In reaction to the dot-com implosion and the collapse in business investment, Alan Greenspan rapidly cut interest rates to spur housing and consumer spending. In June 2003, even as the tax cuts were passing and the economy took off, he cut the fed funds rate to 1% and kept it there for a year.Read the whole thing.
His stimulus worked -- far too well. The money boom created a commodity price spike as well as a subsidy for credit across the economy. Economist John Taylor of Stanford has analyzed the magnitude of this monetary mistake in a new paper that assesses government's contribution to the financial panic. The second chart compares the actual fed funds rate this decade with what it would have been had the Fed stayed within the policy lanes of the previous 20 years.
"This extra easy policy was responsible for accelerating the housing boom and thereby ultimately leading to the housing bust," writes Mr. Taylor, who worked in the first-term Bush Treasury, though not on monetary affairs, and is known for the "Taylor rule" for determining how central banks should adjust interest rates.
By pushing all of this excess credit into the economy, the Fed created a housing and mortgage mania that Wall Street was only too happy to be part of. Yes, many on the Street abandoned their normal risk standards. But they were goaded by an enormous subsidy for debt. Wall Street did get "drunk" but Washington had set up the open bar.
For that matter, most everyone else was also drinking the free booze: from homebuyers who put nothing down for a loan, to a White House that bragged about record home ownership, to the Democrats who promoted and protected Fannie Mae and Freddie Mac. (Those two companies helped turbocharge the mania by using a taxpayer subsidy to attract trillions of dollars of foreign capital into U.S. housing.) No one wanted the party to end, though sooner or later it had to.
Here is more on the Taylor Rule.