Government intervention, like it or not, is everywhere in today's economy. While companies such as Goldman Sachs (NYSE:GS), JPMorgan Chase (NYSE:JPM), and American Express (NYSE:AXP) repaid their bailout funds in full, Washington still has a firm grip on companies such as Citigroup (NYSE:C) and Bank of America (NYSE:BAC). These ownership stakes that took shape around this time last year were unprecedented, to say the least.

Yet some of the most powerful interventions don't grab as much attention, because they target the whole economy, rather than individual companies that are easy to point fingers at. They're the interest rate cuts, tax policies, liquidity injections, and stimulus packages that began years ago.

To get a better understanding of the latter, I recently had a brief email chat with Stanford economist John Taylor. Dr. Taylor is perhaps most famous for creating the Taylor Rule, a formula that guides monetary policy and has become a standard lesson in nearly every economic textbook. Alan Greenspan, Ben Bernanke, and Paul Krugman have all frequently cited his work.

His latest book, Getting Off Track, argues that failed government policy created and prolonged the financial crisis. Below is a summary of our conversation, which centered on the book's main topics:

The biggest surprise [of economic policy over the past few years] was the return -- with no empirical evidence that it would work -- to highly discretionary policy interventionism after two decades of emphasis on developing clear predictable policies where government tried to set the rules for the market and then tried to get out of the way. For example, the stimulus package of 2008 of temporary tax rebates was passed with much support, even though there was no evidence that it would work (and it did not). This activism is being increased now, despite even more evidence that it does not work. More generally, policymakers have developed a bailout mentality which will be hard to reverse.

I am more convinced that the economic policies the United States was using from the early 1980s until recently were responsible for both creating economic stability and encouraging economic growth during that period. My earlier research had shown, for example, that the period of the Great Moderation was largely due to good monetary policy. But now we have even more evidence: Once we got off track, economic performance deteriorated significantly.

Over the past year, my concerns about the difficulty of implementing good government policy have grown. For example, when I was heading up the international division at the United States Treasury (2001-2005) I was in charge of developing and then implementing a policy of a new currency for Iraq. I later wrote a "lessons learned" book about such implementation tasks, showing how difficult they were and how policymakers need to be more concerned about implementation of policy. Now we are learning more about how existing supervisory and regulatory policy was not implemented well, as exemplified by the problems in the highly supervised and regulated banks and the gaps relating to the [structured investment vehicles]. I also think that the intervention into [Washington Mutual] and Wachovia raises questions about how an even more complex resolution process would be implemented in practice.

I also asked Dr. Taylor to provide a list of economic policies that he believes are the most damaging to the economy. His answers:

  • The monetary policy to set a very low federal funds rate in 2003-2005, which accelerated the housing boom [and] led to excessive risk-taking and the eventual housing bust. The Fed funds rate was still at 1% in 2004, three years after the recession ended in 2001. The simulations in my book provide evidence.
  • The encouragement of mortgage activity and risk-taking by [Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE)].
  • The rapid expansion of liquidity starting in 2007, when the problem was risk rather than liquidity. I believe this weakened the dollar and helped accelerate the huge run-up of oil prices in the spring of 2008. You can include the "stimulus" package of 2008 in this category, as well as the [term auction facility] and the sharper-than-needed cuts in the Fed funds rate in the winter/spring of 2008.
  • The chaotic interventions into financial firms. After Bear Stearns, policy should have been clarified, but it was not. Thus the [Lehman Brothers] event was an unnecessary surprise followed by more confusion around the time of the TARP rollout. The severe panic of the fall of 2008 was a serious blow to the economy; while we will be sorting this out for many years, I think these policy responses made it worse.
  • The explosion of the Fed's balance sheet, especially if it proves difficult to rein in.
  • The "stimulus" package of 2009 and the associated massive increases in the federal debt.
  • The purchase of medium term Treasury bonds by the Fed in 2009.

Have your own thoughts on the outcome of Uncle Sam's hand in the economy? Feel free to share them in the comment section below.

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