Unintended Consequences

Earl R. Smith II. PhD

(Read More From My Blog)

When I was at the Sloan School of Management at MIT, I had the privilege of studying with Prof. Jay Forrester the father of systems dynamics. His focus was on the understanding of the behavior of complex systems. Two insights came out of his early research. The first one was that solutions in complex systems are almost always counterintuitive. As an example, when he modeled the real estate market in Boston in an effort to analyze the impacts of public policies and discovered that the way to make affordable and quality housing available to the poor was to facilitate the construction of luxury housing. With a new stock of luxury housing available, the wealthy would move up and, subsequently, every level of society would do the same. The result was that the poor moved into neighborhoods and housing stock that were a more desirable alternative to the massive housing projects which then passed for new construction of affordable housing.

The second insight, and the one I want to focus on, was that second and third level effects defined the experience of people inhabiting complex systems far more than a primary objective. In simple terms, what that means is that a policy designed to do something has, by its nature, a ripple effect in a complex system. This ripple effect generates second and third level effects. So, as an example, if the objective of a policy is to improve a particular area with in a complex system, a secondary effect might be to damage interests elsewhere in the system. In many cases the damage created is much larger than the benefits achieved.

As examples, I would suggest three. The first is the rather simpleminded approach that the Bush administration took when they decided to deal with Iraq. With the principal goal of toppling a dictator within the context of the son finishing what daddy started, all sorts of unintended consequences began to emerge. People within the administration began manufacturing rationalizations and propaganda to support the central intent of the policy. Commercial interests quickly realized that it was to their advantage to advance the notion that the dictator had to go. There were, after all billions of dollars now available for defense contractors. War and chaos open up such opportunities. Huge amounts of cash were shipped to Iraq and subsequently lost. Corruption spread both in terms of unethical business practices and the dispensing of favors to favorites. Young Americans died senselessly, treasure was wasted on a war that never should have been and could not be won, the American taxpayer were saddled with ever-increasing debt, there was no effective oversight or control of the process and the profiteers enjoyed wave after wave of revenue. All of these consequences were not central to the original policy but flowed directly from it.

My second example is an act during the Clinton administration which started out with high sounding objectives and ended up generating the greatest financial crisis since the Great Depression. For many years an act of Congress had separated the industries of investment banking and traditional banking. The latter took deposits, made loans, generated mortgages and generally had a relationship with their depositors. The former was in the business of dealing with the investment objectives of the very wealthy. They identified and/or generated investment opportunities and generally managed the wealth of their clients. In an attempt to increase homeownership and make mortgages more available, the Clinton administration tore down the partition between these parts of the banking community.

Michael Lewis and others have documented the results extensively so I don’t intend to rehash them here. The long and the short was that, directly because of the action during the Clinton administration, investment banking turned into a casino operation. Wall Street turned from a primary focus on equity to a focus on debt. It manufactured and marketed a bizarre range of debt instruments. One of the major drivers of the surge that created the financial meltdown was their ability to enter into arrangements with traditional banks and subsequently manufacture financial instruments which found a ready market with their clients.

As a direct result of the policy, not only did Wall Street start to look more like a gambling casino but the affiliated industries began to be corrupted. The rating companies whose job it was to pass judgment on the quality of a given investment began to apply AAA ratings to assemblages of junk mortgages. Regulators, whose principal job was the oversight of an industry critical to the health of the US economy, increasingly turned a blind eye to an obviously building crisis. Politicians, who were elected by the people to protect their interests, decided that campaign contributions were more important than their obligations to their constituencies – or to put it another way, they decided that the campaign contributors were actually their constituency. Finally the justice system decided that, although fraud had clearly been committed, few of the people involved should actually face charges and fewer still should actually go to jail.

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