"Getting Off Track"

Prof John B. Taylor from Stanford University just authored an excellent short new book on the crisis:
Getting Off Track. How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis.

See the author summing up his points in the wsj here. A review of the book by his colleague from the Hoover Institution can be found in Forbes.

Prof. Taylor is the economist who gave his name to the "Taylor Rule" which says "the interest rate should be one-and-a-half times the inflation rate plus one-half times the GDP gap plus one. (The GDP gap measures how far GDP is from its normal trend level)". (Am not sure what the rule says when the result of the above equation is negative!)

The book is a short read and answers the following questions rather convincingly.
What caused the financial crisis?
What prolonged the crisis?
Why the crisis worsened dramatically a year after it began?

What caused the financial crisis?
Too loose monetary policy (interest rates lower than the above rule would have suggested and for longer than necessary) contributed to the housing boom.
"Queen of Spades Problem": complex securitization ensured that people didn't and still don't know where the bad mortgages are.

What prolonged the crisis?
According to the author the problem was at first wrongly diagnosed. The rise in spreads that seized market in August 2007 was first attributed to liquidity problems rather than a counterparty risk problem. The policies that followed were then mistaken and ineffective(TAF, 100bn US$ checks to households, aggressive cut in rates that led to higher oil prices)

Why the crisis worsened dramatically a year after it began?
In this chapter the author questions the conventional wisdom according to which letting Lehman Brother go bust led to a worsening of the crisis. Mr Taylor makes an interesting detailed event study to prove his point (basically the surge in Libor-OIS spread happened more than a week after that event and just after the TARP announcement). For the author the wrong diagnosis and the lack of a predictable framework for intervention were big contributors to the worsening of the situation.