Unintended consequences may be upon us
The idea behind, “unintended consequences” had been around for centuries, but it was Professor Merton who brought the term into popular use. It now shows up more and more frequently in our conversations as we wrestle with the increasingly complex systems surrounding everyday life. The often bizarre and occasionally lethal side effects of some pharmaceuticals repeatedly provide everyday examples, and government socio-economic programs supply a seemingly endless supply of memorable reminders of unintended consequences.
The increasing skepticism of the 21st century has added a conspiratorial note to the usage of the term by adding a question mark. It is used to express wonder as to whether the unintended consequences of a program were really unintended.
Unintended consequences are not always bad, although they so often are. Occasionally we are pleasantly surprised by results. And sometimes outcomes can be difficult to evaluate.
Economists, politicians and others who have been looking into the federal debt issue, for example, are all very familiar with the spike in government debt caused by the financing of World War II in the years 1941-1945. Less well known are the reasons why the accumulated debt did not increase in real terms (dollars adjusted for price levels), and actually declined sharply as a percentage of Gross Domestic Product (GDP).
Economic research by Carmen Reinhart and M. Belen Sbrancia provides an answer. Published as a working paper by the National Bureau of Economic Research, their research, “The Liquidation of Public Debt,” explains how public debt was “restructured” in the United States and other countries in the decades following World War II.
Generally speaking, when public debt rises to a high level compared with economic output – as a percentage of GDP – governments are faced with three options: default, “restructured” debt or rapid inflation.
The word “restructured” is put in quotation marks because the methods available to a sovereign government to restructure its debts are very different from those available to individuals or private sector businesses. Governments, for example, can simply mandate the purchase and holding of this debt by regulated institutions like banks and private, collective entities such as pension funds.
The mandates effectively take the public debt off the market. In the U.S. this off-market characteristic was further assured by selling government debt instruments like non-marketable bonds that had to be held to maturity. In most cases, though, there were no resale restrictions since the total amounts to be held were mandated.
The idea that a substantial portion of the public debt had a guaranteed number of buyers who would hold the Treasury bonds and keep them off the market is particularly appealing to U.S. policy makers and politicians because it maintains the appearance of market-driven capitalism while effectively making the debt disappear.
If that idea has a familiar sound to it, it should. Welcome to the world of Quantitative Easing, the policy pursued by the Federal Reserve since late in 2008 that has taken over $2.2 trillion worth of public debt off the market.
The debt disappearance policy made sense when it began, because both our financial markets and our financial institutions were probably too shaky to absorb the level of deficit financing the government intended to pursue. Besides, selling the debt on the open market would almost certainly raise interest rates well above the zero level targeted by the Fed’s monetary policy.
There are costs and unwelcome, possibly unintended, consequences to making government debt disappear by taking it off the market. Stuffing Treasury bonds in an unused desk drawer at the Fed is only a temporary measure but it still distorts and creates imbalances in our economy.
The “tapering” policy of gradually winding down Fed purchases of Treasury bonds has begun but will take a while to have a significant impact. Meanwhile, there are concerns about what happens when the $2.2 trillion in the Fed’s desk shows up like an apparition in our financial markets.
Some believe that the regulatory ball of yarn called the Volker Rule provides the perfect answer. Its details and language are still being pondered by regulators. There is little doubt, though, that if it is used to mandate that commercial banks must beef up their capital position by purchasing and holding lots of government bonds, the government debt could be made to disappear once again. It’s magic. Whether the unintended consequences will also disappear — poof! — is another matter.
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