Setting the Record Straight

Making the market economy work

Why stronger consumer protection laws are essential

Here's a question to ponder the next time you buckle yourself into a seat in a commercial airliner: which approach would you rather see the United States take toward air carrier safety – the free market fundamentalist approach (in which airline safety would be left up exclusively to airlines responding to "consumer demand") or the regulatory approach in which a public watchdog is charged with enforcing a basic set of safety standards? How about when it comes to restaurant inspections? Hospital licensing? Stock exchanges?

That you, like any sane person, answered "regulatory approach" to these questions does not, of course, make you a "socialist." What it makes you is an average American with a measure of common sense. By acknowledging the need for government regulation of the market in order to protect consumers, you are not arguing for its abolition. Rather, you are arguing for a structure that makes it work better and, in many important ways (e.g. with fewer deaths) more efficiently.

Despite having popularized the term "invisible hand," Adam Smith was in fact an adherent to the regulatory approach.

Here's modern economist Joseph Stiglitz on Smith:

"Adam Smith, the father of modern economics, is often cited as arguing for the "invisible hand" and free markets: firms, in the pursuit of profits, are led, as if by an invisible hand, to do what is best for the world. But unlike his followers, Adam Smith was aware of some of the limitations of free markets, and research since then has further clarified why free markets, by themselves, often do not lead to what is best. As I put it in my new book, Making Globalization Work, the reason that the invisible hand often seems invisible is that it is often not there.

Whenever there are "externalities"-where the actions of an individual have impacts on others for which they do not pay or for which they are not compensated-markets will not work well. Some of the important instances have been long understood-environmental externalities. Markets, by themselves, will produce too much pollution. Markets, by themselves, will also produce too little basic research. (Remember, the government was responsible for financing most of the important scientific breakthroughs, including the internet and the first telegraph line, and most of the advances in bio-tech.)"

Financial transactions

Few areas of the economy lend themselves more naturally to consumer protection regulation than financial transactions. If ever there was a field in which one side of most transactions (and sometimes both) have imperfect information, this is it. One need look no further than the recent economic meltdown, which was in large measure, precipitated by the widespread deregulation of home mortgage financing and the spread of ridiculously complex and poorly understood (much less regulated) investments like "mortgage-based securities," "derivatives" and "credit default swaps," to see what happens when the Wild, Wild West meets Wall Street.

This reality is plainly apparent to any American consumer who thinks for even a minute about any number of their basic daily transactions. Consider, for instance, that credit or debit card that currently resides in your purse or pocket. Who among us is truly conversant with all of the terms of the contract that accompanies it? How many average consumers are actually up to speed on how the interest rates and late fees will be calculated and under what terms they can be amended? What about the mandatory arbitration clauses?

Now, if you're lucky enough to own (or be buying) a home, think about all of the terms that one agrees to and what's at-stake for one's economic future. Is this really a matter in which an average consumer can really approach, say Bank of America, on equal terms?

The fact of the matter, of course, is that Americans have long understood and acknowledged that effective government regulation is essential when it comes to consumer financial transactions. This is especially true when it comes to transactions that target people of lower income who, by and large, tend to be less economically sophisticated and, often, even functionally illiterate. The classic recent example of this kind of regulation in North Carolina was the General Assembly's wise decision to ban the making of so-called "payday loans" – an almost invariably predatory product that harmed a huge percentage of the borrowers who made the mistake of getting involved with it.

Restoring a balance

One of the best things that's occurred in recent months in Washington has been the slow but steady movement to revive a federal commitment to strong consumer protection laws in the world of finance. During the Bush years (and to a lesser extent the Clinton years as well), such laws were regularly ignored and weakened. President Obama, in contrast, is taking important steps to restore some semblance of balance.

This past week, North Carolina Attorney General Roy Cooper weighed in to support one of the most promising of the Obama proposals – the establishment of a new Consumer Financial Protection Agency. Currently, authority to regulate the dizzying array of consumer financial transactions that occurs in the American economy is spread across a wide variety of agencies. In many instances, lenders have so much leeway that they can actually choose the federal regulator that oversees them. Many experts lay the blame for a good share of our recent economic troubles on this scattering of authority.

Under the Administration's proposal, the new agency would have the power to rein in the current free-for-all and establish some measure of uniformity and consistency when it comes to governing mortgages, real estate, credit cards, debit cards, consumer loans, payday loans, credit reporting agencies, debt collection, stored-value cards, investment advisory and financial advisory services, and selected other businesses. Moreover, as is noted in this Los Angeles Times article,

"The agency would write the user-safety rules for virtually all consumer financial products and would have the legal firepower to levy huge fines — tens of thousands of dollars a day per violation in some cases — and prosecute lenders, brokers and others who break the rules."

According to Cooper, who has established a national reputation for helping to make North Carolina both pro-consumer and pro-business, such a change would be an extremely welcome development. He notes that given the exclusive federal jurisdiction over many of these issues, there's little his staff can do for most of the consumers who complain to his office in this area. This has been particularly frustrating in recent years (during which consumer complaints to his office have tripled).

If such an office is established (and rest assured, market fundamentalists will fight it tooth and nail), it will have plenty to do. In addition to consolidating and streamlining oversight of a daunting variety of traditional products, it will also need to act fast to get a handle on a number of new and potentially abusive products that lenders have been rolling out in recent years.

Tops on this list will be the explosion in hidden bank fees for overdrafts (most typically applied to debit cards). As was detailed last week in a powerful report from the Center for Responsible Lending, banks and credit unions collected nearly $24 billion in overdraft fees in 2008 – 35% more than they collected just two years previously. A huge proportion of these fees were collected from consumers automatically and with little, if anything, in the way of notice.

Setting the record straight

In the market fundamentalist view of the world, the economic "invisible hand" is the cure-all for just about every problem. If each individual pursues his or her own self-interest and government stays out of the way, goes the logic, the invisible hand of the market will take care of the rest. Like a lot of fundamentalists, however, the free "marketeers" have misread their original texts and ignored the reality before their eyes.

Perhaps the saddest thing about this is that in their absolutist zeal, they have helped grievously wound the very institution they profess to cherish most. As in the era following the Great Depression, it appears it will be up to pro-regulation progressives, to restore the health of the market economy.   

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