One of the three problems I’ll cover as regards resorting to legislation to deal with societal issues is that politicians throughout history have been shown to have been incapable of considering more than 1st order consequences. They have scant interest in 2nd order consequences and don’t even give a thought to 3rd order consequences. And it is these 2nd and 3rd order consequences that have the most impact, and usually unintended adverse consequences causing much bigger problems.
Consider these few examples:
Albanese / Chalmers CGT change
The Albanese / Chalmers Labour government, possibly to avert or arrest future fiscal deficits, decided to remove the CGT (capital gain tax) discount. All else being the same, this would (mathematically) increase the amount of CGT the government would collect. That’s a 1st order consequence. A 2nd order consequence that comes to mind is that those who own assets, such as a property or shares in a business, will not sell. If they need cash, they’ll borrow against the value of that asset. Because they decide not to sell when they would otherwise have sold, no GST is payable and so government collects far less in tax, the opposite of what it tried to achieve. Third order consequences are harder to predict and even harder to quantify. Entrepreneurs and prospective entrepreneurs could leave for greener pastures, resulting in less income and CGT payments to government and fewer jobs. Parties seeking additional capital will find it a lot more difficult to find – because investors will be reluctant to switch out of (sell) an asset to invest in that venture. That would lead to lost business, tax and job opportunities. Also, parties seeking capital will need to pay a lot more for it – to offset the investor’s CGT payment on switching assets. As a result, capital won’t more to the better businesses, which now cannot grow or not grow as fast and that has adverse profit, tax, and employment consequences. The lower profits nd employment will translate into lower dividends, performance bonuses and salaries, which will reduce the amount of money those recipients would otherwise have spent in the market. Then other suppliers will have less demand for their products, and so on.
Abolishing the gold standard in 1914
Prior to the outbreak of World War I, the British pound was the world’s reserve currency nd London the centre of global finance. During this period Britian and other trading countries adopted the gold standard, the effect of which was that a person could exchange their paper money for a predetermined weight of gold. At the outbreak of WWI Britian and other European countries realised that their gold reserves were insufficient to fund their war effort – so they dropped convertibility of money into gold. This enabled them to borrow and just print more money. All did so heavily, some more than others. This could be considered a 1st order consequence. The second order consequence was that the significant increase in money supply debased their currencies and resulted in inflation and hyperinflation in Germany and Russia. The third order consequences could include the Russian revolution, the rise of Stalin and Hitler, Britain becoming a debtor nation (mainly to the USA), the British pound being replaced by the USD as the world’s reserve currency, and London losing its status as the financial centre of the world. While attempts were made to go back to a gold standard or similar, those failed and ultimately abandoned in 1971, when Nixon terminated the Bretton-Woods arrangement, which gave foreign central banks the right to convert USD to gold. Thereafter the world has operated on fiat currencies, with the USD as the world’s reserve currency. Without this money supply limitation, debt obligations of the USA and many other countries around the world, including Australia, skyrocketed. Was this all contemplated in 1914? Absolutely not!
The Bubble Act of 1720 to the USD 10 trillion shadow bank today
An excellent piece by The Timeless Investor, Arie van Gemeren, titled “The $10 Trillion “Shadow Bank” Nobody is Talking About (Today) and the Historic Parallel” The $10 Trillion “Shadow Bank” Nobody is Talking About (Today) and the Historic Parallel, shows the unintended long-term consequences that have flowed from the 1720 Bubble Act, which was enacted at the behest of the South Sea Company. It achieved its 1st order objective of outlawing competition for capital, but created unintended consequences. It drove the market for capital into the dark for over a century, causing enormous opportunity costs to the economy, which prompted fresh legislation that caused other problems, repeating the classic pattern of:
A problem emerges in the visible, regulated sector. Legislation/regulation is passed to eliminate it, which it cannot do. The underlying appetite (the buy and sell side of capital) remains, so the market for it moves into the shadows. Over time the shadow market grows so large it threatens global economic stability. New rules are then written to pull the activity back into the light to contain the new monster. The cycle repeats. It repeats because the underlying appetite by borrowers remains as does that for investors seeking return.
His piece shows that the 1720 Bubble Act pushed capital formation into the shadows for a century. Some 300 years later, in 2006, the FAS 157 rule tried to drag everything into the light but instead served as an accelerant to the downward spiral in asset values during the 2008 GFC, exacerbating the crisis. The Dodd-Frank and Basel II/III were introduced to address the problem caused by FAS 157. It required banks to hold more capital for riskier assets. Another noble 1st order consequence, but it has unintentionally created a monster – an opaque multi-trillion-dollar private credit industry, partly funded by banks – effectively putting the riskier instruments back on their books but with less capital allocation. Will the regulators tackle this monster before a severe default cycle hits, what will it do and what unintended consequences will flow from it?
Markets do not respond to simple prohibitions or mandates the way legislators intend. Rules change where and how the activity occurs but don’t eliminate the underlying drivers. The water keeps flowing, it just finds another way through and that becomes a channel.
The conclusion draw from it is that it is futile trying to regulate markets because it doesn’t eliminate the risk exposure for society, that risk exposure merely moves somewhere else. It would be far better for government to get out of the way – to leave the market to find a way to identify and assess risk. Once a market is regulated, the participants carrying the risk (lenders and investors) assume the risk is low and fail to properly assess it. For example, prior to the GFC, fund managers, municipalities and regional banks around the world relied exclusively on the credit rating assigned to the instrument. They didn’t assess the risk or even question the rating. And those on the other side, the sellers, did what humans are naturally inclined to do, confidently espouse the merits of their product. The buyers were caught because they did not exercise their survival instincts humans have developed since the dawn of time. They didn’t do so because they relied on an authoritative party having done so.
I’ve now covered the first of the three problems I mentioned with resorting to legislation to deal with societal issues / concerns. The other two, I’ll just touch on.
One of them is that legislation needs to be enforced, and history has shown regulators, reliant on humans and their frailties, have been shown to have slipped up badly, while others have revelled in their newfound power to be draconian, unreasonable and completely losing sight of the legislative intention.
The third and final problem I wanted to mention is that interpretations of laws and regulations are determined by judges – by people who are accountable to nobody, who can be dishonest, biased, ignore evidence, make up stuff, fail to perform their fundamental duty and still face no adverse consequences. It is also apparent that judges have become fixated on strict interpretations of laws, ignoring legislative intent and ignoring their fundamental duty to administer justice. They also do not consider 2nd order consequences of their decisions. That is patently not meeting society’s needs. They are acting as machines, not capable of individual thought.
To wrap up – I am not going so far to say we should not regulate financial markets, just that we should have minimal regulation and need to ensure it does not interfere with natural human behaviour for advancement on the one hand and survival instincts on the other. Government can assist in highlighting risks and stopping unconscionable behaviour such as fraud, misrepresentation and so on.
Written by Mark M.J. Morris (June 2026)