Unintended consequences

July 18, 2012

Economics is about systems, and it’s not uncommon to see well-intentioned interventions in economic systems produce unintended consequences.  I ran across a good example a few weeks ago.  A well-meaning high school decided to increase the nutritional content of its lunches.  Good idea, right?  The students, though, had a different idea.  They walked down the street and bought as much unhealthy food as they wanted.

I was reminded of this when I read Darrell Duffie’s comments on financial regulation in the Minneapolis Fed’s “The Region.”  Darrell is one of my favorite economists, someone who can mix common sense and high-level math without doing damage to either one.  He raises the systems issue in relation to two features of financial regulation.

One is the “Volcker rule,” which prohibits proprietary trading.   The idea is reduce the risk to banks with the goal of making the financial system more stable.  Good idea, right?   Well, maybe.  But what if this leads market-making activities to leave banks and move to some less regulated part of the financial system.  Then we might — emphasize might — make the system less stable even if we make banks more stable.

The second example is money market mutual funds, a topic addressed earlier by my colleagues Tom Cooley and Kim Schoenholtz.  Money market funds are already outside the banking system, but their collapse during the crisis followed the same pattern we’ve seen for centuries with banks:  rapid withdrawal of funds  (a “run”) threatened their viability, and with it the stability of the financial system.  It didn’t happen, but only because the Treasury intervened with (essentially) deposit insurance.  Here the logic suggests regulation to encourage “design of these funds so that they are not so prone to flight by institutional investors.”

It’s a reminder that the financial system is indeed a system.  Which makes regulation like a game of Whack-a-Mole:  when you hammer one thing down, something else pops up.

Postscript:  Schoenholtz passes on this terrific video of Atul Gawande talking about healthcare systems.  The lesson:  things will go wrong, the trick is to respond effectively.

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