Unintended Consequences and Third Order Effects Influence Our Finances and the Economy

by Hank Coleman

The law of unintended consequences states that the actions of people and especially of the government have effects that are unanticipated or unintended.  Unintended consequences are sort of like the famous butterfly effect theory which is that when a butterfly flaps its wings in Africa, it might change the weather patterns in Kansas, a small change at one place in a complex system can have large effects elsewhere throughout the system.  The same can be seen in our financial economy today and in the past.  Here are some examples of unintended consequences…

Mark to Market Rule & Enron.  Enron actually plays a large in our current financial market crisis.  Just when we thought that we had put the scandals of Enron and WorldCom behind us, they come back to bite us again.  Because of the Enron, WorldCom, and other corporate meltdowns, the federal government wrote the Sarbanes-Oxley Act of 2002 into law.  A consequence of that law was the change of the “Mark to Market” Accounting Rule.  The rule makes financial institutions revalue their asset holdings such as mortgages based on current market prices and not the previously allowed historical prices.  So, the loans that banks held had to be reduced on banks’ balance sheets continuously putting a needless strain on banks creating a paper loss that reduces capital and restricts lending.  Forced asset sales and reclassification regardless of actually selling the asset brings down the value of both good and bad assets.

Community Reinvestment Act.  The government passed this act and revamped it throughout the 1990’s which forced banks to loan money to poor citizens or face consequences.  This act eventually let broke people who should not have qualified to receive home loans under this plan borrow more money than they could afford.  Congress forced bad loans into the financial system in an attempt to let poor people buy a house.  It was a noble cause, but it has backfired fueling a part of this economic downturn when the poor defaulted in record numbers.

Meat Crisis of 1972.  The 1972 meat crisis was caused by a massive reduction in the population of anchovies, of all things, living off the coast of South America. As these tiny fish had migrated somewhere else, the farmers who relied on them for animal feed had to pay rapidly increasing prices, driving up the cost of beef around the world. This led to black market butchers, runs on beef supplies, and the rise of pasta as a main dish.

Americans with Disabilities Act.  Economists Daron Acemoglu and Joshua Angrist the passage of the ADA in 1992 statistically led to a sharp drop in the employment of disabled workers because employers, concerned that they would not be able to discipline or fire disabled workers who happened to be incompetent, apparently avoided hiring them in the first place.

Laws have a way of backfiring on politicians whether they want to own up to it or not.  The introduction of Social Security in America helped alleviate poverty among senior citizens and widows, but left the country’s working class with a mental block to save money for retirement because they know that their Social Security checks will be waiting on them in their Golden Years.  When the government gets involved and does not let free markets control situations, there are unintended consequences, third, and fourth order effects.  Actions that we take today have a far-reaching ripple effect on subsequent events in the future, and governments do not necessarily put these things together when passing laws like the bailout plans we have been seeing this month.

If you are interested in other examples, check out this great article on the subject from the Library of Economics and Liberty.

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