In late February, Senator Chris Dodd of Connecticut, the Democratic chairman of the Senate Banking Committee, announced the showpiece of his financial-regulatory reform plan: a "Bureau of Financial Protection." It's fitting that the name of the proposed agency sounds faintly Soviet. Washington thinks that it can create a functional, healthy financial system from the top down, just as the Soviet Union's 20th-century central planners thought that they could create a functional, healthy economy from the top down.
What today's would-be financial fixers fail to grasp, though, is the same essential principle that Russian planners never understood. A healthy financial system, just like a healthy economy, is the indirect result of tens of thousands of free-market companies competing on a fair playing field and governed by consistent rules. It's not the direct result of a central-planning decree. There are no shortcuts here.
Dodd's "Bureau of Financial Protection" would have a worthy goal. Like the White House's proposed "Consumer Financial Protection Agency," it would aim to protect regular Americans -- consumers -- from dangerous financial products like the "exotic" teaser-rate mortgages that lured tens of millions of Americans into so much trouble at the height of the real estate bubble.
Though Congress hasn't yet finalized the details, the new agency could approve financial products such as the mortgages and credit-card offers that banks and other financial firms offer. The agency likely could decide, in some cases, that a financial innovation is simply too dangerous for the public to handle.
The problem, though, is that a central bureaucracy can't predict from on high what's good for consumers, what's slightly bad and what's unacceptably toxic. Take, for example, a mortgage with a high fixed interest rate that a bank could offer to home buyers with bad credit. In offering such a loan, does a financial institution take advantage of someone with few other options for immediate home ownership? Or does the institution do the borrower a service by giving her an option to buy rather than keep renting -- a choice that she otherwise would not have -- while compensating its shareholders for the higher risk?
Or consider a high-interest credit card. Is such a card an example of predatory lending? Or is it an opportunity for an entrepreneur who needs a few thousand dollars in ready cash to buy supplies for a new business, but can't borrow from a bank? What about those tempting checks your credit-card company sends you at Christmastime? It seems pretty terrible for a card company to seduce borrowers into making purchases that they can't afford. But a construction worker with no work in a cold snap could consider the checks to be a lifeline, as they could allow him to pay the rent as he awaits springtime work.
Washington's previous forays into the consumer-lending arena don't indicate that the government can adequately protect consumers from bad financial decisions. In 2009, Congress and President Obama approved an $8,000 tax credit for first-time homebuyers. The credit came with an expiration date of last November (later extended five months). The credit was a high-pressure sales tactic designed to tempt unsophisticated buyers into the housing market -- even though there was no indication that housing prices had bottomed out in many markets by the credit's expiration date. Many buyers, then, would have been better off waiting.
Washington has similarly preyed on existing homeowners. The Obama administration's mortgage-modification plans have temporarily slashed interest rates to encourage people to keep paying mortgages on houses whose values have plummeted. Many borrowers would be better off turning in the keys and renting a similar house at a much cheaper monthly cost, saving the balance, say, for their kids' education. If a financial institution, without government approval, proposed such plans to keep homeowners saddled with debt on assets that aren't worth the borrowed money, the institution would rightly merit a government rebuke.
On the topic of education, federally guaranteed student loans are another way in which Washington takes advantage of borrowers. Government student-lending programs, of course, allow many middle-class students to attend elite universities and earn millions of dollars more than they otherwise would have over their lifetimes. But the programs also encourage some impressionable teenagers and 20-somethings to take on tens of thousands of dollars worth of debt that can't be discharged in a bankruptcy to take financially worthless master's degrees in, say, creative writing. If the government didn't support such loans, Dodd's proposed Bureau of Financial Protection would likely come calling. But it's safe to say that the protection agency, if enacted into law, will protect education-loan merchants rather than their customers.
The point is that no large institution, whether it's the federal government or Citigroup, can know what's good for each individual. That's why we need competition, variety and disclosure, to such a degree that no government agency could possibly micromanage it all. That way, people can decide what's right for them, sometimes rightly and sometimes wrongly. When government bureaucrats from the Soviet Union visited American supermarkets, they famously couldn't understand why American stores offered four different brands of baked beans. But competition improves quality and prices, in financial services as well as in legumes.
Real competition, though, requires the credible threat of failure. Financial institutions and their shareholders and creditors must know that they will pay a price if the financial firms lend customers so much money that those customers will never be able to pay it back.
Indeed, the real story of the credit crisis and Great Recession isn't that America was missing some sort of benevolent financial authority to decree what kind of lending was safe and what wasn't. Instead, the story is that for two and a half decades -- since Washington first started bailing out "too big to fail" banks in the eighties and protecting their bondholders and other uninsured lenders from losses -- the credible, consistent threat of failure has been nonexistent in the financial industry.
Under Washington's too-big-to-fail policy toward finance, bondholders who invested in financial industry firms knew that making such investments was akin to investing money with the U.S. Treasury. It's no surprise, then, that bondholders lent and lent and lent to the financial industry -- and that financial firms turned around and profligately lent that money right back to consumers, whether through mortgages or credit-card debt.
When the government subsidizes something, it gets more of it -- whether that something is corn in Iowa or reckless financial industry debt that manifests itself in unsustainable consumer borrowing. The culprit of the credit crisis isn't "exotic" mortgages or impossible-to-understand loan agreements but, simply, too much debt. Mortgages with initial teaser rates were only a symptom of this problem, not the problem itself.
Today, too-big-to-fail is alive and well. Even the savviest team of government bureaucrats, then, has no chance of protecting consumers against the market signal that the government is sending to investors: that it's OK to keep lending without a care to the financial industry, because the industry has access to bailouts on demand.
The best way to protect consumers is not for the government to approve every iteration of a mortgage on a case-by-case basis, but for the government to make it clear to financial firms and their investors that there's a price to pay for unwise lending. That means creating a regulatory system in which big banks and other complex financial firms aren't too big to fail.
The government can accomplish this goal with a few simple rules. For example, Washington should require that borrowers make a substantial down payment -- 10 to 20 percent or so -- on any speculative investment, including a home, just as regulators have long required in the stock market and in old-fashioned derivatives markets. That way, when borrowers and lenders make a big mistake, they can do so without leaving so much unpaid debt behind that it bankrupts the economy -- requiring the massive bailouts that investors in financial companies have come to expect.
Congress should also revisit the bankruptcy "reform" that it passed in 2005, which made it more difficult for all but the poorest Americans to escape their debt burdens and thus win a second chance after making bad decisions. Lending is supposed to carry risk for the lender as well as for the borrower. That's the only reason lenders set interest rates according to the risk that they perceive -- to compensate themselves for the risk they're shouldering.
Financial firms must perceive an actual market risk in lending irresponsibly. They, and their investors, must know that they risk customer default and company bankruptcy if they miscalculate. Therein lies a market solution to the problem of the irresponsible lending that harms consumers. Just as free markets are the best way to get unglamorous beans into grocery stores, they're also the best consumer protection for which Americans can hope.
Nicole Gelinas, contributing editor to the Manhattan Institute's City Journal, is author of After The Fall: Saving Capitalism From Wall Street -- and Washington.