The moves of our Federal Reserve and Treasury in the last few weeks are gigantic in scope. Decades from now students will study 2008 when the financial markets changed, when the relationship between the government and the private sector was forever altered, and when doggedly held beliefs were shaken from their established perches. Of course unprecedented times call for unprecedented measures, but massive actions in complex systems always create unintended consequences. What will ours be? Can the brightest minds in the world fail? How can apparently simple solutions breed terrible consequences? Easy.
Take the building of the Panama Canal. The French found the brightest among them to engage in one of the most historic engineering events of the era. They tapped their countryman Count Fedinand de Lesseps who helped build the Suez Canal to oversee the project. They tapped Gustave Eiffel (as in the Eiffel tower) to build the locks for the canal. They tapped some of the best doctors of the day to care for the thousands of workmen on the job.
And so it began. The brightest and the best all working as a team. They built huge wards with rows of beds to take care of injured or sick workers. To keep the stinging bugs and tarantulas from crawling up the legs of the hospital beds onto the patients, the brilliant French doctors had a plan. They placed each bed leg in a bowl of water. The bugs would not crawl into the bowl and swim to the legs of the beds. The solution to the problem of dangerous bugs seemed simple, even ingenious.
But the rate of Yellow Fever and Malaria among the hospital patients was soaring. Even the rate of infection of the workers in the fields was soaring. Dozens died daily. Soon hundreds died daily. The problem kept compounding until finally, more than 20,000 workers died. The French gave up. The bonds used to finance the building of the canal project were worthless. Middle class families who invested in the bonds back home in France lost everything. The smartest people, from one of the most educated countries on earth at the time, failed miserably.
Turns out, it was the law of unintended consequences writ large in the Central American jungle. As we now know, mosquitoes breed in stagnant water and transmit tropical diseases through their bites. The bowls of water meant to keep crawling bugs from reaching the sleeping patients actually served as a breeding ground for mosquitoes. The French inadvertently created an epidemic that killed people at an appalling rate. Take infected people; place them in a ward with workers who might only be injured. Place hundreds of little mosquito homes at the foot of everyone’s bed. Make sure that all mosquitoes now will carry the diseases in their blood. Make sure all patients in the ward are infected. Send the legions of infected insects out into the fields to infect more workers. Fill more wards. More bowls. More dead.
The law of unintended consequences is very real. Hard walls in a complex system force the system to find a way around. When the Treasury asked (and received) permission to bail out Fannie and Freddie, they wanted the markets to feel good about lending them money, about buying their stock, and about buying their mortgage backed securities. Instead, just the suggestion of the bailout created a crisis of confidence. If the government takes over, will it render my stock worthless? Will it make my bonds junior in importance to their bonds? The move intended to avoid a bailout, forced a bailout.
Now the government intends to buy tens of thousands of bad loans and begin a massive program of debt forgiveness and loan restructuring. What will the unintended consequences be? Will good borrowers stop paying on their loans so they can get on the gravy train? What will the unintended consequences be of the government’s move to buy preferred shares of huge banks? Instead of encouraging the banks to lend again, the move might simply delay the inevitable pain and failure of bad banks. Perhaps it will not encourage lending at all – just a round of cannibalizing consolidation.
The markets into which the Fed and the Treasury are digging their fingernails are deep, complicated, and connected globally on the lowest and the highest levels. A complex system requires us to tread with caution, to think in terms of decades not hours. Can the brightest minds in the world make mistakes? They do all the time. In the case of Panama, they killed 22,000 people without pointing a gun. Can the best laid plans fail? Of course. As the Roman playwright Titus Maccius Plautus observed a couple of thousand years ago, “things we not hope for often come to pass more than things we wish.”