Policy Makers Need to Keep in Mind the Law of Unintended Consequences

The law of unintended consequences dictates that the deliberate decisions, choices, or actions of people, business, or government can lead to unanticipated or unintended consequences. In other words, although the purpose of a decision, choice, or action might be beneficial, that decision, choice, or action could have unanticipated effects—benign or adverse—that have little to do with the original intent behind that decision, choice, or action.

Such outcomes are possible because people lack prescience. No person, institution, or technology offers a crystal clear window to the future. Aside from natural phenomena, human behavior and interactions are so complex that the possible range of future effects of a given decision, choice, or action are all but infinite. As a result, a range of future effects is both unknown and unknowable.

Recent examples abound.

On March 30, 2009, The New York Times reported:

Amid the shaky economy of the last couple of years, housing has emerged as the central pillar of support. The market for housing has become less volatile and less prone to oversupply than before; it has also become the Federal Reserve's main lever for reviving the economy…

Housing prices have been increasing faster than general inflation for several years, and they have accelerated in recent months to their fastest real rate of gain in decades.

All this has bolstered consumer spending and helped salve the wounds that the falling stock market inflicted on households.

On July 20, 2009, The Washington Post reported:

The chemicals, called hydrofluorocarbons (HFCs), were introduced widely in the 1990s to replace ozone-depleting gases used in air conditioners, refrigerators and insulating foam.

They worked: The earth's protective shield seems to be recovering.
But researchers say what's good for ozone is bad for climate change. In the atmosphere, these replacement chemicals act like "super" greenhouse gases, with a heat-trapping power that can be 4,470 times that of carbon dioxide.

In both examples, the benefits seemed clear. The downside risks appeared to be limited, if they existed at all. Yet, housing proved to be no “Rock of Gibraltar” in the medium-term, as a giant bubble developed and burst, creating severe global synchronized recessions. In the latter case, addressing one environmental problem created a potential hazard for addressing another.

The law of unintended consequences is particularly relevant today. In the wake of unprecedented monetary and fiscal policy stimulus, policy makers need to be looking ahead to the future and developing scenarios for at least some of the possible unintended consequences that might arise. Given the enormous scope of policy decisions, the exercise needs to be particularly robust.

Possible unintended consequences include, but are not limited to:

• A return of reckless decision making on account of moral hazard resulting from bailouts and other extraordinary government assistance.

• The impact of increased market concentration that results from the failure of small financial services firms at a time when the federal government has acted as a guarantor for those that were deemed “too big to fail.” Amplification of such a risk should the federal government fail to develop an adequate regulatory response to the “too big to fail” issue.

• Political goals crowding out business objectives for firms that had received massive federal aid.

• A shift in investor sentiments concerning U.S. Government debt on account of a combination of increased debt from the fiscal stimulus and possible health care reform legislation should that legislation lack budget neutrality and fail to address the persistent growth of health expenditures in excess of nominal GDP, which amounts to a long-term expenditures bubble so to speak.

• A reappearance of excessive inflation from a delayed scaling back of the fiscal and monetary policy stimulus or the onset of a second recession from the premature or overly aggressive scaling back of the stimulus.

• A fundamental shift in risk perceptions that could lead to the emergence of a future housing bubble should the federal government make mortgage payments for unemployed homeowners.

• A slowing of the long-term economic growth trajectory should the federal government rely too heavily on tax hikes to fund new programs, finance existing mandatory spending programs without major reforms, or try to reduce its annual budget deficits.

• The impact on public- and private-sector finances and investment should long-term interest rates embark on a secular rise.

• The overall impact on economic growth, market risks, and innovation should the federal government’s post-financial crisis regulatory reforms result in excessive or inadequate regulation.

• A shift in investor sentiments concerning the U.S. dollar resulting from current and expected policy moves, economic outcomes, and a long-term diminishing of the dollar’s role as a world reserve currency.

• The fiscal and monetary policy proves sufficiently successful to bolster public confidence in government’s role of addressing economic crises that a new burst of economic euphoria unfolds.

It will be important that policy makers have a contingency plan for each of these scenarios, among others. In addition, the contingency plans will need to be sufficiently robust to lay out possible consequences of those measures, possible antidotes for those consequences, and contingency measures for those antidotes, as well.

In the post-housing bubble years, the law of unintended consequences is especially relevant given the magnitude of policy measures that have been undertaken and are likely to be pursued in the near-term. Although some risks are unknown or unknowable, it is imperative that policy makers take a rigorous approach toward identifying and addressing major risks in a proactive fashion. Neglect of this essential responsibility could have particularly high costs, especially when long-term economic and geopolitical trends are added to the mix.

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