Rising distance between lenders and borrowers, a measure of risk, affected the financial crisis

See Amazing New Facts About the 2007-2009 Global Financial Crisis by John Taylor.

"This week Raghu Rajan spoke at the Hoover Economics Policy Working Group on “Going the Extra Mile: Distant Lending and Credit Cycles” a joint paper João Granja and Christian Leuz. Here is a video of his presentation https://www.hoover.org/events/policy-seminar-raghuram-rajan-1 along with the slides https://www.hoover.org/sites/default/files/going_the_extra_mile.pdf and the paper itself https://www.hoover.org/sites/default/files/going_the_extra_mile_may_3_2021.pdf

Raghu focused on the causes of the Global Financial Crisis of 2007-2009. He brought entirely new data to the question of what caused the crisis. He examined the distance between lender and borrower. Raghu argued that greater distance is a measure of increased risk, holding the technology of making loans, which can provide better information on the probability of repayment, constant. The lower the interest rate–as generated by the federal funds rate which is in turn set by the Fed–the more there is a tendency to go to longer distances and thus increase risks in an effort to preserve profit margins.

Raghu and his colleagues find by this measure that the period leading up to the financial crisis was a period of increased risk taking. A higher federal funds rate set by the Fed would have reduced long distance lending, and thus riskiness of the loans. A higher federal fund rate would have resulted in less risk taking, and would have avoided or at least greatly mitigated the financial pressures which led to the crisis. In this sense, Raghu Rajan argues that a monetary policy closer to what I argued for back in a 2007 paper would have been better.

The following chart of the interest rate illustrates the issue. The chart is from the 2007 paper which I gave at Jackson Hole, “Housing and Monetary Policy,” and published in Housing, Housing Finance, and Monetary Policy, the proceedings of FRB of Kansas City Symposium. I did not use the informative data or the measures that Raghu and his colleagues use now. I simply looked at policy rules and the deviations from the rules. The counterfactual interest rate is what would have been implied by a policy rule. The actual rate is much lower. The conclusion is clear and Raghu’s recent work supports it: a somewhat higher interest rate in 2003-2006 would have been a better approach for the Fed and would have avoided much of the Global Financial Crisis."