John Taylor, a professor of economics at Stanford University and a senior fellow at Stanford's Hoover Institution, answers that question in a new book published this week called Getting Off Track: How government actions and interventions caused, prolonged, and worsened the financial crisis.
As you might guess from the title, Taylor concludes that blame lies primarily with the Federal Reserve's unreasonably low interest rates for much of the last decade. He also points an accusatory finger at "the failure to rein in Fannie and Freddie" (meaning Rep. Barney Frank and other Democratic congressional enablers) and "the lack of clarity in the operation" of last fall's financial bailout plan (meaning the Bush administration, plus congressional leaders who drafted the legislation).
In other words, the blame is thoroughly bipartisan.
Taylor is in a unique position to make these judgments: he was a Treasury Department undersecretary in the Bush administration, has been vice president of the American Economic Association, and was a member of President Carter's and President George H.W. Bush's economic advisory boards. Perhaps more importantly, he published a landmark paper in 1993 with a formula -- called, of course, the Taylor rule -- that suggests how high or low central banks should set interest rates.
Interest rate policy sounds like a topic that only an econometrics geek might appreciate, but in reality central banks can cause horrific damage through bad decisions. Interest rates that are too low tend to encourage people to load up on debt, including adjustable rate mortgages, yielding a speculative bubble and then a crash. (This is why a small minority of economists and a few politicians such as Rep. Ron Paul would abolish the Federal Reserve.)
Taylor says that starting in late 2000, the Fed lowered interest rates far beyond what the state of the economy should have allowed. "This deviation from the Taylor rule was unusually large; no greater or more persistent deviation of actual Fed policy had been seen since the turbulent days of the 1970s," he writes. "This is clear evidence of monetary excesses during the period leading up to the housing boom."
To back up that argument, Taylor constructed a model simulating what would have happened if the Fed stuck to a normal policy. If that had happened, he says, "clearly there would not have been such a big housing boom and bust." Two European Central Bank economists who constructed an alternate model arrived at the same conclusion.
Taylor also takes aim at what the Bush administration and the Democrat-controlled Congress tried to do through new laws, bailouts, and regulations. He said last February's so-called stimulus legislation, which delivered tax rebates to many people, led to people spending "little if any of the temporary rebate, and thus consumption was not jump-started." Last fall's emergency steps by the Bush administration created "a great deal of uncertainty about what the government would do" and had "no basis in economic theory or experience."
Even worse, Taylor says, Washington politicians and bureaucrats incorrectly concluded that liquidity, rather than the inability to value deteriorating financial assets, was the problem. Whoops. He writes: "They prolonged (the crisis) by misdiagnosing the problems in the bank credit markets and thereby responding inappropriately, focusing on liquidity rather than risk. They made it worse by supporting certain financial institutions and their creditors but not others in an ad hoc way, without a clear and understandable framework."
Alan Greenspan, who was chairman of the Federal Reserve during that time, defended his ultra-low interest rate policy to CBS News in September 2007, saying: "It was our job to unfreeze the American banking system if we wanted the economy to function. This required that we keep rates modestly low."
Taylor's Getting Off Track serves as a timely reminder that central bankers are anything but omniscient, and that, given the steep losses on Wall Street, Greenspan and his Federal Reserve colleagues at the time may have some more explaining to do.
His little volume -- at just over 90 pages, the advance copy provided to CBS News reads more like an expanded version of an economics paper -- will not be the last word on the Crash of 2008. But it offers an useful and insightful starting point for future discussions, and it could hardly be more timely.
Milton Friedman and Anna Schwartz didn't publish their classic history of the Great Depression until a generation later. Competing analyses, also taking issue with Keynesian explanations, didn't appear until the 1960s.
Fortunately for us, Taylor didn't wait that long today.