Economist John Taylor writes in “Getting off Track” that our current financial crisis was due to missteps in governmental monetary policy.

He faulted excessively low interest rates for fueling the housing bubble. Had the Fed followed the Taylor Rule for setting interest rates that had guided the relatively moderate period since the recession of 1982 Taylor believes that the bust would have been sooner and much less severe.

He also believed that the response to higher interbank rates in 2007 was mistaken. The Fed assumed that the problem was liquidity and thus injected liquidity. While it appeared to have some short term positive affect the rates spiked again.

The problem was not liquidity but counter party risk. Banks questioned the balance sheets of banks they were lending to. It was analogous to misdiagnosing a cancer patient with a gastro problem, leading to a weaker patient and a more advanced disease.

Taylor also was not surprised to see the first stimulus payment fail. Others have noted that single distributions have less stimulative effect than recurring payments (also known as tax cuts.)

In a Wall Street Journal article Alan Greenspan takes exception to the idea that the Fed caused the housing bubble with interest rates that were too low. Greenspan noted that there was a noted decoupling of mortgage rates from short term Fed rates. While there had been some relation it is not unusual that large capital purchases would be more tied to long term rates.

The growth in the global market economy, a healthy development, led to increased global savings in China and other developing countries. The increase in the global savings pool drove interest rates down and the Fed had no control over global savings rate, nor should they.

Greenspan and Taylor are leading economist and friends; yet they disagree on the precise causes of our current crisis. Yet they both warn that government micromanagement is counter productive. Greenspan suggests higher capital requirements and better enforcement of regulations.

Unfortunately debates on monetary policy is less satisfying for partisan ideologues who want to trash Bush and tax cuts rather than take the time to understand the problem. Like Taylor’s medical analogy they want to react quickly without a proper diagnosis. Doctors understand that a careful diagnosis is critical to proper treatment. The proper treatment for the wrong disease can kill a patient.

The first dictum for the doctor and our politicians should be the same. First, do your patient no harm.

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