The Financial Crisis: Miss-Diagnosis and Reactionary Responses

The financial crisis that began in the fall of 2007 continues well into 2010, and has proved to be one of the longer lasting periods of financial disruption in decades. The policy responses to the crisis can be divided into three distinct phases. Phase I was a period of misdiagnosis in which policy makers viewed the crisis as a traditional liquidity crisis and they attempted to treat it as such. That misdiagnosis cost the economy almost a year of recovery. Phase II was a period of triage as it became clear that there were significant solvency problems in many of the country's largest financial institutions and in those of other countries as well. However, the policy responses also created significant uncertainty in financial markets and arguably exacerbated the recession. Finally, Phase III can be characterized as a period of extreme monetary policy ease as the Federal Reserve has resorted to extraordinary efforts to stem the declines that have taken place in the housing market and real economy more generally. The result has been an explosion of the Federal Reserve's balance sheet and likely has interjected the Fed into incomes policy. This paper describes the financial market conditions that characterized each of the three phases. It details the policy responses in each phase and attempts to sort out what we have learned and not learned from this crisis.