1. What caused it?

1. What caused the financial crisis:
a. Classic explanation- monetary excesses that lead to booms or busts (housing boom/bust in recent criss )
2. What caused the monetary excess?
a. Evidence that there was monetary excesses before housing boom and bust: Loose fitting monetary policy regarding interest rates- large deviation from the Taylor rule that was shown to have worked in the past, especially during the Great Moderation.
b. Reason for deviating from taylor rule: interest rate was low to address the fear of deflation
3. Argument: extra easy policy was responsible for accelerating the housing boom and thereby ultimately leading to the housing bust
a. As a result of the unprecedentedly low interest rates, the number of housing starts drastically increased (figure 2). The counter factual line shows what the rate of housing starts would have been if the Taylor line had been followed.. The resulting bust is very easy to see. If this is not evidence enough, the CPI inflation also increased by 60% (3.2% - well above the recommended 2%).
4. Alternative explanations-
a. global savings glut (excess of world saving) pushed interest rates down 2002-2004. However, there is no evidence of this
b. In actuality there was a savings shortage during this period (figure 3). US was actually running a current account deficit during this period, meaning that saving was less than investment.
5. Monetary policy in other countries
a. Global deviations: other central banks also deviated from the Taylor rule (possibly following our lead).
b. Consequentially, the housing booms were largest in countries that deviated the most from the rule (figure 4).
c. The question is whether the ECB followed the FED or vice versa. There is statistical evidence for both sides (figure 5). Or, a third outside variable such as global real interest rates.
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