By John B. Taylor
W.W. Norton & Co.; 235 pages; $24.95
Ben Bernanke's Federal Reserve comes in for harsh criticism — and not just from any gadfly — in "First Principles."
Stanford University Professor John Taylor, for whom the "Taylor Rule" of monetary policy is named, rips the Bernanke Fed for the way it handled the financial crisis and for its efforts to help the economy recover from the ensuing recession.
Taylor is not just any schlub. He's a respected monetary economist who has advised both the Fed and foreign central banks and held senior positions in both Bush administrations. His Rule, which essentially directs the central bank to adjust short-term interest rates when inflation and unemployment deviate from specified norms, is considered a model of how to operate monetary policy.
His chief complaint is that the Fed, under Bernanke, has increasingly followed a discretionary path unconstrained by any systematic or rule-based strategy.
This short but comprehensive book also offers prescriptions — perhaps aimed at the next Republican president — for fiscal policy, banking regulation and health care. The unifying theme, per mentor Milton Friedman, is that economic freedom works best and is essential to the maintenance of political liberty.
But Taylor's real expertise lies in the monetary area, and it is here he lays waste with a sharp pen. Taylor contends Bernanke got it all wrong in responding to the mortgage crisis. The Fed never should have bailed out Bear-Stearns in March 2008, he argues; having done so, it set up expectations that other investment banks would get the same treatment — hopes that were dashed when the Fed let Lehman Brothers go under six months later.
Recalling that the Fed then reversed course to rescue AIG's creditors, Taylor charges "the Fed's on-again/off-again bailout measures were thus an intergral part of a generally unpredictable and confusing government response to the crisis, which, in my view, led to panic."
Nor does Taylor have much use for the "quantitative easing" the Fed undertook after the panic shook the economy. Contrary to Fed claims, he says its massive purchases of mortgage-backed securities "had at best a small effect on mortgage rates." And he warns the resulting explosion of bank reserves "creates risks to the financial system and the economy."
"If it is not reduced, then the bank money will eventually pour out into the economy and cause a rise in inflation," he says.
The author also has tart words for the "cozy connections" between Wall Street and the New York Federal Reserve Bank, then under the leadership of Timothy Geithner, in the years before the crisis.
Taylor even alleges "the European debt crisis...has U.S. fingerprints on it." His logic runs as follows: By keeping the federal funds rate too low from 2003 to 2005, the Fed forced European nations to hold their own rates artificially low to avoid an appreciation of their currencies against the dollar that would have hurt their exports and slowed their economies. Those low rates fuelled European housing booms like the U.S. experienced — with similar consequences.
Bernanke contends it was a "global savings glut" that caused interest rates to be low worldwide and that the Fed's low official rates had little to do with the housing boom/bust. But Taylor documents policy deliberations showing foreign central banks set their rates in line with Fed rates.
Taylor criticizes former Fed Chairman Alan Greenspan, his one-time boss, for deciding to "deviate in 2003-05 from the predictable rules-based policy that worked well in the 1980s and 1990s." But he laments that, after Bernanke replaced Greenspan in 2006, "we saw monetary activism as it never had been seen before in the United States."
Taylor is a perennial guest and speaker at the Kansas City Fed's famed annual symposium in Jackson Hole, Wyoming, and it would be surprising if he were not in attendance again in 2012. But he might get some cross looks.