Keep It Simple: A New Take On Regulation

The complexity of the modern world can seem overwhelming. The world moves faster every day, and despite obvious advances in technology and living standards, public officials see the chaos of life and seek ways to soften the world’s edges. The great temptation is to match the world’s growing complexity with corresponding rules and programs that help citizens and firms navigate the tumult.

Evidence increasingly suggests, however, that the content, number, and unforeseen interplay of these multiplying rules is doing far more harm than good. The economy’s continued underperformance, therefore, offers an opportunity to fundamentally reexamine our approaches to regulation and public finance. We believe such a reexamination will suggest a stark new path: one that demands simple rules for a complex world.1

Two examples highlighted below suggest bad rules can even begin with the very best of intentions. Yet, the results can be catastrophic.

A Labor Market Example

In the wake of the Great Recession, the employment-to-population ratio has dropped to around 58% from an average in the decade preceding the Great Recession of around 63%. Beyond the official unemployment rate, millions of Americans have stopped working. The initial wave of Baby Boomer retirements explains only a small part of this work slump. One of the prime culprits is our well-meaning but complex social safety net, which too often hurts the people it is meant to help.

Gary Alexander, the public welfare commissioner of Pennsylvania, summarized the complexity and perversity of the safety net in a simple chart.2 Programs like Medicaid, food stamps, the earned income tax credit (EITC) and other cash support, child care, Head Start, and housing, heating, and transportation subsidies are intended to mitigate hardship. The compounding effect of these programs, however, often discourages work and marriage, and, over time, depletes human capital.

As Alexander shows, a single mother, taking advantage of the transfer programs, is better off earning $29,000 a year than she is earning $69,000 a year. The value of the benefits declines much faster than her income rises. I have drawn two additional dashed black lines to show other extreme perversities: in terms of total net income and transfers, the Pennsylvania single mother is better off making $9,000 than $64,000. She is even better off earning zero than she is earning $50,000! At many points along the income curve, her marginal tax rate is well over 100%.

 Casey Mulligan, an economist at the University of Chicago, thinks these and other support programs, such as unemployment and disability insurance, are a chief cause of the prolonged economic slump. In his book, The Redistribution Recession, Mulligan estimates that as unemployment, food stamps, disability, and other programs were expanded during the downturn, the average marginal tax rate for this income range jumped to 48% from 40%.3 

These policies don’t affect everyone in the same way. At the margin, however, these policies discourage work and human capital formation—and thus, economic growth.

A Capital Market Example

There is another recent example where the interaction of multiple well-intended rules has been even more dynamic, unpredictable, and acutely harmful. The financial panic of 2008 was the biggest economic calamity since the Great Depression. The proximate cause was a housing boom and bust, especially in subprime mortgages. Yet, as Federal Reserve Chairman Ben Bernanke noted, “The stock market goes up and down every day more than the entire value of the subprime mortgages in the country.”4  The collapse was far sharper, bigger, and more complicated than a mere housing downturn could explain.

Who could have predicted that four sets of well-meaning and seemingly unrelated policies, offered by smart and reasonable people, would combine to yield an historic crash? Each of these policies could be defended at the time, and many defend these policies even in retrospect. Some of the policies even achieved their intended effects. One does not have to oppose these policies, in part or in whole, to acknowledge how they mixed to form a poisonous brew.

  • Fannie Mae and Freddie Mac subsidized home lending and borrowing.
  • The Fed’s 1% rate (and subsequent negative real interest rates), along with Treasury’s weak-dollar policy, inflated prices of hard assets such as homes, oil, and other commodities.
  • In an attempt to encourage banks to hold safe assets, Basel capital guidelines and the RecourseRule of 2001 created insatiable demand for “AAA” securities.
  • Targeting financial transparency, mark-to-market (fair value) accounting instead created opacity and helped detonate and sustain a panic.
  • In 2006, the housing market peaked and subprime mortgage delinquencies and defaults began to rise. Yet, as Bernanke noted, the size of this market was not nearly large enough to sink the entire economy. 5

Banks had accumulated mountainous piles of AAA mortgage backed securities (MBS) to fulfill capital guidelines under Basel and the Recourse Rule. After home prices peaked, arguments erupted about the true value of these mortgage securities. These arguments would stretch out for years, but because of the practice of mark-to-market accounting, these “marks” were now treated as real prices and they filtered through financial markets.

The industry had packaged millions of mortgages into complex securities designed to achieve AAA ratings. The inclusion of faltering subprime mortgages in some of these AAA bonds meant some of the AAA ratings were suspect. Many, or even most, of the world’s AAA bonds, however, were in fact fairly described as AAA. The rules, regulators, and accountants, however, found it very difficult to discriminate. Firms were forced to mark “prices” in an illiquid, non-functioning market.

These indiscriminate mark-downs spread in waves across the financial landscape.6  Mark-downs reduced bank capital. To maintain their regulatory capital floors, firms had to sell more assets. Prices fell further. Capital plunged again. Ad infinitum. It was a fire sale, a panic.

This series of events led to an historic lending contraction. In all, $500 billion in mark-downs of MBS and other asset-backed securities led to trillions in reduced lending capacity. The interaction of housing and monetary policy and capital and accounting guidelines amplified the impact beyond almost anyone’s worst imagination. As John Allison, the former CEO of BB&T bank concluded, “Accounting systems should never drive economic activity. They should reflect it. Fair-value accounting significantly contributed to the collapse of liquidity in capital markets (in 2007-2009).”7

A Path to Pro-Growth Policy

We could easily supplement the preceding two stories. The U.S. tax code, for example, is an infamous morass. Or consider that even as we write rules for a new Internet age, the Communications Act of 1934 still mandates the deployment and maintenance of copper wires and telephone switching equipment that ever-fewer people use. Complex rules can distort markets and hurt the economy directly. They also do so indirectly, by diverting resources toward unproductive activities. Vast sub-industries of lawyers, accountants, and consultants are needed to navigate, avoid, and exploit government’s complex web.

The challenge is greater than ever because policymakers and regulators increasingly are succumbing to the temptation and offering ever-more complex rules for a complex world. The Dodd-Frank financial reforms, for example, fill 2,319 pages and call for 243 new rules. The Volcker Rule alone is 298 pages. Obamacare, likewise, is more than 900 pages, and regulators have already issued more than 3 million words of accompanying rules.

As a first step toward the development of a systematic way of evaluating public policy, we submit the following table listing some attributes and examples of both good rules and bad. 

In a remarkable essay called “The Dog and the Frisbee,” Andrew G. Haldane of the Bank of England perhaps said it best:

Because complexity generates uncertainty, not risk, it requires a regulatory response grounded in simplicity, not complexity.   

Delivering that would require an about-turn from the regulatory community from the path followed for the better part of the past 50 years. If a once-in-a-lifetime crisis is not able to deliver that change, it is not clear what will. To ask today’s regulators to save us from tomorrow’s crisis using yesterday’s toolbox is to ask a border collie to catch a frisbee by first applying Newton’s Law of Gravity.8 



1 Epstein, Richard A. Simple Rules for a Complex World. Harvard University Press. 1995.

2 Alexander, Gary. “Welfare’s Failure and the Solution.” American Enterprise Institute. July 2012.

3 Mulligan, Casey B. The Redistribution Recession. Oxford University Press. New York. 2012.

4 Financial Crisis Inquiry Commission. Financial Crisis Inquiry Report. 2011. p. 227.

5 For additional critiques of mark-to-market (fair value) accounting, see: Isaac, William M. Senseless Panic. Wiley. 2010; and Allison, John A. The Financial Crisis and the Free Market Cure. McGraw-Hill. 2012.

6 See, for example, Stanton, Richard, and Nancy Wallace. “The Bear’s Lair: Index Credit Default Swaps and the Subprime Mortgage Crisis.” June 1, 2011.

7 Allison, John A. The Financial Crisis and the Free Market Cure. McGraw-Hill. 2012.

8 Haldane, Andrew G. “The Dog and the Frisbee.” Kansas City Federal Reserve Jackson Hole Conference. August 31, 2012.