Grading How the Fed Responded to the Financial Crisis

It's been more than four years since the Wall Street bailouts. But smart people are still trying to figure out what happened, how well it worked, and what it means for the future.

One thing we know: The future won't be the same. The bailouts and massive liquidity injections by the Federal Reserve have changed banks like Bank of America (NYSE: BAC  ) and Goldman Sachs (NYSE: GS  ) forever.

Last week, I sat down with Stanford economist John Taylor. He's a former Treasury official and Mitt Romney advisor who is behind some of the most influential monetary-policy theories of the last few decades.

Here's what Taylor had to say when I asked him about the Fed's role after the crisis began (transcript follows).

Morgan Housel: So the Federal Reserve, in your opinion, made errors early last decade, '03-'04-'05. Come 2008 when Ben Bernanke started making massive policy interventions, was that the right thing to do, or were there substantial mistakes in that period as well?

John Taylor: No, early on I think it was; it was late as October, November, December 2007 seemed to be pretty clear there was a problem in the financial system where some intervention was needed, a credit problem, but it was addressed mainly by a liquidity means. The term "auction facility," for example, the Fed got special ways for firms to get loans. And then the intervention with Bear Sterns -- hard to second-guess things like that in an emergency, but after Bear Sterns, I think that it was really in interventionist mode, and people didn't know what was going to happen, so when Lehman came, it was a huge surprise.

I think after all that in the panic period of really October, November, the Fed deserves a lot of credit for coming in and stabilizing things in a very panicked environment. But then afterwards in 2009-2010, the panic was gone, and the intervention continued. I think that's where I would find problems with the policy now.

Morgan Housel: It seems from my perspective, QE1 and QE2 were offsetting decline, whereas QE3 now is trying to boost us forward. Is that a right way to think about it?

John Taylor: Certainly with QE3; it depends what you mean by QE2. I just defined QE1 as these large-scale asset purchases really began mainly in 2009. There was intervention in 2008, which I think made sense. It was offsetting these pressures, but I think I would say even in 2009, you began to see concerns about a weak recovery and interventions. I remember we had a conference here at Stanford in, I think it was March 2008, and I was raising concerns that these interventions may change the way monetary policy works in the future. The vice chairman that was here was Don Cohen at the time, said, No, don't worry; those are just emergencies. We won't be doing those regularly. But now they're doing them regularly, so monetary policy hasn't really changed.

End transcript.

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