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KEITH HENNESSEY, DOUGLAS HOLTZ-EAKIN, AND BILL THOMAS 

vestments by keeping interest rates too low for too long. Critics of Fed policy argue
that, beginning under Chairman Greenspan and continuing under Chairman
Bernanke, the Fed kept rates too low for too long and created a bubble in housing.
Dr. John B. Taylor is a proponent of this argument. He argues that the Fed set in-
terest rates too low in – and that these low rates fueled the housing bubble
as measured by housing starts. He suggests that this Fed-created housing bubble was
the essential cause of the financial crisis. He further argues that, had federal funds
rates instead followed the path recommended by the Taylor Rule (a monetary policy
formula for setting the funds rate), the housing boom and subsequent bust would
have been much smaller. He also applies this analysis to European economies and
concludes that similar forces were at play.
Current Fed Chairman Bernanke and former Fed Chairman Greenspan disagree
with Taylor’s analysis. Chairman Bernanke argues that the Taylor Rule is a descriptive
rule of thumb, but that “simple policy rules” are insufficient for making monetary
policy decisions. He further argues that, depending on the construction of the par-

ticular Taylor Rule, the monetary policy stance of the Fed may not have diverged sig-
nificantly from its historical path. Former Chairman Greenspan adds that the
connection between short-term interest rates and house prices is weak—that even if
the Fed’s target for overnight lending between banks was too low, this has little power
to explain why rates on thirty-year mortgages were also too low.
This debate intertwines several monetary policy questions:

• How heavily should the Fed weigh a policy rule in its decisions to set interest
rates? Should monetary policy be mostly rule-based or mostly discretionary?
• If the Fed thinks an asset bubble is developing, should it use monetary policy to
try to pop or prevent it?
• Were interest rates too low in –?
• Did too-low federal funds rates cause or contribute to the housing bubble?

This debate is complex and thus far unresolved. Loose monetary policy does not
necessarily lead to smaller credit spreads. There are open questions about the link be-
tween short-term interest rates and house price appreciation, whether housing starts
are the best measure of the housing bubble, the timing of housing price increases rel-
ative to the interest rates in –, the European comparison, and whether the
magnitude of the bubble can be explained by the gap between the Taylor Rule pre-
scription and historic rates. At the same time, many observers argue that Taylor is
right that short-term interest rates were too low during this period, and therefore
that his argument is at least plausible if not provable.
We conclude that global capital flows and risk repricing caused the credit bubble,
and we consider them essential to explaining the crisis. U.S. monetary policy may
have been an amplifying factor, but it did not by itself cause the credit bubble, nor
was it essential to causing the crisis.
The Commission should have focused more time and energy on exploring these
questions about global capital flows, risk repricing, and monetary policy. Instead, the