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The economist: The law of unintended consequences

Tucker Hart Adams //July 1, 2009//

The economist: The law of unintended consequences

Tucker Hart Adams //July 1, 2009//

Back when I took college physics, I learned Newton’s Third Law of Motion: Every action has an equal and opposite reaction. I’m not sure that holds in economics.  In fact, a better statement may be: Many actions have a totally unexpected and unequal reaction. Let’s call this the Law of Unintended Consequences.

One of the most fascinating examples of the Law of Unintended Consequences is what occurred after the reform of bankruptcy laws in 2005. Between 1980 and 2004, a period when the population of the United States increased by 29 percent, personal bankruptcy filings increased 422 percent, from 288,000 to 1.5 million.  More Americans were filing for bankruptcy than were graduating from college or getting a divorce. 

Congress decided in 2005 that the bankruptcy option was being abused, that too many people were using it as an easy way to escape debt, particularly credit card debt, which had grown from 3.2 percent of the median family income in 1980 to 12.5 percent in 2004.  Reforms were passed that made it more complicated and expensive to file and that required debtors with higher incomes to repay more of what they owed from post-bankruptcy income. To no one’s surprise, there was a surge of filings near the end of the year just before the law took effect.

The unexpected consequence of the new personal bankruptcy law was the increase in financial distress that accompanied the decline in bankruptcy filings. Lenders, less worried about people using bankruptcy as a financial management tool, loaned more freely, even to consumers with bad credit. Credit card qualification standards were eased, and credit card debt grew rapidly. Subprime and Alt-A mortgages flourished.

A study from the National Bureau of Economic Research found that many consumers borrowed more than they could easily handle, ignoring the risk of financial distress. Economists even have a fancy name for this shortsighted behavior – hyperbolic discounting. The borrower intends to pay off the debt immediately, but each month spends too much and ends up postponing repayment until the following month. Thus, the debt level increases.

At the same time that credit became riskier but more available, a second thing was occurring: a frantic search for the double-digit returns on investments to which we’d become accustomed during the technology bubble of the late 1990s. As the yield on safe securities fell to near-record lows, investors moved into riskier assets to obtain higher interest rates. Securitization of the risky loans that bankers were making provided a ready source of these assets. The investors looking for yield eagerly purchased the packages of subprime loans, but in so doing they bid up the price and lowered the return. 

The Law of Unintended Consequences, alive and well, ensured that the risk was mispriced and the spread between rates on safe and risky securities narrowed to only a couple of percentage points. Rather than realizing what was occurring, the search intensified for assets with higher yields, as we convinced ourselves that we’d eliminated risk through slicing and dicing risky loans and packing them as structured credits.

Just because some actions have unintended consequences doesn’t mean we shouldn’t try to correct something that has gone wrong. It is clear that part of the blame for the recent financial crisis was a financial services industry operating under regulations no longer appropriate today. But the law does imply that we need to think about unintended consequences before we act. 

When gas prices soared a couple of years ago, the suggestion was made that gasoline taxes should be reduced to stabilize prices. Fortunately, that suggestion went nowhere.  The unintended consequence would have been that the incentive to drive smaller cars, carpool or use public transportation – in other words to conserve an increasingly scarce resource – was eliminated. 

The impending re-regulation of the financial services industry could easily have consequences as unintended as reducing the tax on gasoline or reforming the bankruptcy code. Legislators need to think carefully about the results of their actions before succumbing to a new Sarbanes-Oxley frenzy to please voters.

Perhaps the president and members of Congress should have “Beware the Law of Unintended Consequences!” emblazoned on their office doors.

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