Dean Sorensen column: Laws of Unintended Consequences

The Troubled Asset Relief Program (TARP), while aimed at recapitalizing the banking sector, has produced some unintended consequences, and the potential for similar harmful consequences exists in the American Recovery and Reinvestment Act of 2009.

The government's investment of more than $350 billion in bank preferred stock, with more government funds to follow, immediately provided needed liquidity in the banking sector. It was believed that this increased liquidity would ensure the survival of problem banks and allow banks to extend loans to businesses and individuals. These funds would then be used for investment and consumption, which would in turn help revitalize the economy.

The Federal Reserve administered financial stress tests designed to determine if the increased bank capitalization would be adequate to maintain the banking sector in the face of a possible further deterioration in the economy. Partial government ownership of banks -- along with congressional review of banks, the banking sector, and bank executive compensation -- was designed to identify problems, craft solutions, and restore public trust in the banking sector.

What have been the results so far?

Seeking relief from the intense public scrutiny and criticism of the past several months, banks and other financial institutions have unintentionally adopted a "make-no-mistakes" attitude. Fearful of making bad loans, bankers are making only a limited number of safe loans. As a result, banks are much better capitalized, but little funding is being made available for consumer and business loans.

Many banks are also actively searching for loan covenant violations in existing loans, in an attempt to call in these loans. Some banks are also attempting to re-price existing loans at higher rates and/or requiring additional collateral for existing loans.

LOCAL BANKERS, traditionally authorized to negotiate loans with long-term local business customers, no longer can make such loans. Loans now have to be reviewed and approved by bank "loan risk" officers who have limited direct knowledge of the customer and are frequently located in distant bank headquarters. The entire process is aimed at increasing bank profit and liquidity and avoiding the mistake of making loans that may go bad in the future. Forgotten in the process are long-term banking relationships with firms with excellent loan repayment records.

The industry today operates under a cloud of fear and mistrust. Many valuable long-term employees have left, and many of those remaining feel demoralized. Many banks are trying to return TARP funds, in an attempt to eliminate government ownership and meddling.

The American Recovery and Reinvestment Act of 2009 has the potential for producing similar, unintended, negative consequences. As Recovery Act funds are provided to state governments as part of the plan to stimulate the economy, state governments are reducing their own budgets because of under-realized tax revenue, partially cancelling the impact of Recovery Act funds. This approximately $1.5 trillion in previously unanticipated government expenditures will eventually lead to a greater federal budget deficit, a significant increase in the money supply, higher taxes, higher inflation, and lower economic growth.

UNFORTUNATELY, even the intended consequences of TARP, the Recovery Act, and concurrent Department of Treasury and Federal Reserve actions have not been well defined. If the intention was to save the banking system, TARP has been extremely successful. If the intention was to allow banks to extend loans to business and individuals, and thereby revive the economy, the intended outcomes have been less than successful. This uncertainty concerning intended outcomes makes it difficult to determine the effectiveness of government action. In many cases, unintended outcomes of government action may reduce or possibly eliminate the intended outcomes.

Where appropriate, all future legislation should include measures of anticipated outcomes, along with plans for the evaluation of the effectiveness of the legislation. Only by comprehensively identifying the intended outcomes of government action can problems of unintended consequences be resolved. Accurate measures can then be developed, data gathered, and reviews conducted to determine the effectiveness of such action. A better understanding of alternative approaches that the government might use to address these issues can be established. This information concerning the anticipated effectiveness of alternative approaches can then serve as valuable input for future government action.
Richard E. Sorensen, dean of Virginia Tech's Pamplin College of Business, serves on the Educators' Advisory Panel of the Government Accountability Office. He may be reached at .