Financial Invention vs. Consumer Protection - Commentary by Professor Robert Shiller
"Financial Invention vs. Consumer Protection"
By Professor Robert J. Shiller
Published in the New York Times July 19, 2009
Read the article in its original context on the New York Times website.
James Watt, who invented the first practical steam engine in 1765, worried that high-pressure steam could lead to major explosions. So he avoided high pressure and ended up with an inefficient engine.
It wasn’t until 1799 that Richard Trevithick, who apprenticed with an associate of Watt, created a high-pressure engine that opened a new age of steam-powered factories, railways and ships.
That is how innovation often proceeds — by learning from errors and hazards and gradually conquering problems through devices of increasing complexity and sophistication.
Our financial system has essentially exploded, with financial innovations like collateralized debt obligations, credit default swaps and subprime mortgages giving rise in the past few years to abuses that culminated in disasters in many sectors of the economy.
We need to invent our way out of these hazards, and, eventually, we will. That invention will proceed mostly in the private sector. Yet government must play a role, because civil society demands that people’s lives and welfare be respected and protected from overzealous innovators who might disregard public safety and take improper advantage of nascent technology.
The Obama administration has proposed a number of new regulations and agencies, notably including a Consumer Financial Protection Agency, which would be charged with safeguarding consumers against things like abusive mortgage, auto loan or credit card contracts. The new agency is to encourage "plain vanilla" products that are simpler and easier to understand. But representatives of the financial services industry have criticized the proposal as a threat to innovations that could improve consumers’ welfare.
As the story of the steam engine shows, innovation often entails tension between safety and power. We need to foster inventions that better human welfare while incorporating safety mechanisms that protect the public. Could the proposed agency accomplish this task?
The subprime mortgage is an example of a recent invention that offered benefits and risks. These mortgages permitted people with bad credit histories to buy homes, without relying on guaranties from government agencies like the Federal Housing Administration. Compared with conventional mortgages, the subprime variety typically involved higher interest rates and stiff prepayment penalties.
To many critics, these features were proof of evil intent among lenders. But the higher rates compensated lenders for higher default rates. And the prepayment penalties made sure that people whose credit improved couldn’t just refinance somewhere else at a lower rate, thus leaving the lenders stuck with the rest, including those whose credit had worsened.
This made basic sense as financial engineering — an unsentimental effort to work around risks, selection biases, moral hazards and human foibles that could lead to disaster.
This might have represented financial progress if it weren’t for some problems that the designers evidently didn’t anticipate. As subprime mortgages were introduced, a housing bubble developed. This was fed in part by demand from new, subprime borrowers who now could enter the housing market. The bursting of the bubble had results that are now all too familiar — and taxpayers, among others, are still paying for it all.
This raises a question: If a consumer agency had been set up 20 years ago, would the subprime mortgage crisis have been prevented? We don’t know, but it seems improbable.
Such an agency would most likely have slowed some abusive practices, like offering low teaser rates on adjustable-rate mortgages and hiding information about future rate increases in fine print that most people do not read. That kind of regulatory intervention would have reduced the severity of the crisis, and that is no small thing.
On the other hand, unless these regulators were extremely vanilla in approach and just said no to any innovation, or unless they had an unusually deep understanding of speculative bubbles, I think they would have allowed most of those subprime mortgages. And they probably wouldn’t have had the detailed knowledge they would have needed to halt the decline of lending standards on prime mortgages in a timely way. In all likelihood, we would still be in this financial crisis.
In short, the new agency seems a good idea, and, if it is created, it should be chartered to support innovation and should be staffed by people who know finance and its intricacies, including some who appreciate that human behavior must be understood and factored into financial design.
But that leaves us with the deeper quandary: Our society needs financial innovation, and still seems vulnerable to changing animal spirits and speculative bubbles that create truly big problems. Even if they can be mitigated, periodic crises may not be preventable, at least not by banning abusive credit cards or even by throwing the bad guys in jail.
We need consumer products that people can use properly, and if this is what “plain vanilla” means, that’s a good thing. But we also need financial innovation that responds to central problems. The effectiveness of our free enterprise system depends on allowing business people to manage the myriad risks — including the risk of asset bubbles — that impinge on their operations in the long term. And this process needs constant change and improvement.
Complexity is not in itself a bad thing. It is, in fact, a hallmark of modern civilization. A laptop computer is an immensely complex instrument, with trillions of electronic components, and almost none of us can explain what goes on inside it. Yet it can be designed well so that it seems plain vanilla to the ultimate user.
And as for steam engines, the modern turbine high-pressure versions are not plain vanilla in any sense. They are sophisticated triumphs of engineering. They help generate most of our electric power with very few accidents.
Robert J. Shiller is professor of economics and finance at Yale and co-founder and chief economist of MacroMarkets LLC.