The Financial Reform Fiasco

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.

Predatory Politics

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.