Fear Itself is Fear Enough

A few months ago I saw squirrel get hit by a car. I had just noticed it starting to cross the street when it spotted an approaching car and froze on the pavement. It was probably safe where it was, but I could see it was overwhelmed by fear and I knew, a second before it happened, that the squirrel was going to panic and run the wrong way, right under the wheels of the oncoming car.

I don’t know why that squirrel stuck in my mind. It’s not like I haven’t seen roadkill before. I guess I’m a little haunted by the fear and the panic and the seeming inevitability of failure.

Which brings me back to the subject of our economy. I have that exact same feeling of watching a horrible mistake being made when I see how our leaders are reacting to the current crisis.

It’s not that I can predict what’s going to happen. Unlike the situation with the squirrel and the car, I’m not smart enough to foresee the details of how the folks in D.C. will screw this up. No one is. That’s kind of the problem.

Economists refer to it by the vague term unintended consequences. That’s what you get when you try to control the behavior of a complex system: The system responds to your control inputs in unexpected ways. It’s not that the system behaves randomly (which is a separate issue) it’s that the system’s behavior is more complicated than you are capable of understanding. This makes it difficult for you to make productive changes to the system.

Let me try an analogy: If you’re in charge of the control room in a nuclear power plant that’s going critical, your response has to be based on a thorough understanding of how the reactor works, what’s going wrong, and how the reactor will respond to the controls. If you just start throwing all the switches you can reach, it’s probably not going to make things better.

Our economy is far more complicated than a nuclear reactor. That’s why this is such dangerous time: With major economic turmoil right before a presidential election, everyone in D.C. is trying to make their party look good by frantically throwing the levers that control our economy. It’s a perfect storm of political economy

Both presidential candidates have essentially the same plan: Take over the economy to save us all. Obama’s talking about the need to “reregulate” and who knows what crazy schemes McCain will think of next.

Unfortunately for all of us, a large national economy is probably the worst case when it comes to complexity because the rules governing the components are not the rigid and essentially simple laws of nature but the flexible intellects of millions of people, many of whom will actively react to all attempts at control.

The people who think of themselves as our leaders will feel the urge to seize control in a crisis. In doing so, they risk following following a well-worn path…No, wait, that’s not right. The problem is the unpredictable complexity of the system, so the path is not well-worn at all. Nevertheless, their attempts to follow it will invoke a familiar pattern.

Think rent control. It all starts when politicians in a city decide they can get a lot of good publicity—and maybe some votes—by “stabilizing” rent prices to protect renters from greedy landlords. It makes a certain amount of sense: Renters can’t afford to pay so much, so don’t allow landlords to charge so much.

(For purposes of discussion, I’ll take it as given that for some reason we care more about the fortunes of renters than the fortunes of property owners.)

Since landlords can’t increase the profits on their property by charging more, they try to make money by spending less. They simplify the landscaping, postpone maintenance, stop replacing the carpets, dismiss the doorman, reduce the temperature of the hot water, let the hallway lights burn out. Nice apartments decline into mediocre apartments. Low-income rental properties become uninhabitable, creating a housing shortage.

The government responds by setting more detailed housing standards, and then hiring more housing inspectors to check them, more lawyers to enforce them, and more internal inspectors to keep the housing inspectors from taking bribes.

Landlords may not be able to charge tenants more, but with the housing shortage, they can look for better tenants. They start kicking out troublesome tenants at the slightest provocation, and they stop allowing pets or waterbeds or pianos…or children or minorities or homosexuals, if they can get away with it. Complaints skyrocket, evictions skyrocket.

With rental properties less profitable, investors stop building them, and the housing shortage intensifies. The governments respond with an exception to rent control for new housing. In the next year, thousands of landlords kick out their tenants, tear down their buildings, and put up new ones. The city sets limits on teardowns for new construction, so owners allow rental property to become so dilapidated that they have to be replaced.

A similar battle is fought over remodeling, complete with detailed legal definitions of the difference between maintaining a property, remodeling a property, and replacing a property.

It keeps on going. Renters start secretly subletting to other people, allowing them to earn the profits the landlords aren’t allowed to earn. Landlords spend more time trying to catch cheaters than maintaining their buildings. Entire apartment buildings are converted to condominiums, forcing out renters who can’t afford to buy. Small, mostly-empty apartment buildings just burn down one night, and arson is suspected.

That may be about as bad as it gets in this country, but in some authoritarian countries (Robert Mugabe, call your office) it doesn’t stop until the government has soldiers everywhere and is forcing landlords to repair the plumbing under threat of death.

I don’t know what the financial markets will look like when nice folks from the government start showing up to help in record numbers, but it’s hard to imagine that there will be less chaos. In fact, a lot of the current problem is due to prior government involvement: Mark-to-market accounting, credit-default swaps, inflexible reserve requirements. A few perverse results seem likely.

For example, I can’t see how they can possibly enforce limits on executive compensation. If the CEO is earning $5 million per year, and the rules say he can only earn $500,000, then he’ll quit and be replaced by a junior executive. The former CEO will then start a consulting firm that receives a $5.1 million contract from his former employer, and the new CEO will take his advice about everything. For the next few years, business consulting will be the fastest growing industry in the country.

One of the things that makes regulation of the financial industry harder than rent control is that landlords can’t take their ball and go home, but financial experts can. Maybe the previous CEO and some of the other executives and their friends will form a new company in Hong Kong that does a friendly leveraged buyout of the original company. The American CEO will earn the legal maximum, but the CEO of the Hong Kong holding company will still earn his $5 million. Within a decade, the 10,000 most productive people on Wall Street will have moved to Hong Kong, taking our entire finance industry with them.

On the other hand, what about all the other banks? There must be thousands of small community banks that were careful about the loans they made. They’re not too happy that their big, stupid competition is getting bailed out. They were looking forward to picking over the corpses for more business. Bailing out the Wall Street banks could cause hard time for the Main Street banks.

There’s also talk of making it harder for banks to foreclose on homes (I guess because of our unsupported belief that home ownership is more important than other financial goals). Aside from the cost and the moral hazard of rewarding irresponsible financial decisions, this is also bad for future home buyers.

If the restrictions on foreclosures apply to future home loans—or if banks expect that congress will apply them to future home loans in the future—banks will be reluctant to make home loans. After all, the point of a traditional mortgage is that the money is safe because the bank can always sell the house to recover its money. That may not be how it’s working out right now, but we’ll never get that kind of mortgage back if banks have trouble foreclosing…at least not at a reasonable price: Expect limits on foreclosures to lead to higher interest for home loans.

And just as with rent control, expect the home loan industry to come up with novel new approaches to home financing. How about stealing an idea from the car leasing business and create a rent-to-own housing contract? Instead of making $2500/month mortgage payments for 15 years, the bank owns the house and you agree to a 15-year lease at $2500/month with an option to buy at a price that decreases slightly every month. Or maybe you use your down payment to become a co-investor with your bank in a real-estate deal that buys a house and rents it to you, but allows you to buy out your partner on a fixed schedule.

Both of those ideas are probably unworkable without a lot more detail, but if you doubt the ability of financiers to work around the regulations, just remember that in Islamic countries it is illegal to charge interest, but their bankers have figured out how to make loans anyway. I’m sure we’ll think of something.

If those predictions seem too easy to fix in regulation, then I predict the response will be something harder to predict and regulate.

We’re already seeing signs of unintended consequences. I’m convinced that most of the giganic swings in the stock market are due to the bailout. If the bailout was a totally done deal, and therefore predictable, the market would already have incorporated it into asset prices. But as long as the bailout is subject to political arguments and the whims of Treasury Secretary Paulson, traders have to keep guessing. If Paulson is spotted in a coffee shop with a sour look on his face, the Dow loses 300 points.

It doesn’t help that the U.S. Treasury is now deep into the financial markets. There are already stories of other financial players taking a wait-and-see attitude, because they don’t want to take an equity position in a bank that the Treasury will take over the next week, especially with Paulson’s offer-you-can’t-refuse style.

There’s no reason to believe the panic has stopped at the bailout. Everyone in D.C. is talking about doing more to save us, from another stimulous package to even more regulation on financial activities. Even if we ignore the poor financial record of our government—$10 trillion in debt and counting—I don’t see how this could help. Free markets are flexible and highly adaptive, making our economy less flexible will only make it worse.