Regulation and cultivating ignorance

by Rob Horning

3 March 2010


The Roosevelt Institute’s Make Markets Be Markets conference I mentioned tin a previous post is taking place today. Felix Salmon directs attention toward Elizabeth Warren’s talk, which presumably is based on this paper (pdf) from the report. Warren argues that because of the regulatory shambles, consumer-credit companies can use obfuscatory complexity to confuse and exploit their customers, who have next to no vanilla alternatives. Salmon summarizes:

In 1980, noted Warren, Bank of America’s credit card agreement was one page and 700 words long; today it’s 30 pages of dense legalese. Banks will never willingly return to a world of 700-word credit card agreements, not when their profits from consumer finance are almost entirely a function of forcing consumers into paying hidden fees they don’t understand at the outset.

From the point of view of ordinary consumers, financial innovation is so much disorienting and distracting flim-flam from snake oil salesmen. Its purpose is not efficiency so much as it is the manufacture of information asymmetries with a captive population. So the main goal of any financial consumer-protection regime would have to be simplification. As Warren explains in the paper, “Shorter, clearer contracts will empower consumers to begin making real comparisons among products and to protect themselves. Better transparency will mean a better functioning market, more competition, more efficiencies, and, ultimately, lower prices for the families that use them.”

Banks would likely protest that without their “innovations” it won’t be profitable for them to lend as much, and marginal borrowers would find themselves unable to get credit and unable “to pursue the American dream” etc., etc. But banks have seemed to count on marginal borrowers being ignorant borrowers; they seems to have designed their contracts precisely to give loan officers incentives to find ignorant borrowers. And ignorant borrowers, by definition, are riskier since they have no real understanding of the contract they are entering into. This played out as the explosion of subprime lending, which was lucrative upfront for banks but patently unsustainable over the long haul. When the refinancing merry-go-round ended, the whole edifice came crashing down.

Warren notes that consumer-protection regulation won’t eliminate ignorance or cupidity, but it can curtail its deliberate cultivation: “Nothing will ever replace the role of personal responsibility.  The FDA cannot prevent drug overdoses, and the CFPA cannot stop overspending.  Instead, creating safer marketplaces is about making certain that the products themselves don’t become the source of trouble.” She addressing the “moral hazard” critique of consumer protection regulation—the idea that people won’t take any responsibility for their decisions if they think the government is out there making sure they can’t make any mistakes. But the goal is not to make it structurally impossible for people to make bad decisions; the goal is to allow for a level playing field on which informed decisions can be made, so that responsibility can be morally inferred. As it stands, it’s hard to argue that borrowers be punished for being snared by predatory lending practices.

Salmon points out that the Fed can’t be expected to enforce regulations that protect consumers:

prudential regulators, meanwhile, exist to make those banks healthier: they like anything which generates income and profits, and have historically not cared in the slightest if such products are only profitable because they rip off consumers with moderate financial literacy. If they end up housing the CFPA, the CFPA will never be allowed to force the banks into the world of simplicity and honesty that we financial consumers so desperately need.

The upshot is we seem to live in a society in which the health of banks seems to come at the expense of consumers, and the state is caught in the middle of that. It is supposed to mediate between the conflicting interests. But since the deregulatory wave hit in the 1970s and ‘80s, it has been inclined to do nothing and sell that to the people who get screwed as the “benefits of small government.” Unless a credible check to the pro-banking forces is set up within the state, consumers will continue to have no way to balance their interests against those of banks and will continue to be prey.

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