves (changes the money supply) so that the actual overnight interbank rate is brought into line with the FOMC's target.
“effectively they set a target and the idea is that the Fed and New York trading desks adjust the reserves or the money supply to bring the actual interest rate into line with their goal”
Even the pre-Great-Depression period before the Fed's modern mistakes was not nirvana — there were many business cycles, including a bad one in 1894 — so the goal is not to return to that but to build sound monetary philosophy into institutions.
“the period before the Great Depression was not nirvana we had lots of business cycles”
Very few commentators were warning about the excessively low rates at the time (the Wall Street Journal editorial pages being one exception); like many things leading up to the crisis, the recognition is largely a benefit of hindsight, as the buildup happened quickly before people noticed.
“there weren't as many as you might think... you like so many things leading up to this crisis is just a few people you can point to”
There has never been a time in our lifetime with so much skepticism about the role of the Fed, with mainstream figures—not just conspiracy-minded ones—now saying something should be done, though it is not obvious what the structural reform should be.
“there has never been a time in our lifetime where there's been so much skepticism about the role of the Fed”