What caused the crisis - monetary policy or regulatory failure?

The search for the villains responsible for the sub-prime mortgage bubble induced financial crisis goes on. The latest debate is over whether it was regulators who failed to regulate effectively or Fed which failed to "take the punch bowl away as the party go going".

Prof. John Taylor, of Taylor Rule fame, has claimed that the Fed erred in keeping interest rates too low for far too long after the dot com bubble burst, thereby inflating the sub-prime mortgage bubble and sowing the seeds for its subsequent disastrous consequences. He points to the sharp divergence that developed between rates as estimated by Taylor Rule and the prevailing federal funds rate since mid-2007 and the consistently low rates set by the Fed in the 2001-06 period. See the slides here.



(Based on output gap and the current rate of inflation, with inflation measured by the consumer price index (CPI), the Fed's assumed inflation target set to 2 percent, output measured by real GDP, and the output gap as estimated retrospectively by the Federal Reserve's primary forecasting model, the FRB/US model)



(Based on output gap and a forecast of inflation over the current and subsequent three quarters. The forecasts are those that were actually made in real time, that is, at the time at which the corresponding policy rate was chosen)

Rejecting Taylor's contention, in a speech (pdf here) delivered at the annual meeting of the American Economic Association (AEA), the Fed Chairman Ben Bernanke laid the blame on the failure of regulators to do their jobs effectively. He said,

"When historical relationships are taken into account, it is difficult to ascribe the house price bubble either to monetary policy or to the broader macroeconomic environment... Stronger regulation and supervision aimed at problems with underwriting practices and lenders’ risk management would have been a more effective and surgical approach to constraining the housing bubble than a general increase in interest rates."

However, refreshingly enough, he also acknowledges that if regulation fails to get the job done, then the Fed must step in and pop bubbles before they get too large by raising interest rates. If this is the case, being a member of the Federal Reserve Board of Governors during most of the first half of the decade, Bernanke must share atleast part of the blame for going along with Greenspan's extraordinary loose money policy for the first half of the decade and his own persistence with it even as the sub-prime bubble was inflating.

As Mark Thoma points out, the Greenspan Fed believed that since it was not possible to identify with any degree of certainty bubbles as they are inflating, it was preferable to clean up after the bubble bursts. In other words, given the problems in identifying bubbles ex-ante, it was better to clean up ex-post. Further, even if it were possible to identify bubbles, interest rate increases imposes collateral damage by affecting all sectors and not just those experiencing the bubble.

It is evident that both regulators and the Fed failed, the regulators spectacularly so and they have rightly been blamed across the board. But the Fed and Bernanke have clearly gotten away lightly, and even been rewarded for preventing a slide into Depression. It is well documented that by 2007 there were enough indications that a very large bubble was getting inflated in the real estate market and there was considerable misallocation of resources among the financial market participants (short term debt, leverage etc). It does not require the wisdom of hindsight to see "bubble" staring out from all the credit and money market indicators, leave alone individual bank balance sheets and risk ratios. If not earlier, atleast then, the Fed should have blown the whistle and raised rates to deflate the bubble slowly.

Barry Ritholtz argues that while the regulations were inadequate and existing ones were not properly enforced, the fact remains that the ultra-low interest rate policy of the Fed had already set in motion an unhealthy scramble for yields. Mark Thoma makes the point that the failures were broad-based, with all the gate-keepers failing repeatedly on their duties. He writes,

"Home buyers, real estate agents, appraisers, mortgage brokers, securitizers, ratings agencies, compensation packages of executives, lack of transparency, and so on and so on all broke down and allowed the housing/credit bubble to inflate. If any one of these groups had held the line and not gone along with everyone else, e.g. if appraisers had not reported bubble prices, if ratings agencies had priced risk correctly, etc., then the bubble either doesn't happen at all, or does much less damage when it pops."

Update 1
Mark Thoma feels that the "bubble itself was driven by 'cash slopping around in the system' that originated from several sources, the Fed being one, and the regulatory failures (such as failing to provide sufficient transparency so that the smoke from the fire could be spotted in time, and failing to limit leverage) allowed the fire to spread rapidly and do major damage".

Fiscal multipliers under different conditions

I have blogged here, here, here, and here about the debate on the impact of fiscal stimuluses, more specifically the fiscal multipliers associated with different types of stimulus spending. While conservatives have argued that multipliers are essentially zero and therefore find no merit in fiscal spending, supporters point to substantial multipliers in government spending, especially in deep recessions when demand is weak and business investments have dried up.

A Vox post by Ethan Ilzetzki, Enrique G. Mendoza, and Carlos A. Vegh (full paper here) adds a new dimension to the debate by claiming that "fiscal multipliers are much weaker in countries that have high debt, lower income, flexible exchange rates, and greater international openness". They also find that preduicting fiscal multilpiers with any degree of certainty is even more difficult for developing economies. Their findings are

1. The response of output to increases in government spending is smaller on impact and considerably less persistent in developing countries than in high-income countries.
2. Fiscal multipliers are much larger in economies operating under predetermined exchange rate regimes than under flexible exchange rates.
3. Relatively closed economies have much larger multipliers than relatively open economies.
4. The output response to increases in government spending is short-lived and much less persistent in highly indebted countries than in countries with a low debt to GDP ratio.
5. The multipliers for the US in the post-1980 period are small both in the short and long-run. On the other hand, multipliers for government investment are large.

These findings carry important policy implications. They lend weight to the need for globally co-ordinated stimulus spending policies, among atleast the major economies, in an increasingly inter-connected global economy, failing which protectionist backlash is inveitable and some degree of protectionism is even desirable. With fiscal expansions having considerable positive externalities, a substantial fraction of the stimulus spending leaks out to the rest of the world through higher imports etc.

It also supports the important but always-forgotten holy grail in fiscal policy making - follow a counter-cyclical fiscal policy and build up surpluses during good times and unwind them and run up deficits during downturns. Governments, especially in the developing world, who have tended to follow either the populist "spend more when the going is good" or the a-cyclical business cycle neutral tax and spending policies, are left with limited fiscal space when the bad times arrive. India is a case in point.

The authors find evidence of "crowding out" effect in developing countries, where an additional dollar of government consumption crowds out some other component of GDP - investment, consumption, or net exports - in the long run. However, this finding may actually turn out to be the opposite in deep recessions, when household demand and private investments become frozen, and government spending can play the important role of "crowding in" aggregate demand. During the current recession, most of the emerging economies did not experience the same extent of output contraction as the developed economies, and therefore fiscal expansions in these countries may not have supplied the same boost to aggregate demand as in the latter.

Mostly Economics points to the US CEA's latest impact assessment of the $787 bn ARRA stimulus spending plan. It finds that the stimulus spending changed the trajectory of the economy toward moderating output decline and job loss; it added roughly 2.3 percentage points to real GDP growth in the second quarter and is likely to add even more to growth in the third quarter; caused employment in August to be slightly more than 1 million jobs higher than it otherwise would have been; and it added between 2 and 3 percentage points to baseline real GDP growth in the second quarter of 2009 and around 3 percentage points in the third quarter. It estimates a very high fiscal multiplier of 2.3 in Q2 2009 and 2.7 in Q3 2009. It also finds that assistance to states played a critical role in helping states facing large budget shortfalls because of the recession by increasing employment relative to what would have happened without stimulus.

Mark Thoma, as always, captures the debate on stimulus multipliers here. Paul Krugman has this response to Robert Barro's assertion of a multplier less than one. The Economist has a nice summary of the multiplier debate and explains why it is so difficult to make any predictions about them given the wide variations in economic conditions.

A recent NBER working paper by Lawrence Christiano, Martin Eichenbaum, and Sergio Rebelo argues that "the government-spending multiplier can be much larger than one when the nominal interest rate does not respond to an increase in government spending". They claim that if the nominal interest rate is governed by a Taylor rule, it rises in response to an expansionary fiscal policy shock that puts upward pressure on output and inflation, and thereby renders the multiplier small. However, when nominal interest rates does not respond to an increase in government spending (when the zero lower bound on the nominal interest rate binds), their model finds that the multiplier is very large. Taking this model and its line of explanation, the effectiveness of fiscal spending is likely to be limited for many developing countries, including India, where the nominal rates are high and where inflationary pressures makes interest rates more sensitive to revisions.

And their conclusion has great relevance for the major developed economies which have nominal interest rates kissing the zero-bound, "In such economies it can be socially optimal to substantially raise government spending in response to shocks that make the zero lower bound on the nominal interest rate binding... for government spending to be a powerful weapon in combating output losses associated with the zero bound state, it is critical that the bulk of the spending come on line when the lower bound is actually binding."

They argue that when the economy is touching the zero-bound and the output falls, a deflationary spiral is unleashed that drives up the real interest rates, which in turn leads to an increase in the level of desired savings. Since investment is zero during such recessions, the aggregate saving must be zero in equilibrium, and the total fall in output required to reduce desired saving to zero is very large. And about how fiscal spending works in a recession when this zero bound is binding, they write,

"This (spending) increase leads to a rise in output, marginal cost and expected inflation. With the nominal interest rate stuck at zero, the rise in expected inflation drives down the real interest rate which drives up private spending. This rise in spending leads to a further rise in output, marginal cost, and expected inflation and a further decline in the real interest rate. The net result is a large rise in inflation and output. In effect, the increase in government consumption unleashes an inflationary spiral that counteracts the deflationary spiral associated with the zero bound state."

Update 1 (28/8/2010)
Mark Zandi (via Ezra Klein) has this graphic which examines the bang for the buck for various types of stimulus spending in the US.

Is Taylor Rule relevant at zero-bound?

David Altig does not appear to be convinced and he makes an impressive case.

He points to Glenn Rudebusch's (also here) description of the Taylor Rule

"The resulting empirical policy rule of thumb—a so-called Taylor rule—recommends lowering the funds rate by 1.3 percentage points if core inflation falls by one percentage point and by almost two percentage points if the unemployment rate rises by one percentage point. As shown in Figure 2, this simple rule of thumb captures the broad contours of policy over the past two decades."

As David Altig notes, economists like Brad De Long have pointed to the shaded area in the aforementioned graphic indicating the "difference between the current zero-constrained level of the funds rate and the level recommended by the policy rule" as representing the considerable "monetary policy funds rate shortfall, that is, the desired amount of monetary policy stimulus from a lower funds rate that is unavailable because nominal interest rates can't go below zero".

There have been widely varying estimates of what the federal funds rate should by according to the Taylor Rule - minus 0.955% now (using CBO data on Taylor’s formula of 1.5 times the inflation rate, plus 0.5 times the gap between the economy’s potential growth rate and the current pace, plus 1), minus 4% for 2010 (Macroeconomic Advisers), minus 5% at the end of 2009 (San Francisco Fed), minus 5.8%for 2009 and minus 9% by December 2010 (Jan Hatzius, the chief US economist at Goldman Sachs).

They claim that since nominal funds rate cannot be lowered below zero (though negative interest rates are possible), these large estimates of negative interest rates demands much more aggressive monetary expansion than what the Fed has been doing. Though the Fed has dramatically expanded it balance sheet, more than doubling it to $2 trillion, by pumping in money through purchases of Treasuries, mortgage securities and agency bonds, economists doubt whether they’ve done enough to meet the Taylor formula.

Apart from expanding its balance sheet to lower the cost of capital and credit availability to businesses and households, the Fed has also been buying long-term securities in the open market in an effort to keep the important long-term interest rates at lower levels. As Glenn Rudebusch writes, "The idea is that, even if the funds rate and other short-term interest rates fall to the zero lower bound, there may be considerable scope to lower long-term interest rates."

David Altig feels that the Taylor Rule assumption about the normal chain of transmission from the funds rate to other interest rates and asset price, is doubtful in the present conditions. He thererfore concludes that instead of rigid adherence to the Taylor Rule, the extraordinary circumstances now dictate that Central Banks follow a monetary policy that draws in a much more broader scope of policies and an "array of interest rates". He feels that even if the the Taylor-rule is followed, the "monetary policy funds rate shortfall" should be recast in terms of the real funds rate.

John Taylor though rejects all of them and argues that economists calling for negative interest rates are using "projections to apply the rule in ways he never intended". He clarifies that "the Taylor rule says what the interest rate should be now, given current numbers" and it cannot be applied to forecasts. He points to fed federal funds futures, which project a target rate of 0.5% by February and 1% by a year from now.

Update 1
The data file on teh aforementoned graphic is available here. Paul Krugman (also here and here) uses the Rudebusch Rule to argue that the clamour for raising rates are way too premature.

Update 2
See Brad de Long here on the debate about interpreting the Taylor Rule, which revolves around the value of the coefficient on the output gap. Brad uses an estimate (as estimated by Glenn Rudebush) of the coefficient that is higher than Taylor's orignal estimate. Taylor has rejected this here and here.

John Taylor has claimed that his coefficiencts were derived not from statistically fitting of historical data, as was done by Rudebusch, but from existing monetary theory and models.

What adds to the confusion is the lack of any form of consensus about what constitutes the output gap.

Analysis of a monetary policy disaster

Martin Wolf has an excellent obituary of "inflation targetting", which had emerged as the "holy grail of fiat (or man-made) money" over the past three decades.

Frederic Mishkin of Columbia University had argued that inflation targeting is an "information-inclusive strategy for the conduct of monetary policy", which allowed for "all relevant variables – exchange rates, stock prices, housing prices and long-term bond prices – via their impact on activity and prospective inflation". Arguing against proactively pricking asset price bubbles, Prof Mishkin wrote that "it is highly presumptuous to think that government officials, even if they are central bankers, know better than private markets what the asset prices should be".

From William McChesney Martin, who claimed that it was the role of Central Bankers role to "remove the punch bowl as the party gets going", to "serial bubble blower" Alan Greenspan and his reluctance to prick asset bubbles, to the present realization that asset price bubbles can have devastating consequences and should be detected and deflated, the wheel has come the full circle.

The "Great Moderation" - the substantial decline in macroeconomic volatility over the past twenty years - had lulled Central Banks into believing that effective monetary policy could smooth over the business cycle and help tide over any economic downturns. Carried away by the euphoria, even the demure Ben Bernanke allowed himself a pat on the back, claiming that "some of the effects of improved monetary policies may have been misidentified as exogenous changes in economic structure or in the distribution of economic shocks... I think it likely that the policy explanation for the Great Moderation deserves more credit than it has received in the literature."

Alan Greenspan had consistently argued that bubbles are hard to identify before they burst and pricking them is even harder without wrecking the economy. He felt that Central banks should act only if bubbles threaten price stability else, they should wait and clean up after they burst. The shallow recession that followed the tech-stock boom of the late 1990s seemed to vindicate them. Martin Wolf points to three critiques of this approach to central banking.

First, the Fed's deviation from the Taylor Rule, which relates interest rates to inflation and output, in keeping interest rates too low for too long in early 2000s caused the credit bubble and housing boom. Further, the low rates also had a cascading effect on central banks across the world, thereby generating bubbles in many countries.



Second, the sub-prime mortgage triggered current financial market crisis is a timely reminder about the dangers associated with asset price bubbles and the need for Central Banks to deflate such bubbles before they balloon out of control. Experience from across the world shows that "when nominal asset prices and associated credit stocks go out of line with nominal income and prices of goods and services, one of two things is likely to happen - asset prices collapse, which threatens mass bankruptcy, depression and deflation; or prices of goods and services are pushed up to the level consistent with high asset prices, in which case there is inflation."

Finally, the economists in the 'Austrian' tradition argue it was a mistake to set interest rates below the "natural rate", thereby generate explosive growth of unsound credit and create conditions for misallocation of resources. Then, in the downturn – as the American economist, Irving Fisher, argued in his Debt-Deflation Theory of Great Depressions, published in 1933 – balance-sheet deflation will set in, greatly aggravated by falling prices and shrinking incomes.

About clearing up the mess from this loose monetary policy and designing a new approach to monetary policy, Wolf writes,

"On the former, we have three alternatives - liquidation; inflation; or growth. A policy of liquidation would proceed via mass bankruptcy and the collapse of a large part of the existing credit. That is an insane choice. A deliberate policy of inflation would re-awaken inflationary expectations and lead, inevitably, to another recession, in order to re-establish monetary stability. This leaves us only with growth. It is essential to sustain demand and return to growth without stoking up another credit bubble. This is going to be hard.

On the latter, the choice, in the short term, is certainly going to be "inflation targeting plus". 'Out' is likely to be the 'risk management' approach of the Fed, which turned out to give an unduly asymmetric response to negative economic shocks. 'In' is likely to be 'leaning against the wind' whenever asset prices rise rapidly and to exceptionally high levels, along with a counter-cyclical 'macro-prudential' approach to capital requirements in systemically significant financial institutions."

In other words, the way forward for central bankers is to detect asset price bubbles and then taking appropriate action to deflate them before they blow over. Macro-prudential approach to financial market regulation can help identify systemic risks as they build up. Further, I have already blogged about how models, Markov regime-switching analysis, can detect advance signs of market turbulence emerging. The challenge will still remain to calibrate the monetary policy actions to deflate the asset price bubbles in such a manner as to minimize its impact on economic growth. Taylor Rule, of course is only the most popular model for calibrating monetary policy in such circumstances.

Another reason for a co-ordinated global fiscal expansion

I had blogged earlier about Paul Krugman's arguement that fiscal policies have strong positive policy externalities, and therefore "if macro policy isn’t coordinated internationally we’ll tend to end up with too little fiscal stimulus, everywhere" and protectionism as nations try to capture all benefits locally.

An IMF research paper finds even more reasons for globally co-ordinated fiscal stimulus - they have higher multipliers than individual nations acting alone. It writes, "The (multiplier) effect on US GDP of investment expenditures is 3.9 when there is global fiscal expansion and only 2.4 when the United States acts alone. Similarly, the effect on Japanese GDP of targeted transfers is 1.5 when there is global fiscal expansion and only 1.0 when Japan acts alone. Differences in multipliers across regions relate to the size of leakages in the different areas, including leakages into saving and imports."

The reports also favors government investment over tax cuts, claiming that for "every dollar spent on government investment can increase GDP by about $3, while every dollar of targeted transfers can increase GDP by about $1". It also finds that "due to international spillovers of demand, simultaneous fiscal stimulus alone can raise each region’s multipliers by a factor of about 1.5, while coupled with monetary accommodation (by the Central Banks) can achieve even larger improvements".

It argues that given the likelihood of the recession being long drawn out, government investment may not be limited by the absence of immediate "shovel-ready" projects and the concern that the expenditures will only be put into place once the economy has begun to recover. It underscores the primacy of "fiscal policy to take on an increased share of the burden during the period in which the financial sector is recovering and is not yet able or willing to extend credit to households and businesses to the extent that it normally does".

Further, in order to unwind the debts run up during such fiscal expansions, it also suggests "appropriate and credible medium-term fiscal frameworks, such as increased emphasis on containing the ratio of public debt to GDP, and the introduction of fiscal rules of the sort used in Chile, which clearly articulate a long-run target for the ratio of the fiscal deficit to GDP and therefore implicitly for the ratio of public debt to GDP". Such targets provide an anchor for medium term inflationary and interest rate expectations.

The paper also suggests that during fiscal expansions, the monetary policy rate should be held constant at its pre-stimulus value for one or two years (as opposed to the forward-looking Taylor-type interest rate rule that during normal times adjusts nominal policy interest rates in response to one-year-ahead forecasts of inflation), thereafter returning to the conventional interest rate rule to anchor inflation in the long run.

In another NBER working paper, Frederic Mishkin argues in favour of decisive conventional and unconventional monetary policy actions which he claims are "more potent during financial crises because aggressive monetary policy easing can make adverse feedback loops less likely".

Policy prescriptions for the crisis

The ongoing global financial crisis turned economic recession is fast turning into a stag-deflation, where banks have turned off their credit taps, consumers have pulled back on consumption and businesses have responded by postponing their investments. Uncertainty and fear have unleashed a self-fulfilling cycle of psychological shocks among the major economic actors, paralyzing all normal economic activity.

As was discussed in an earlier post, "the specific economic and financial market conditions that created the crisis, bad as they are, have been overtaken by the psychological apprehensions and fears of the market participants. The increasingly entrenched rational expectations of the investors and lenders, consumers and businesses about themselves, others and future prospects, have brought all normal financial and economic activity to a virtual standstill. The challenge is to break this grid-lock and get economic normalcy restored".

Now, in a neat summary of the debate on the prescriptions for immediate action, the Chief Economist of IMF, Olivier Blanchard, draws the distinction between "subjective" (unknown unknowns) and "objective" (known unknowns) uncertainty, and claims that in the present economic environment the former rules, leaving investors, consumers and firms paralyzed. The result has been a flight from all forms of assets perceived as even slightly risky, including the emerging markets. His prescription

1. Reduce uncertainty, by removing tail risks, and the perception of tail risks, by - establishing atleast a floor price on distressed assets, ring fencing them and taking them off bank balance sheets; commit to do now and in future, whatever it will take to avoid a Depression, from fiscal stimulus to quantitative easing. The responses should be clear, decisive, immediate, and large.
2. Stabilize the financial markets by helping recycle the funds towards risky assets, through recapitalization etc. The governments should intervene aggressively with capital injections into the domestic financial markets and the emerging economies, which have been facing massive exodus by foreign portfolio investments.
3. Break the wait-and-see attitude of consumers and firms by incentivizing them to spend and invest now rather than later - temporary subsidies etc. Government infrastructure spending and other stimulus measures, tailored and communicated well, can not only stimulate and replace private demand, but also reassure consumers and firms.

Alberto Alesina cautions against any unlimited, blank-cheque monetary and fiscal stimulus, and points to the need to keep the budgetary constraints, especially for the future, in mind. He also finds fault with the unprioritized and "throw everything you have at the economy" approach advocated by Blanchard. More specifically, he advocates temporary incentives to make banks lend and investors borrow and invest - public insurance against defaulting borrowers for banks who lend; fiscal incentives to encourage private investors to invest this year rather than next (easily done with depreciation allowances); fiscal protection against stockmarket losses, using temporal variation in capital-gains taxes and loss deductions etc.

Robert Shiller draws attention to the importance of "confidence multiplier", as against the conventional "economic multiplier", which would improve economic agents' level of trust in other people and businesses, and thereby break the "wait-and-see" gridlock. He therefore advocates that the "focus has to get off of 'what fraction of this stimulus will be spent' to 'how does this stimulus affect confidence." Since "different kinds of stimulus have different effects on confidence, depending on how they are viewed and interpreted by the public", we need to keep this in mind while structuring the fiscal stimulus .

Mark Thoma argues that given the uncertainty about the sources of the problems, and about which remedies will be effective, we should "do the equivalent of throwing a full spectrum antibiotic at the problems and hope this somehow manages to work" - a "portfolio of policies", which are "too much rather than too little". He also underlines the need to reassure consumers, lenders, and businesses by "rebuilding and restructuring of these markets to insulate them against future problems — including regulatory changes".

Eswar Prasad draws attention to the importance of coordinated fiscal stimulus in major economies, which if "suitably trumpeted and implemented on a massive scale, could deliver a much bigger bang for the buck than uncoordinated policies". He also warns of the harmful effects of protectionist rhetoric, especially on businesses and investments.

Tyler Cowen is right in arguing that the policy solutions have to go beyond merely stimulating aggregate demand, and seek to restore confidence and dispel fears. He therefore advocates the use of placebo policies (placebos often wor as much as drugs!) - initiatives which appear bold and have great symbolic value, but which don't necessarily cost us very much. He points to the importance of making the "painful adjustment to lower levels of spending and debt", which requires "reallocation of resources out of construction, finance, and debt-financed consumption", all of which will be made harder by boosting aggregate demand.

Ricardo Caballero fears that the plummeting asset values and consequent de-leveraging could quickly wipe out equity capital values of financial institutions with with strict capital requirements (banks, insurance companies, and monolines), and simultaneously close their option to raise new capital. Further, "forcing them to raise capital, be it private or public, at panic-driven fire-sale prices threatens enormous dilutions to already shell-shocked shareholders, further exacerbating uncertainty and fueling the downward spiral".

While his analysis is a partial explanation, the prescriptions can be disputed. He proposes the replacement of the "two functions of bank capital — a buffer for negative shocks and an incentive device to reduce risk-shifting — by the provision of a comprehensive public insurance, and by strict government supervision while this insurance is in place". Arguing against nationalization, he advocates a comprehensive insurance backstop for banks, after removing their rotten assets and recapitalising them on terms that are not penal to existing shareholders. He also feels that the government should become the explicit insurer for generalised, extreme, panic-driven risk, as opposed to the microeconomic risk and moderate aggregate shocks.

Free Exchange, proposes "contingent policies", widely known in advance, that are triggered when a predetermined bad state of the economy is reached. Such policies would reassure households, investors, and businesses that tail risks are less likely to be realised, and they should become more willing to spend or invest, further reducing those tail risks. Apart from conventional contingent policies like deposit insurance and Taylor rule, anc automatic stabilizers like health care subsidies and unemployment insurance, there is scope for others like Central Banks becoming lenders and insurers of last resort.

Update 1
Brad De Long (and here) analyses the four policy options to combat a depression - inflation, monetary policy, credit policy and fiscal policy. And he feels that only the last two are effective now, and we need to try both at the same time.

Taylor Rule

Taylor Rule, formulated by Stanford economist John Taylor in 1993, stipulates how much the central bank should change the nominal interest rate (say, federal funds rate in US) in response to divergences of actual GDP (or employment level) from potential GDP and of actual inflation rates from a target inflation rates.

It provides a guide for Central Banks to "set short-term interest rates as economic conditions change to achieve both its short-run goal for stabilizing the economy and its long-run goal for inflation". It identifies three determining factors for the "real" short term interest rate
1. where actual inflation is relative to the targeted level that the Fed wishes to achieve
2. how far economic activity is above or below its "full employment" level
3. what the level of the short-term interest rate is that would be consistent with full employment (Taylor assumed this to be 2% for the US economy).

Part of the reason for Greenspan's apparent success, atleast till the sub-prime crisis blew the cover, with monetary policy was the close adherence to Taylor Rule.



Fed Governor Ben Bernanke has this to say, "when output is above its potential or inflation is above the target, the Taylor rule implies that the federal funds rate should be set above its average level, which (all else being equal) should slow the economy and bring output or inflation back toward the desired range."

More discussion on Taylor Rule is available here, here, here, and here. Econbrowser has a discussion on Prof Taylor's simple model to try to predict housing starts on the basis of past values of interest rates.

Paul Krugman points to a Goldman Sachs estimates of the potential output, whose comparison with the Taylor Rule, would appear to predict that the Fed would have to cut rates to minus 6% by 2010, a clear indicator of deflation and a liquidity trap.