My colleague Todd Zywicki and I have a piece out in Lombard Street today on the proposed new Consumer Financial Protection Agency. The issue has a number of contributions from proponents and critics of the new agency. The piece is well timed, with President Obama making the case for the CFPA in his Wall Street speech and specifically linking failures of consumer protection with the financial crisis:
First, we’re proposing new rules to protect consumers and a new Consumer Financial Protection Agency to enforce those rules. This crisis was not just the result of decisions made by the mightiest of financial firms. It was also the result of decisions made by ordinary Americans to open credit cards and take on mortgages. And while there were many who took out loans they knew they couldn’t afford, there were also millions of Americans who signed contracts they didn’t fully understand offered by lenders who didn’t always tell the truth.
CFPA proponents, and now President Obama, have made this claim repeatedly in defending the CFPA. But to my knowledge, there is no empirical evidence to demonstrate that consumer mistakes in lending markets played a substantial role in causing the financial crisis. Zywicki and I expand on this point in the short article.
President Obama goes on to explain the claimed benefits of the new agency:
This is in part because there is no single agency charged with making sure it doesn’t happen. That is what we’ll change. The Consumer Financial Protection Agency will have the power to ensure that consumers get information that is clear and concise, and to prevent the worst kinds of abuses. Consumers shouldn’t have to worry about loan contracts designed to be unintelligible, hidden fees attached to their mortgages, and financial penalties – whether through a credit card or debit card – that appear without warning on their statements. And responsible lenders, including community banks, doing the right thing shouldn’t have to worry about ruinous competition from unregulated competitors.
Now there are those who are suggesting that somehow this will restrict the choices available to consumers. Nothing could be further from the truth. The lack of clear rules in the past meant we had innovation of the wrong kind: the firm that could make its products look best by doing the best job of hiding the real costs won. For example, we had “teaser” rates on credit cards and mortgages that lured people in and then surprised them with big rate increases. By setting ground rules, we’ll increase the kind of competition that actually provides people better and greater choices, as companies compete to offer the best product, not the one that’s most complex or confusing.
This last paragraph doesn’t make any sense to me. The President denies that the CFPA will restrict consume choice and says nothing could be further from the truth. But in the very next sentence, the President explains exactly how the agency will restrict consumer choice. The defense of the restrictions in consumer choice is that the CFPA will pick out choices that are bad for consumers, e.g. teaser rates on credit cards and mortgages. A restriction of choices viewed as “bad” by the new agency is still a restriction in choice. The Obama administration’s defense is that this restriction in choice is good for consumers because they make bad choices in financial product markets. Many have been persuaded by that argument. I am not. But I want to make highlight that I find it interesting that the President really seems to be saying that the CFPA will identify choices and “the kind of competition” that generates “bad” choices for consumers and eliminate them from the menu. I don’t understand how, given this argument, claims that the agency will restrict choice are “far from the truth.”
One can make a slightly more sophisticated claim that there will be no reduction in choice because, as those who have been following the CFPA debate will know, the new agency would also have power to approve “plain vanilla” lending products and could force lenders to offer the plain vanilla product before any alternative. In this scenario, proponents argue, consumer choice is not reduced because the non-vanilla product can still be offered. But notice that this “choice-neutral” interpretation of the CFPA assumes that: (1) the CFPA does not have the authority to simply prohibit some products outright, and (2) that any costs that the CFPA imposes on consumers demanding non-standard products or lenders wishing to offer them will not impact their profitability and, in turn, likelihood that lenders are willing to offer them or consumers incur the cost to select their preferred product. To the contrary, the CFPA does have the authority to ban products. And it is a relatively straightforward argument that just because the CFPA will allow the sale of non-vanilla products does not mean that we will not see a reduction in choice if the costs of buying and selling those products increase (and profitability decreases).
More generally, critics of the CFPA, including myself, are worried about the extremely wide latitutde the proposed agency will be granted in its ability to design products, prohibit products, and impose costs on consumer decisions to purchase (and lender decisions to offer) non-vanilla products. Given the CFPA’s explicit and deep links to the behavioral law and economics literature and its style of cost-benefit analysis, one can quite logically be concerned that the CFPA will exercise its authority to identify and prohibit “bad choices” for consumers in a manner that chills welfare-increasing forms of competition and product variety.
In any event, the right economic question, it seems to me, is whether the regulations promulgated by the CFPA with its authority are likely to improve consumer outcomes. This includes contributing to avoiding future financial crisis, obviously. With respect to the latter, I’ve seen no convincing evidence proferred by the administration or CFPA proponents that failures of consumer protection contributed to the financial crisis. With respect to the former, as discussed in greater length in the Lombard Street piece (and even greater length in a forthcoming paper on the CFPA with David Evans — look here soon for the link), the claims that consumer mistakes in consumer financial product markets justify the contemplated restriction in consumer choice and reduction in availability of credit from an economic perspective are even more dubious.
