Blame It All on Unintended Consequences

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Why do economic downturns catch experts unawares? Even more intriguingly, why do they defy analysis after they've happened?

Neither economists nor financiers can agree on why the world's economies are in free fall today. More than 70 years later, there's still no agreement on what caused the Great Depression. Not even in hindsight does consensus emerge.

The answer to this puzzle lies in the fact that economic activity sets in motion a battery of unintended economic consequences. They can be propitious for growth, or not. Usually they move in different directions, but sometimes they converge to produce disasters like the one we're experiencing.

In 1776 Adam Smith used the law of unintended consequences to explain how individual ambition served the common good. It's not from the benevolence of the butcher, the brewer or the baker that we expect our dinner, he noted, but from their regards to their own interest. The unintended consequence of their self interest, mediated by competition, was better and cheaper meat, beer and bread. The invisible hand of the market converted their motives into a force for good.

Unintended consequences don't lend themselves to the mathematical modeling preferred by today's economists. But that hasn't stopped them from bouncing around in the give and take of economic transactions. People's intentions may be perfectly rational, but those intentions can, and usually do, trigger an array of unintended reactions.

For instance, in a 1958 consent decree the Supreme Court forced RCA, IBM and AT&T to sell patent licenses to foreign firms. The justices had no intention of encouraging RCA to maximize short-term profits from its patent licenses. But that's what RCA did and so sped up the transfer of color TV technology to Japan. In the merry way of unintended consequences RCA's reactions to the decree gave a new company, Sony, its opening in consumer electronics.

Another example of an unintended consequence came when the mavens of information technology followed William Shockley from Massachusetts to his former home near Palo Alto. Leaving Massachusetts with its strict no-compete laws for former employees did not figure in the decisions that sent information technology firms west. Yet California's more permissive laws enabled many of the new residents to leave their employers with ideas learned on the job. Start-ups soon set the pace for Silicon Valley's growth and prosperity.

Unintended consequences get overlooked in economic analysis. They appear, if at all, as a wild card or a wrench in the works because we privilege intentions that people set out to do, or at least say that they intend to do. Though unintended, other consequences are every bit as strong as their more legitimate, unintended cousins, as we're learning first hand from the recent unintended consequences that plunged us into a worldwide recession.

For example, when Asian families decided to build nest eggs against a repeat of their 1997 depression, they didn't intend to stimulate American consumption with the cheap credit their savings created. When Republican and Democratic administrations endorsed home ownership as sound social policy, they didn't intend to set off a race among bankers to issue subprime mortgages to be securitized for eager investors.

When CEOs at investment banks and hedge funds paid star traders handsome year-end bonuses, they intended to reward and encourage superior performance. Totally unintended was the creation of a testosterone-driven competition so intense it kept at bay second thoughts, looking at the larger picture or listening to naysayers.

So we can say that our Great Recession is the result of the unintended consequences of the deregulation movement that began in the 1970s with the deregulating of transportation and moved to banking with the"a href="">Gramm-Leach-Bliley Act of 1999, which allowed commercial and investment banks to consolidate. This is not to assign blame, but rather to point out that the freer the market system the more individual initiatives -- all of them pulling along in their train those pesky unintended consequences of their actions.

Usually unintended consequences move through daily economic activity like any other propellant, but sometimes they converge and mutually enhance each other. When they do, we're reminded that no one is in charge of the market economy. This fact makes it all the more imperative to draft laws that add some regulatory ballast to capitalism's frothy voyages.

Suffering through one of these periods of convergence now, we ought to draw up a chair and watch for the unintended consequences of our efforts to get out of this economic mess -- or perhaps the unintended consequences of studying unintended consequences.

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    Jeff Schneider - 4/12/2009

    Conventional wisdom depends on ignorance of the counterarguments. Who believed these were unintended consequences: The bad actors, those who were fundamentally kiting checks with our money? The investors who were taken in by "smart people" who told them not to worry because every night they could refinance their loans to the tune of billions of dollars? The regulators who either looked the other way or were not appointed to the SEC? Geithner who claims he was not a regulator when he was head of the NY Fed??

    These acts were not anymore unintended consequences than the late paper by the student who continually does her work at the last minute. The dog ate my printer. I could not raise the money, Help!! Then the financial industry fell on its face and the rest of us are suffering, while the lucky people got out before the crash. Unintended consequences is not an error in this case. It is the failure to look at the history and the trust in liars loans and people who claim they can make something out of nothing. Check kiting is not legal for a reason. Would you buy someone's bad check???

    Ricardo Luis Rodriguez - 4/10/2009

    "This fact makes it all the more imperative to draft laws that add some regulatory ballast to capitalism's frothy voyages."

    Typical myopic academic thinking. The whole of the preceding article refutes regulatory ballast. The regulatory ballast itself has its own unintended consequences.
    To wit, the very same example the author uses.
    Rules were created to prevent "red lining" in high risk lending communities. Thus irrationally forcing banks to make high risk loans. The market then responded rationally by creating hedges to spread the risk of risky loans.
    The unforeseen consequence was the explosion of credit to people who could not afford it.
    Ballast indeed.
    The author is, I assume, not a small business owner. Thus he/she can be excused for not grasping a single fact of life:

    1) An economic behavior with toxic unintended consequences does not persist because once the unintended victim is subject to the unintended consequences, it must avoid this behavior or cease to exist as an economic entity.
    The economic behavior of banks is to lend money. An intended consequence of such behavior is have the loan repaid. An unintended consequence is to have the loan default. There is a learning process as to which loans will likely yield the intended result. Which is why banks had stricter lending policies in risky neighborhoods. They did not want to go out of business making bad loans.
    2) An economic behavior coded into law artificially perpetuates the behavior, and impairs the ability of the unintended victim to respond directly. The bank now cannot avoid making risky loans. It has to find a way to adapt or cease to exist. Thus the various hedging financial instruments to cope with the risky loans.
    The risk was then spread thru government backed securities to all of us taxpayers, a deliciously ironical unintended consequence of the government's attempt to reduce the risk of mortgage default.

    Randll Reese Besch - 4/6/2009

    Despite not using the x factor in their equations the past as prologue still applies in this case. We knew what would happen if Glass-Stegal was rescinded, what we have now. Nothing of a surprise there eh?

    And please stop using that euphemism for depression please? It was created in the first place to obscure what was really going on to befuddle the populace. Carrying on the lie does you no favors.