First, it's important to understand what economics does not tell us. Monetary theory does not provide any mechanism through which the Fed's decisions about the money supply can produce massive distortions in the relative prices of assets, cause banks to make loans to customers who clearly can't pay them back, or lead investors to systematically misprice risk. Monetary theory does tell us that if the Fed keeps rates unnaturally low, we'll suffer from inflation—but as Brad DeLong points out, this is not at all what happened in the current crisis.
Let's take a look at the only publicly available and even slightly rigorous argument that Taylor has provided for his position: this speech from September 2007. In it, he performs a "counterfactual simulation," comparing the rise in the housing starts simulated under the actual Fed rate to an alternate path computed under what Taylor believes the rate should have been. This is what he obtains:
To better fit the data, he adds a new dimension to the model:
However, such sharp falls frequently occur at the end of booms because of rapid changes in housing inflation expectations. In fact, there is a close interactive relation between housing price inflation and housing construction (technically, two-way Granger causality). Placing housing inflation directly into the housing starts equation, and adding a simple equation to explain housing inflation, helps explain more of the decline as shown in Figure 3, but psychological factors (a Shiller swoosh) still seem to have been at work as the boom ended.The result is a slightly more impressive picture:
And if speculative feedback—enhanced by regulatory failure and widespread mispricing of risk—is the real culprit, we're brought to a very different set of conclusions. Pinning responsibility on the Fed, Taylor makes it seem as if our real problem is simple and technical: just set rates according to his formula and everything will be fine. Reality, however, isn't so simple, and we'll need more than slight tweaks to monetary policy to make ourselves safe in the future.