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The Law of Unintended Consequences: Part II

In my last article, I touched upon the superior economic growth rates of the U.S. as compared to Europe, relative to each country’s political and economic systems. Over the past couple of centuries, the U.S.’s freer approach to markets has fostered an environment more conducive to economic growth. Although I acknowledged the need for regulation, I introduced its propensity to create unintended consequences that exacerbate the underlying issue. One such example is the Dodd–Frank Wall Street Reform and Consumer Protection Act, which Arthur Brooks discussed in an interview with Hedge Fund Manager, Cliff Asness of AQR Capital Management. I dive deeper into this interview and the unintended consequences of regulation in this post.

During the interview, Dr. Asness admitted the difficulty of understanding the Dodd-Frank Act, which he boiled down to the creation of several new bureaucracies—or a tremendous expansion of government power. As I wrote in my last post, the government became the so-called solution to a problem it helped cause, as government is often relied upon as the answer to society’s woes. In fact, Dr. Asness’ description of Dodd-Frank suggests that its creators assumed the legislation had God-like power and virtue to accomplish its goals. I call these unstated premises the omniscient, omnipotent, and omnibenevolent assumptions of Dodd-Frank.

The Omniscience of Dodd-Frank

The Financial Stability Oversight Counsel (FSOC) was created by Dodd-Frank to identify the next financial crisis, and fix the underlying problems before a reoccurrence of the 2008 crisis materializes, according to Dr. Asness. However, he does not believe this is possible:

People who say they called it to the minute are lying. People who got the 2008 crisis right were very lucky that they weren’t saying it a year and a half earlier or they would have gone bankrupt.

If the ability to spot a financial crisis in real time proves nearly impossible for gurus in the industry like Dr. Asness, how could a bunch of bureaucrats in D.C. identify and time a crisis better than the markets?

As Dr. Asness conceded, “we’ve tried that”—referring to the Former Chairman of the Federal Reserve, Alan Greenspan. Dr. Greenspan was looked to as the “genius” or “maestro” who would act as a watchdog for problems in the economy before they occurred. His unfortunate timing caused him to retract his theory of irrational exuberance right before the end of the technology bubble in the late 1990s.

Furthermore, properly predicting a crisis proves even harder without impeding growth: “It’s easy to stop a lot of crises if you stop every single new venture before they start. Nothing ever blows up but nothing ever gets created.” Consequently, the risk takers who run the economy’s engine are stalled: the productive and innovative forces of the Dagny Taggarts, Ellis Wyatts, and Dan Conways (from Atlas Shrugged) of the world fight, rebel, or retreat.

The Omnipotence of Dodd-Frank

Dodd-Frank also includes a new resolution authority. This power enables the FSOC to deem financial firms as systemically important financial institutions, extending its reach beyond large banks. Should a firm be deemed systemically important, they can “circumvent bankruptcy laws and take it over,” as explained by Dr. Asness. In other words, regardless of market signals, the FOSC can declare a firm as “in trouble” and “important,” whereby the business is “taken over and you’re done.” This arbitrary power grab of essentially picking winners and losers is certainly a “scary prospect,” and a breeding ground for cronyism.

The Omnibenevolence of Dodd-Frank

Dr. Asness described the Consumer Financial Protection Bureau (CFPB) as providing the false hope that it is fully protecting individuals, as it aims to vet more institutions. For example, Dodd-Frank ensures that all hedge funds register with the Security Exchange Commission (SEC); but as Dr. Asness noted, Bernie Madoff was registered with the SEC. Catching intelligent frauds who are intentionally trying to fool regulatory authorities proves much more difficult than requiring honest firms to make small changes: “When they say they are going to cover everyone, it’s easy for people to assume that everything’s safe.”

Although the probability of disaster—another financial crisis—may be the same, Dr. Asness believes the magnitude of disaster will be worse as people will rely upon the government’s disingenuous protection. The world is safer when individuals are aware of its risks: “a world where you have the FSOC and CFPB on a retail level, and think your back is covered everywhere, when your back can never be covered everywhere, is a much more dangerous world.”

[pq]Financial institutions are built on confidence, and great expectations lead to great failures.[/pq]

While the Act claims to end too-big-to-fail (TBTF), the FSOC’s ability to deem firms systemically important—as discussed above—ensures that institutions will not fail. (Sounds a lot like the “Anti Dog-Eat-Dog Act” in Atlas Shrugged, which aims to slow the influx of bankruptcy claims by businesses). Thus, Dr. Asness stated two consequences that persist: Financial firms are incentivized to gamble with other people’s money since they know they can be bailed out, and the effects of a financial firm failing are much worse because they won’t be anticipated.

When the government deems an institution as TBTF, it creates expectations in the market that the institution cannot fail. If a TBTF institution does fail, the disappointment and damage will be even greater than if the government had done nothing. Financial institutions are built on confidence, and great expectations lead to great failures. This scenario offers another example of Dodd-Frank’s unintended consequences.

In part III of this series, I will discuss Dodd-Frank’s most nefarious feature—as proposed by Dr. Asness—and connect it back to Europe and the unintended consequences of sweeping legislation.