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The Law of Unintended Consequences: Part I

Last week, Josh Good posted a Values & Capitalism video that highlights the rapid progress of wealth and justice over the past couple of centuries due to the emergence of modern capitalism and the spread of free markets. The video notes that someone who survived childhood in London during the mid-18th century could expect to be impoverished, illiterate, and unhealthy thereafter. From 1000 AD to 1820 AD, the world’s per capita income grew by only 50 percent, yet since then, it has spiked by 800 percent. During the past two centuries, the U.S. and Europe grew sixteen times more than the eight centuries prior. More telling, however, is the graphic that illustrates these facts, which clearly distinguishes the U.S.’s towering growth rate over Europe’s during the same time period.

Although Europe maintains strains of capitalism, there has been no country freer, bound with more opportunity to achieve economic prosperity than the U.S. The video states that less government control means more liberty for men and women to express their gifts, passions, and creativity. Hence, the innovation and ingenuity harnessed by freedom has acted as the motive power behind the U.S. economy, fueled, in part, by the John Galt’s of the world.

With that said, Mr. Good rightly qualified capitalism as the “least-bad economic system the world has every known.” No system is perfect, and capitalism is no exception. Despite the many economic, political, and social benefits it continues to breed, some regulation is needed to maintain order and thwart negative externalities. Nevertheless, regulation often creates the façade of fixing problems, while actually proving more burdensome and dysfunctional when set in motion.

Last spring, Arthur Brooks interviewed Hedge Fund Manager, Cliff Asness of AQR Capital Management. During the conversation, Dr. Asness articulated the counterproductive and overzealous nature of the Dodd–Frank Wall Street Reform and Consumer Protection Act. This particular piece of legislation provides an apt example of the law of unintended consequences relative to regulation.

A few weeks ago, I briefly touched upon the Dodd-Frank Act in my post on the Wolf of Wall Street. As Dr. Asness describes, the Act is an amorphous collection of ideas that was expediently implemented at an opportune time: subsequent to the financial crisis. More bluntly, it is “a left-leaning wish list of the past twenty years.”

Upon the release of the film about Jordan Belfort’s pump and dump scheme, Leonardo DiCaprio voiced in interviews that he “really wanted to put it up on screen because in many ways, it felt like a reflection of the time we were living in,” meaning the 2008 financial crisis. Herein lies the problem: Mr. DiCaprio cannot discern between an exception, and a systematic failure.

[pq]In the 2008 financial crisis, greed certainly expanded the bubble, but the government provided the soap.[/pq]

This Hollywood perception of Wall Street extends to the bureaucrats crafting legislation in D.C., who are often ill-informed and thus pass ill-conceived regulation. As Dr. Asness explained in the interview, “We did not have one crisis, we had a very big credit, real estate bubble come down, and then we had a financial crisis.” In fact, the source of the bubble can be traced back to the government, “from cheap money, to everyone can have a subsidized house, to remember when banks were terrible for not lending, to credit rating agencies that had a monopoly.” Certainly greed expanded the bubble, but the government provided the soap. Even worse, despite its role as one of the initiators of the crisis, the government rushed to the forefront with the supposed solution.

This so-called solution is wrought with god-like attributes that translate into more government power, while creating a less stable financial system. Moreover, the Act encourages a political system reminiscent of Europe’s, that is not conducive to the exceptional economic growth the U.S. has achieved over the past couple centuries with far less bureaucracy.

I will further explore these regulatory consequences, and Dr. Brooks’ interview with Dr. Asness in my next article.