{"id":2687,"date":"2010-08-16T10:42:49","date_gmt":"2010-08-16T18:42:49","guid":{"rendered":"http:\/\/hodakvalue.com\/blog\/?p=2687"},"modified":"2010-08-16T10:59:45","modified_gmt":"2010-08-16T18:59:45","slug":"the-central-question","status":"publish","type":"post","link":"http:\/\/hodakvalue.com\/blog\/the-central-question\/","title":{"rendered":"“The central question…”"},"content":{"rendered":"

David Leonhardt suggests that<\/a> “The part of the [financial services overhaul] law that will directly affect the most people will be the new Consumer Financial Protection Bureau<\/span>, which has already been the subject of heated debate. And the central question <\/strong>facing the bureau will be how to distinguish between corporate malfeasance and consumer frailty.”<\/p>\n

This is how I would expect a NYT columnist to see the central question, i.e., as a distinction that experts must make about when a financial instrument or transaction goes from being merely too hard for someone understand to being deceptive.\u00a0 While many pundits and readers no doubt share this view of “the central question,” I think it distracts us from far more interesting questions:<\/p>\n

– Does there actually exist a line of demarcation between a complex versus a deceptive financial instrument?\u00a0 A seven year balloon mortgage might be perfectly sensible for someone planning to live someplace for only four or five years.\u00a0 It might be silly or dangerous for someone without any plan other than to refinance when their home value goes up.\u00a0 You can’t judge a financial instrument–like a balloon mortgage–apart from the way it is being used, any more than you can judge a knife apart from how it’s being used, i.e., by a capable cook or by a someone who shouldn’t be around sharp objects.\u00a0 But the CPFC is not about improving financial literacy among our most vulnerable–it’s about regulating every financial services provider regardless of their capabilities<\/a> or track record<\/a> of providing value for their customers.<\/p>\n

– If the problem is not the instrument or transaction but the financial sophistication of the persons involved, how effective can one be regulating the instruments or transactions themselves?\u00a0 Leonhardt spouts the party line:\u00a0 “More often than not, [the CPFC] will allow banks to continue a given practice \u2014 but force them to explain, in clear terms, what it means for consumers.”\u00a0 As if getting lawyers more involved in a transaction will help clarify its terms for the layman.\u00a0 How many times has that happened in history?<\/p>\n

– Assuming the best intentions among the regulators, how will they balance the need for financial innovation with the need to protect vulnerable consumers?\u00a0 With most of the electorate believing that “financial geniuses” were responsible for the meltdown, there is nothing in the political calculus weighing in favor of Wall Street cooking up anything good under any circumstances.\u00a0 The penalties of allowing someone who got rooked in some deal from wailing on the pages of the NYT will far outweigh the largely invisible benefits of innovations that didn’t happen.\u00a0 By an organizational necessity we have seen many times before, this regulatory agency will develop a bias against approving new financial products, a bias that can only be outweighed by vigorous lobbying.<\/p>\n

– So, let’s not pretend that the CPFC will be insulated from politics.\u00a0 Although the CPFC is largely intended to be a disclosure regime, it has nevertheless been given the power to review, approve, and potentially ban financial instruments or transactions.\u00a0 How will it ultimately decide which to ban?\u00a0 In theory, it would do so based on their danger to the least financially literate consumer.\u00a0 But that’s a useless distinction that could apply as much to common equity as to exotic derivatives.\u00a0 Granting them the power to ban products for what are necessarily arbitrary reasons is a recipe for politicized decision-making.\u00a0 Those who invest most in dealing with the agency have the best chance of eventually getting their products approved.\u00a0 The regulators and their patrons in Congress will basically be in the position of asking the banks “how much is in your<\/em> wallet,” and all banks will be lobbying like Fannie and Freddie in the new regime.\u00a0 That’s how fine distinctions are made in Washington.<\/p>\n

– Does it even matter that a balance get struck between complexity versus deceptiveness, or between innovation versus danger?\u00a0 Probably not.\u00a0 With the average NYT reader so easily sold on the premise that financial service providers are indifferent to, or actively working to ruin their customers, and that a small army of bureaucrats can effectively prevent bad things from happening to dumb people, the regulators will certainly be encouraged to a zealous start.\u00a0 If history is any guide, we will have to depend on a courageous few bureaucrats who see the crushing effects of their rules<\/a>, using their common sense to begin to strike such a balance.\u00a0 These courageous bureaucrats will be vilified by progressives as “captured” by those they are supposed to regulate.<\/p>\n

What is missing from this analysis–the key to a much better “central question”–is that every rule the bureaucrats come up with has four consequences:<\/p>\n

1)\u00a0 It will make communications between the service provider and customer more complicated, putting the least financially literate consumer at a disadvantage.\u00a0 I mean, count the number of times that getting lawyers involved in communications has helped clear things up.\u00a0 That is why the comment<\/a> “Done right, the new bureau can begin to…require banks to speak in the language of customers, not internal bureaucracy” is such a lunatic expectation.<\/p>\n

2)\u00a0 It will raise the costs to the service provider and, by necessity, to the customer.\u00a0 Those lawyers and their accompanying army of compliance experts don’t come cheap.<\/p>\n

3)\u00a0 It will slow useful innovation that must now get over the hurdle of arbitrary rules.\u00a0 Imagine how a computer industry would develop with a regulator making sure that hardware and software are always compatible, or that the software never causes the computer to crash, etc.\u00a0 Can’t imagine such a computer industry?\u00a0 Just picture the computer world of 1990 being our world today.\u00a0 The miracle of Windows 3.0 (without the bugs)!!\u00a0 A (non-crashing) GUI interface on every desk!!\u00a0 The irony is that we wouldn’t miss a thing.<\/p>\n

4)\u00a0 It will speed up useless innovation in an effort to get around the rules.\u00a0 The day after Glass-Steagall was passed separating investment banks from commercial banks, investment banks began inventing derivative instruments to re-create the debt exposures that were nominally forbidden to them, and commercial banks began inventing derivatives to re-create the equity exposures that were nominally forbidden to them.\u00a0 Nearly all of the complexity that evolved in our financial system over the last seven decades was this useless kind done simply to get around rules that banks in Canada, Europe, or Asia didn’t have to deal with.<\/p><\/blockquote>\n

History is quite clear on the progress of increasingly regulated industries:\u00a0 the more regulated they become, more inwardly focused they are with regards to compliance and regulatory concerns, and the less time, money, and attention they have to deal with customer concerns.\u00a0 As the fixed costs of compliance go up, so do barriers to entry in that industry, thwarting the kind of competition that would spur useful innovation, quality improvements, and better customer focus.\u00a0 The customers that fare best in this ecosystem are the most sophisticated, the most able to decipher and arbitrage the regulatory regime to their advantage. \u00a0\u00a0 This is what happened to increasingly regulated railroads, utilities, telephone services, trucks, airlines, you name it.<\/p>\n

Having lived through railroad deregulation, it was like a huge weight lifted off our chests.\u00a0 Suddenly, we could charge our customers whatever we wanted (oh my!) and guess what?\u00a0 Our prices began to fall.\u00a0 They fell because we no longer had an army of tariff clerks and lawyers to go through when setting a price for a route.\u00a0 This allowed us to experiment with prices in order to attract more business, including reducing prices, even to our captive shippers (the people who needed to be protected from the big, bad railroad) without fear that whatever breaks we gave them in order to make them more competitive would get enshrined into law.\u00a0 And we were free to get rid of unprofitable routes (oh my!).\u00a0 That encouraged us, and a slew of new entrants, to establish new services without an army of lawyers, and without fear that any new service would become an entitlement for some industry.<\/p>\n

We are facing the reverse of this process in financial services.\u00a0 While Leonhardt is asking about malfeasance versus frailty, I think a much better central question<\/strong> is:\u00a0 how much should regulators get between the providers of financial services and their customers in the name of protecting the latter while raising costs, complexity, and barriers to entry for everyone?\u00a0 Wouldn’t we have been much better off (all of us outside the government, anyway) by taking the budget for the CPFC and dedicating it to raising or our general financial literacy.<\/p>\n

Progressives accuse financial services providers of preying on the financially illiterate.\u00a0 I would argue that progressives prey on financial illiteracy in order to secure more money and more power for the government they wish to control.\u00a0 Unfortunately, government has the ultimate barrier to entry–a monopoly on violence that effectively prevents any challenge to its authority.\u00a0 So, unlike a failed business model that can get wiped away by the market, the government’s policy failures become an enduring part of the nations landscape, until evidence of its failure becomes obvious to even the most economically illiterate voter.\u00a0 By then, we have lost a entire generation of useful innovation.<\/p>\n","protected":false},"excerpt":{"rendered":"

David Leonhardt suggests that “The part of the [financial services overhaul] law that will directly affect the most people will be the new Consumer Financial Protection Bureau, which has already been the subject of heated debate. And the central question facing the bureau will be how to distinguish between corporate malfeasance and consumer frailty.” This […]<\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[10,9],"tags":[],"class_list":["post-2687","post","type-post","status-publish","format-standard","hentry","category-invisible-trade-offs","category-unintended-consequences"],"_links":{"self":[{"href":"http:\/\/hodakvalue.com\/blog\/wp-json\/wp\/v2\/posts\/2687","targetHints":{"allow":["GET"]}}],"collection":[{"href":"http:\/\/hodakvalue.com\/blog\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"http:\/\/hodakvalue.com\/blog\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"http:\/\/hodakvalue.com\/blog\/wp-json\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"http:\/\/hodakvalue.com\/blog\/wp-json\/wp\/v2\/comments?post=2687"}],"version-history":[{"count":15,"href":"http:\/\/hodakvalue.com\/blog\/wp-json\/wp\/v2\/posts\/2687\/revisions"}],"predecessor-version":[{"id":2702,"href":"http:\/\/hodakvalue.com\/blog\/wp-json\/wp\/v2\/posts\/2687\/revisions\/2702"}],"wp:attachment":[{"href":"http:\/\/hodakvalue.com\/blog\/wp-json\/wp\/v2\/media?parent=2687"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"http:\/\/hodakvalue.com\/blog\/wp-json\/wp\/v2\/categories?post=2687"},{"taxonomy":"post_tag","embeddable":true,"href":"http:\/\/hodakvalue.com\/blog\/wp-json\/wp\/v2\/tags?post=2687"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}