Policy responses to crises can exhibit adverse, unexpected consequences. Any corrective measures should take these risks into account.

1. Leadership, Regulation, Markets
and the Law of Unintended
Consequences
BARRY SCHACHTER
FOR PRESENTATION
JANUARY 31, 2009
SWEET BRIAR COLLEGE

2. Leadership in the Crisis
Obama Presses for Quick Jolt to the Economy
By
B JACKIE CALMES and DAVID M. HERSZENHORN
d M
Published: January 24, 2009, New York Times, page A1
“WASHINGTON — President Obama on Friday stepped
d b d d
squarely into the fractious effort in Congress to assemble
an $825 billion economic recovery package, seeking to
quell criticism f
ll iti i from both parties and to retain leadership
b th ti dt t i l d hi
on an initiative that could define his term.”
“Democrats are eager to help Mr. Obama succeed,
knowing that their success rides on hi Still th are
k i th t th i id his. Still, they
refusing to cede their status as leaders of a co-equal
branch of government…”

3. The Moral of This Talk
Crises create enormous pressures on people in leadership
positions
ii
Certain purposive actions in response to those pressures
may be only the appearance of leadership
Our ability to control our surroundings is limited. Not
recognizing the limitations gives rise to unintended
consequences
“ipsa scientia potestas est” – Francis Bacon,
Meditationes Sacrae (1597)
“Power tends to corrupt, and absolute power corrupts
absolutely. Great men are almost always bad men.” –
Baron Acton, Speech - House of Lords (1770)
Acton

4. Quick Summary of Recent History
May 5, 2006 – Merit Financial files for bankruptcy
February 27,2007 – US stock markets fall 4%
April 3, 2007 – New Century Financial files for bankruptcy
July 31, 2007 – 3 Bear Stearns hedge funds close doors
31
November 27, 2007 – Abu Dhabi invests in Citi
January 22, 2008 – Fed cuts by 75bps
March 16, 2008 – Bear Stearns acquired b JPM
h d by
July 23, 2008 – Fannie, Freddie bailout passed in Congress
September 18, 2008 – Lehman declares bankruptcy
September 19, 2008 – SEC short-selling ban
October 7, 2008 – Iceland banks nationalized

5. Causes and Effects
“The Great Moderation”
Low interest rates and mortgage borrowing
Securitization, its agency effects, toxic waste
, g y ,
Post-bubble lack of transparency
“The Great Unwind” (de-leveraging)
( g g)
The risk aversion trade (an alternate universe)
Government actions (and their unintended
(
consequences)
The blame and revenge

6. Economic Policy and Unintended Consequences
“In the department of economy, an act, a habit, an
institution, a law, gives birth not only to an effect, but to
a series of effects. Of these effects, the first only is
immediate; it manifests itself simultaneously with its
cause - it is seen. The others unfold in succession - they
are not seen: it is well for us, if they are foreseen. … Now
this difference is enormous, for it almost always happens
that when the immediate consequence is favourable, the
ultimate consequences are fatal, and the converse.
That Which is Seen, and That Which is Not Seen Claude
Frédéric Bastiat (1850)

7. Energy Independence and Corn Ethanol
The goal is to reduce imports of oil
The claim is corn ethanol costs less energy to
produce than it generates
The lidit f the l i
Th validity of th claim seems t rest on th
to t the
significance of unintended consequences:
New infrastructure for transport, storage, & distribution
p, g,
Lower fuel economy
Higher auto maintenance costs
Increased cost of food from corn
Increased medical costs from toxic emissions (e.g.
formaldehyde)
Deforestation and other i
Df t ti d th increase acreage side effects
id ff t

8. The Law of Unintended Consequences
Any p p
y purposeful action will produce some
p
unintended consequences
Corollary: The unintended side effect can be more
significant than the intended effect.
A classic example is a bypass that attracts new
development and with it more t ffi resulting i
dl t d ith traffic, lti in
two congested streets instead of one.
http://en.wikipedia.org/wiki/Unintended_conseque
http://en wikipedia org/wiki/Unintended conseque
nce

9. Leadership through Action
The pendulum swings towards regulation
By Lawrence Summers [Director White House National Economic
Council]
Published: October 26 2008 , Financial Times
“Policies that contain the crisis, support the economy and generate
recovery are not sufficient to meet the historic challenge of this
moment. Even with the best conceivable fiscal, monetary, financial
and regulatory policies economic performance depends on deeper
policies,
and more structural policy choices. Nations cannot fine tune their
way to delivering a prosperity that is more broadly based. In
important ways, then, the crisis creates space to address longer
standing problems.”
t di bl ”
“…the pendulum will swing – and should swing – towards an
enhanced role for government in saving the market system from its
excesses and inadequacies.”
inadequacies.

10. The Fatal Conceit
Uncertainty and the human p y
y psyche
Institutions and traditions as security blanket
The grand idea of central p
g planningg
Uncertain mechanics of modern economies
What Enlightenment philosophers didn’t understand
Demons, Black Swans, and Market Misbehavior
Willful suspension of disbelief in a period of crisis

11. Law of Unintended Consequences
Robert K. Merton in 1936 wrote of “the need for a systematic and
objective study of the elements involved in the development of
unanticipated consequences of purposive social action.”
(American Sociological Review V. 1, No. 6, Dec., pp. 894-904)
“the consequences of purposive action are … those elements
q fp p
which would not have occurred had the action not taken place”
“…the aim of an action and the circumstances which actually
ensue may coincide without the latter being a consequence of the
action. Moreover, th l
ti M the longer th i t
the interval of ti
l f time b t
between ththe
action and the circumstances in view, the greater the probability
(in the absence of contrary evidence) that these circumstances
have happened ‘by chance.’ Lastly, if this interval is g
pp y y, greatly
y
extended, the probability that the desired circumstances will
occur fortuitously may increase until virtually the point of
certainty. This reasoning is perhaps applicable to the case of
governmental action ‘restoring prosperity.’”
restoring prosperity

12. The Inevitability of Unintended Consequences
The “system” is deterministic, but complex. A complex
system exceeds our ability to isolate the particular
action(s) that will yield the desired effect, all
consequences taken into account
account.
The “system” is dynamic. Relationships among relevant
factors change over time (e.g., impact of oil p
g g, p price on
consumer expenditure). The changes are not mechanical
and cannot be predicted without error.
The “ t ” i t h ti
Th “system” is stochastic. At every point i ti
i t in time t l
truly
random effects interact with fixed relationships to limit
p
predictability of outcomes.
y

13. S&P Study:
Impact of Mortgage Loan Modification Ideas
Borrowers may have
y
incentive to become
delinquent.
Total loss severity
experience will be higher for
loans that re-default.
An iincrease i d li
in delinquencies
i
from this “moral hazard”
issue could negate p
g potential
benefits from loan
modifications.

14. More Reasons for Unintended Consequences
Rational ignorance. The additional resources needed
g
to pursue further analysis of consequences are
deemed to exceed the benefit of acquiring additional
knowledge.
k ld
Irrational ignorance. A compulsion to act precludes
acquiring additional information first. Also a
first
preconception, habit or tradition inhibits seeking
additional information.

15. The Short Selling Ban
SEC chief has regrets over short-selling ban
By
B Rachelle Younglai
Published December 31, 2008, Reuters
W S NG ON
WASHINGTON – For a few wee s [from 9/19/08], the SEC stopped
o ew weeks [ o 9/ 9/08], t e S C
investors from making bearish bets on [800] financial stocks…
The SEC's office of economic analysis …point to several unintended
market consequences and side effects caused by the ban…Less
liquidity in the markets was one of the unintended consequences
consequences...
The SEC imposed the temporary ban under intense pressure from
the Federal Reserve and Treasury Department which insisted it was
crucial to the short-term survival of these institutions, Cox said.
,

16. Preventable Unintended Consequence?
We need to guard against destructive creation
By Jagdish Bhagwati (Prof Econ. Columbia U )
(Prof. Econ U.)
Published: October 16 2008 , Financial Times
“...’policy innovations had been racing ahead of comprehension.
policy innovations’ comprehension
The securitisation of mortgages was an innovation that led
unwittingly to what Wall Street calls “betting the company”. Credit-
default swaps allowed AIG to bring in huge returns but at high risk
if things went wrong, which they did ”
wrong did..
“We therefore need a truly independent commission of experts to
look closely at each financial innovation and work out its potential
downside. Keynes once wrote that the inevitable never happens, it is
y pp
always the unexpected. This commission would be charged with
trying to narrow the range of the unexpected.”