Leadership, Regulation, Markets and the Law of Unintended

Consequences

B A R R Y S C H A C H T E R

Consequences

B A R R Y S C H A C H T E RF O R P R E S E N T A T I O N

J A N U A R Y 3 1 , 2 0 0 9S W E E T B R I A R C O L L E G ES W E E T B R I A R C O L L E G E

Leadership in the Crisis

Obama Presses for Quick Jolt to the Economy B JACKIE CALMES d DAVID M HERSZENHORNBy JACKIE CALMES and DAVID M. HERSZENHORNPublished: January 24, 2009, New York Times, page A1

d b d d“WASHINGTON — President Obama on Friday stepped squarely into the fractious effort in Congress to assemble an $825 billion economic recovery package, seeking to

ll iti i f b th ti d t t i l d hi quell criticism from both parties and to retain leadership on an initiative that could define his term.”“Democrats are eager to help Mr. Obama succeed, k i th t th i id hi Still th knowing that their success rides on his. Still, they are refusing to cede their status as leaders of a co-equal branch of government…”

The Moral of This Talk

Crises create enormous pressures on people in leadership i ipositions

Certain purposive actions in response to those pressures may be only the appearance of leadershipmay be only the appearance of leadershipOur ability to control our surroundings is limited. Not recognizing the limitations gives rise to unintended consequencesconsequences“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) Baron Acton, Speech House of Lords (1770)

Quick Summary of Recent History

May 5, 2006 – Merit Financial files for bankruptcyFebruary 27,2007 – US stock markets fall 4%April 3, 2007 – New Century Financial files for bankruptcyJuly 31 2007 – 3 Bear Stearns hedge funds close doorsJuly 31, 2007 3 Bear Stearns hedge funds close doorsNovember 27, 2007 – Abu Dhabi invests in CitiJanuary 22, 2008 – Fed cuts by 75bps

h d bMarch 16, 2008 – Bear Stearns acquired by JPMJuly 23, 2008 – Fannie, Freddie bailout passed in CongressSeptember 18, 2008 – Lehman declares bankruptcySeptember 18, 2008 Lehman declares bankruptcySeptember 19, 2008 – SEC short-selling banOctober 7, 2008 – Iceland banks nationalized

Causes and Effects

“The Great Moderation”Low interest rates and mortgage borrowingSecuritization, 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

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 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. ultimate consequences are fatal, and the converse. That Which is Seen, and That Which is Not Seen Claude Frédéric Bastiat (1850)

Energy Independence and Corn Ethanol

The goal is to reduce imports of oilThe claim is corn ethanol costs less energy to produce than it generatesTh lidit f th l i t t th The validity of the claim seems to rest on the significance of unintended consequences:

New infrastructure for transport, storage, & distributionp , g ,Lower fuel economyHigher auto maintenance costsIncreased cost of food from corn Increased cost of food from corn Increased medical costs from toxic emissions (e.g. formaldehyde)D f t ti d th i id ff tDeforestation and other increase acreage side effects

The Law of Unintended Consequences

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

Leadership through Action

The pendulum swings towards regulation By Lawrence Summers [Director White House National Economic 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 and regulatory policies, economic performance depends on deeper 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 t di bl ” standing problems.”

“…the pendulum will swing – and should swing – towards an enhanced role for government in saving the market system from its excesses and inadequacies.” excesses and inadequacies.

The Fatal Conceit

Uncertainty and the human psychey p yInstitutions and traditions as security blanketThe grand idea of central planningg p gUncertain mechanics of modern economies

What Enlightenment philosophers didn’t understandDemons, Black Swans, and Market Misbehavior

Willful suspension of disbelief in a period of crisis

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 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 f p pwhich 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

ti M th l th i t l f ti b t th action. Moreover, the longer the interval of time between the 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 greatly pp y y, g yextended, 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 ’”governmental action restoring prosperity.

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 consequences taken into account. The “system” is dynamic. Relationships among relevant factors change over time (e.g., impact of oil price on g g , p pconsumer expenditure). The changes are not mechanical and cannot be predicted without error.Th “ t ” i t h ti At i t i ti t l The “system” is stochastic. At every point in time truly random effects interact with fixed relationships to limit predictability of outcomes.p y

S&P Study: Impact of Mortgage Loan Modification IdeasImpact of Mortgage Loan Modification Ideas

Borrowers may have yincentive to become delinquent. Total loss severity Total loss severity experience will be higher for loans that re-default.

i i d li iAn increase in delinquencies from this “moral hazard” issue could negate potential g pbenefits from loan modifications.

More Reasons for Unintended Consequences

Rational ignorance. The additional resources needed gto pursue further analysis of consequences are deemed to exceed the benefit of acquiring additional k l d knowledge. Irrational ignorance. A compulsion to act precludes acquiring additional information first Also a acquiring additional information first. Also a preconception, habit or tradition inhibits seeking additional information.

The Short Selling Ban

SEC chief has regrets over short-selling banB Rachelle YounglaiBy Rachelle YounglaiPublished December 31, 2008, Reuters

WASHINGTON – For a few weeks [from 9/19/08], the SEC stopped W S NG ON o a ew wee s [ o 9/ 9/08], t e S C stopped 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 consequencesliquidity in the markets was one of the unintended 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.,

Preventable Unintended Consequence?

We need to guard against destructive creation By Jagdish Bhagwati (Prof Econ Columbia U )By Jagdish Bhagwati (Prof. Econ. Columbia U.)Published: October 16 2008 , Financial Times

“ ’policy innovations’ had been racing ahead of comprehension ... policy innovations had been racing ahead of 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 ”if things went wrong, which they 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 ppalways the unexpected. This commission would be charged with trying to narrow the range of the unexpected.”