John Taylor on Fiscal and Monetary Policy

Episode Summary

Executive Summary: Russ Roberts and John Taylor discuss the weak 2011 recovery, arguing that erratic fiscal and monetary interventions—not just the housing slump—help explain sluggish growth. Taylor says the stimulus largely failed, QE did little, banks held excess reserves, and policy should return to rules, steady monetary growth, and spending restraint.

Main Topics: Weak post-recession recovery: Taylor characterizes the 2010–2011 recovery as unusually weak compared with past recoveries, especially 1981–82, and sees policy as a major reason. Housing market drag and strategic default: The conversation examines how underwater mortgages, foreclosures, and bank balance-sheet problems may slow recovery, but Taylor argues housing alone cannot explain the broader weakness. Fiscal stimulus and ARRA critique: Taylor and Cogan’s research is used to argue that the stimulus package mostly did not raise spending; households saved transfers and states offset grants by borrowing less or redirecting funds. Quantitative easing and monetary policy limits: Taylor argues QE1 and QE2 were largely ineffective at lowering long-term rates or stimulating lending, despite huge asset purchases and reserve creation. Bank reserves, lending, and uncertainty: The discussion focuses on why banks held massive excess reserves and how weak loan demand, corporate cash holdings, and policy uncertainty reduced lending and investment. Debt ceiling, deficits, and spending restraint: Taylor urges a deal that pairs debt-limit increases with meaningful spending reductions, preferring cuts in spending growth over tax hikes to restore fiscal sustainability. Rules versus discretion in macro policy: Taylor advocates more rule-based Fed and IMF behavior, criticizing discretionary interventions that create uncertainty, bailouts, and political favoritism.

Key Arguments: The recovery is exceptionally weak by historical standards; Taylor compares 2.8% cumulative growth in the first two years to 7% after the 1981–82 recession. Housing distress matters, but it cannot explain low business fixed investment and broad economic weakness on its own. The stimulus package failed to generate the intended spending response: households saved a large share of transfers and states used grants to reduce borrowing or shift spending. The apparent lack of stimulus is consistent with basic economic theory and with earlier experience from state grant programs in the late 1970s. QE1 and QE2 were designed to reduce long-term rates, but Taylor found very small and uncertain effects, especially on mortgage-backed securities purchases. When policy rates hit zero, the Fed should have focused on maintaining money growth rather than large-scale asset purchases. Banks held huge excess reserves at the Fed rather than multiplying lending, suggesting reserve creation did not translate into broad credit expansion. Weak loan demand and business uncertainty, including regulation, taxes, health care, and deficits, likely suppressed investment and borrowing. The right policy response is not bigger short-term stimulus but a return to sound, steady fiscal and monetary rules. On the fiscal side, Taylor prefers reducing spending growth over raising taxes and wants outlays back near their pre-crisis share of GDP. The IMF and similar institutions should be constrained by rules to avoid repeated bailouts of creditors and countries. Taylor distinguishes anti-Keynesian from anti-government: he supports public goods and rule of law, but rejects discretionary fine-tuning as a practical stabilization tool.

Data Points: Cumulative growth in first two years of recovery: 2.8% - Taylor compares the 2011 recovery to the 1981–82 recovery, which had 7% growth in its first two years. Cumulative growth in first two years after 1981–82 recession: 7% - Used as a benchmark for a stronger historical recovery. Unemployment duration above 9%: roughly two years - Roberts opens by noting unemployment had stayed above 9% for about two years. Stimulus package size: about $800 billion - Taylor says about a third of the package sent to households was saved rather than spent. Household share of stimulus saved: about one-third - Taylor and Cogan found transfers to households were largely saved. Federal purchases under stimulus: less than 0.1% of GDP - Taylor argues direct federal purchases were too small to matter much. QE2 size: $600 billion - Roberts describes QE2 as roughly the size of the stimulus package. QE1 MBS purchases: 1.25 trillion - Taylor says QE1 included about $1.25 trillion in mortgage-backed securities purchases. QE1 Treasury purchases: $300 billion - Part of QE1 alongside MBS purchases. Fed reserve holdings: about $1.5 trillion - Taylor notes banks held gigantic excess reserves at the Fed. Bear Stearns support: about $30 billion - Roberts cites the toxic assets acquired/guaranteed in the Bear Stearns rescue. Target fiscal spending reduction: $2.5 trillion over 10 years - Taylor’s preferred immediate agreement tied to an increase in the debt limit. Long-run spending reduction needed to restore 2007 outlays share: $6 trillion - Taylor says this would bring federal outlays back to around 19.5% of GDP. Federal outlays as share of GDP in 2007: 19.5% - Taylor uses this as a pre-crisis benchmark. Federal outlays as share of GDP now: over 24% - Taylor cites this as evidence of spending expansion. Debt held abroad: half of the debt - Taylor argues foreign holdings raise the risk of rapid market repricing.

Pivotal Quotes: "What we learned is a lot of the interventions to try to fix this, working for the foreclosures, first-time home buyers, have really not done the trick, basically." — John Taylor: On the housing crisis and why interventions have not resolved it. "We think it's very important to estimate the effect of a stimulus package by looking at what actually happened, not to simulate another model again, because the models differ." — John Taylor: On methodology for evaluating the stimulus package. "The right strategy, I believe, would have been when the interest rate hit zero is just to make sure money growth didn't decline rather than have these gigantic injections..." — John Taylor: On what the Fed should have done at the zero lower bound.

Implications: Taylor’s view implies slower, rules-based policy and spending restraint are more likely to support recovery than activist stimulus or QE. For policymakers, the lesson is to reduce uncertainty, curb deficits, and avoid repeating interventions that mainly reshuffle rather than expand demand.