How Big, Bold Policy Changes Breed Economic Catastrophe

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Got an idea to change the world? It'll probably have some terrible unintended consequences.davidow-3-27.jpg

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Conventional economic theory assumes that systems converge to equilibrium -- for example, supply will equal demand. But it is very dangerous to take precipitous actions based on these theories in highly connected, gridlocked environments. In highly connected systems the high levels of positive feedback can create environments with numerous equilibrium points. Systems can get stuck at these equilibrium points -- locked in -- and become almost impossible to dislodge.

In other words, a policy created with the hope of providing affordable healthcare or a secure retirement for state employees might quickly become a locked-in system with unsustainable, skyrocketing costs that undermine anticipated benefits.

If you doubt that making changes to fix these problems in gridlocked environments is difficult, take a look at California's politicians attempting to reform the state pension system.

Much of conventional economic theory also assumes that actions are based on rational expectations that change slowly, if at all. Under such circumstances, markets tend to converge. But if expectations change rapidly, positive feedback can drive them to change even more rapidly. Panic and greed set in, markets become very volatile, valuation bubbles arise, and economic financial crises take over.

When there are massive amounts of positive feedback in the system, the slightest policy errors get magnified and situations rapidly spin out of control while politicians in gridlocked governments argue about what to do. Many of the surprises during the 2008 Economic Crisis were a result of our lack of appreciation of the effects of higher levels of connectivity and the large amounts of positive feedback it engenders -- much of it driven by the Internet. Think of the housing bubble and the meteoric growth in over-the counter derivatives from $60 trillion to over $600 trillion in seven years. The Greek Crisis is another perfect example of virulent positive feedback at work and its ability to surprise.

The main motivation behind the euro was the hope that it would lead to an integrated Europe that could rival the United States. But the success of the euro depended on getting the less fiscally responsible Mediterranean countries to undertake meaningful structural reform. This would be accomplished by getting all the euro members to conform to the strict rules of the Maastricht Treaty. Many mistakes were made, but one of the policy errors that got magnified by positive feedback processes is that the Maastricht rules were not strictly enforced. For example, euro members were limited to budget deficits of 3 percent of GDP. Needless to say, this was a rule honored in name only.

So let's take a look at one of the positive feedback processes at work. The euro was an undervalued currency for Germany and an overvalued one for Greece. It also enabled Greece to borrow money in euros rather drachma. This meant that lenders didn't have to take into account the fact that Greece might devalue its currency. Lenders also assumed that it was highly unlikely a euro member would default. Since they didn't face currency and default risk, lenders were willing to loan large amounts of money to Greece at lower interest rates. The result was easy to predict. In 2011, Greece's debt skyrocketed to around 160 percent of GDP, from 100 percent of GDP in 2005. As you can see, when positive feedback is present, things race out of control very quickly.

Policy-making bodies in environments with large amounts of positive feedback have to act quickly to control such situations. In short, rapidly responding economic systems require rapidly responding controls. This is why government gridlock is so dangerous. In a gridlocked system, things will race out of control even before those regulators most eager to clamp down can respond.

We had to take precipitous action to deal with the 2008 economic crisis, in the form of hasty and massive bailouts. We had no choice. But I, for one, would have delayed the expansion of the healthcare system in a gridlocked environment. Yes, we need to solve the healthcare problem. But it is far too dangerous to make an abrupt policy change and put in place a system where costs can spiral out of control and become locked in place until bankruptcy sets us free.

The estimated cost of the Affordable Care Act -- Obamacare -- has risen from $940 billion at the time the law was passed to $1.76 trillion, according to the Congressional Budget Office. Some experts believe that as a result of the act millions of American's will be pushed off private insurance rolls and into Medicaid. If such a program becomes embedded in our system, it will be very difficult to dislodge -- with dire economic consequences.

Another example of precipitous action was the 1999 repeal of the affiliation provisions of the Glass-Steagall Act, which prohibited commercial banks from engaging in risky investment banking and trading. Many of the positive feedback-driven abuses that played an important role in the 2008 Financial Crisis would never have occurred if Glass-Steagall had been left intact. In place of the 37-page Glass-Steagall act we now have the impossibly complex 2,319 page Dodd-Frank legislation.

Making major policy changes in gridlocked environments with large amounts of positive feedback is a formula for disaster. Such moves should be undertaken only out of absolute necessity. And when we do take these actions, we should attempt to lay out simple principles and leave the actual implementation to regulators who can, we hope, respond more quickly to dynamic situations.

Of course, overly zealous, imperious regulators are a real danger. Regulators get gridlocked as well. But they are less dangerous than the abrupt change created by complex laws filled with loopholes that are put in place in environments teeming with positive feedback.

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Bill Davidow is an adviser to Mohr Davidow Ventures and the author of Overconnected: The Promise and Threat of the Internet.

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