For months now, I've been remembering my great uncle Oscar and some of my more distant relatives, usually when I hear someone assert that regulating consumer financial products will stifle innovation and creativity.
I have mentioned before that I grew up among businessmen and women. When I have blogged about them, I have tended to focus on the immediate family for important reasons: 1) they are the ones I know best and 2) this blog more or less focuses on the intersection of economics and ethics. When I go further afield than aunts, uncles, first cousins, parents, and grandparents, the intersection of economics and ethics in some of the more distal branches of my family tree approaches the null set.
So let me tell you about great uncle Oscar. Great uncle Oscar is regarded as the family's itinerant "entrepreneur." He traveled throughout the US mid-west in the early 20th century selling "pillow ventilators." No one in the family has ever been sure what a pillow ventilator is (although thanks to Google books, I now know and you can, too), but we were all pretty well convinced that whatever it was it had no real value. That didn't stop great uncle Oscar from selling them to people. And since people bought them, I have to assume (as an economist) that the price they paid corresponded in a money metric to some incremental gain in utility they expected to obtain from owning one (or a set for the entire family).
The point being that great uncle Oscar made a living selling something that may have had very little objective value (in terms of its purported abilities to freshen pillows). Nevertheless, (good salesman that he was) he was able to elicit in rational humans a desire to part with money in exchange for it. Were they better off? They thought they were or they wouldn't have parted with the cash and that's all that matters in economic theory. But I digress.
Now consider another of my great uncles (Oscar's brother). He owned a store that sold durable goods in a small Appalachian town during the Depression. Despite the depression, he managed to purchase a late-model car. How could he afford a new car during the Depression, you ask? Well, he was creative. He parked the new car in his sales window with a sign that announced that a chance for a free car would be given with each purchase of merchandise from the store. After a month or so of stronger than usual sales, my great uncle gave away a car. Minor detail: the car he gave away was his old car, not the new one in the window. It's a whole new nuance on bait and switch.
And then there was second cousin Charlie, now departed. I loved second cousin Charlie. He was a sweet, generous man. I loved his wife and his kids. He was a charming raconteur and a wheeler dealer from way back. During the depression, he and his two brothers would place ads in local newspapers along the Appalachian spine of the east coast, occasionally making forays into the adjacent flatlands. The ads were for secretarial and clerical jobs. This guaranteed that only women would show up. They would rent a hotel room (no, this isn't going where you think it's going) and when some poor woman, desperate for work showed up, they would tell her the job had been filled. This usually elicited a hard luck story from the woman which allowed them to ask if she had any jewelry she would like to sell. Often she did, either on her (since she dressed for a job interview) or nearby. Charlie and his brothers bought the jewelry and sold it at a profit. This isn't necessarily a bad thing. After all, it provided the women with cash that they needed at a time when they needed it. I've always hoped the women didn't part with family heirlooms and I've always hoped that second cousin Charlie paid something that resembled a fair market price to them. Lest you think entirely badly of him, you need to know that Charlie went on to a very successful career in real estate (after WW II) and later devoted much of his income and time in his waning years to an orphanage and to getting kids with birth defects the surgery they needed to live normal lives. He was a businessman and he had a good heart.
Why am I telling you all this?
Because, much as I love all of the entrepreneurs and innovators to whom I'm distantly related (I've always pictured Oscar and his brother as Garth and Hub in Secondhand Lions), they occasionally sailed a little close to the ethical winds. It is sometimes a very fine line between innovation and a confidence trick, between an innovator and a con artist. Many of us won't buy pillow ventilators at any price, but I'm pretty sure many of us are consuming prescription drugs that are of little or no incremental benefit compared to a cheaper generic or OTC drug. When we're down and out and desperate, many of us will not be "rational" and will be more easily parted from things of value, like jewelry or money, without receiving fair recompense. When it comes to complex, innovative financial products like mortgages, credit card agreements, and payday loans, the opportunities for rent-seeking by those with economic and political power and information asymmetries on their side are staggering to contemplate.
Are all entrepreneurs and innovators outright or borderline con artists? Not by a long shot, but financial products seem to offer more opportunities for destructive innovation. As financial products get more complex you can't always rely on customers to know the difference between a product that is akin to a confidence trick and a product that is truly beneficial. Can we rely on the creators of financial products to innovate in ways that are truly beneficial (to both customer and society)? As we contemplate this question, we have a track record from which to extrapolate. Here's Joe Stiglitz (Nobel Memorial Prize in Economic Sciences, 2001)from his book, Freefall:
In all these go-go years of cheap money, Wall Street did not come up with a good mortgage product. A good mortgage product would have low transaction costs and low interest rates and would have helped people manage the risk of home ownership, including protection in the event their house loses value or borrowers lose their job. Homeowners also want monthly payments that are predictable, that don't shoot up without warning, and that don't have hidden costs. The US financial markets didn't look to construct these better products, even though they are in use in other countries. Instead Wall Street firms, focused on maximizing their returns, came up with mortgages that had high transaction costs and variable interest rates with payments that could suddenly spike, but with no protection against the risk of a loss in home value or the risk of job loss.
So now you know why lately I've been thinking more about my distant businessmen relatives. And you understand the dismay I feel when I read that Tim Geithner (and maybe Larry Summers) are opposed to Elizabeth Warren as head of the new Consumer Financial Protection Board . Yves Smith reports that Warren is not opposed by Treasury after all, but I'm not reassured.
We need someone who is clearly, unequivocally on the consumer's side, not the side of the firms that create and sell such products. At present, I suspect the average US resident would agree, regardless of political ideology, that the current administration appears to be altogether too much on the side of and sympathetic to the creators of financial "innovation." Paul Krugman, blogging about Elizabeth Warren as a potential candidate to head the CFPB, said it best:
There’s also a political aspect. The Obama administration suffers from the perception that it’s been too much in the pocket of Wall Street — partly because there’s at least a grain of truth to the accusation. Appointing a prominent pro-consumer crusader would have to help repair the image, while appointing somebody unknown to the public, especially when expectations are running high, would hurt.
That's the politically expedient reason to appoint Warren. The economically sound reason is that not all innovation delivers benefits, either individually or socially. We know from recent experience that markets don't do such a good job of policing complex risk-obscured financial products. I have every confidence that Wall Street and investment bank interests will be represented no matter who heads the CFPB. I want some assurance that Main Street's interests are also represented in deciding how financial products are packaged and marketed to my neighbors, my relatives, and to people I only pass in the street. Elizabeth Warren as head of the CFPB would be an important first step in tipping the scales toward Main Street and a more secure and growing middle class.
Note: all family names have been changed to protect the culprits. It was a long time ago and they're all dead. RIP.