Rationality on regulation

When we hear the word "regulation," economists tend to panic (shh, don't tell anyone I just called myself an "economist"!). We think of price controls and government-mandated monopolies, restrictions on hiring and firing, France-style labor market controls, etc. And that panic is smart - nothing wrecks an economy quicker than a government trying to control it.

But, as Elizabeth Warren points out on TPMCafe, the strength of our economy depends in large part on prudent, effective regulation. She writes:

Nearly every product sold in America has passed basic safety regulations well in advance of being put on store shelves. As a result, we don't eat tainted meat or buy collapsing infant car seats, and the free market flourishes. [emphasis mine]

This is true. Now, someone in favor of 100% deregulated markets could say "No, regulation is inefficient; let the buyer beware." But the buyer beware-ing is the problem - when the buyer has incomplete information, the buyer may decide not to buy perfectly good products. If you knew any car you bought might blow up, would you buy a car at all? Probably not. So there could be plenty of perfectly good cars sitting on the lot that nobody buys, and eventually people might stop making cars altogether. That's called "adverse selection." And don't tell me it's an efficient market outcome, because it's not.

Warren says we should apply the same logic to financial services that we do to electric appliances:

No one expects every customer to become an engineer to buy a toaster that doesn’t burst into flames, or analyze complex diagrams to buy an infant car seat that doesn’t collapse on impact. By the same reasoning, no customer should be forced to read the fine print in 30-plus-page credit-card contracts to determine whether the company claims it can seize property paid for with the credit card or raise the interest rate by more than 20 points if the customer gets into a dispute with the water company.

I agree with this completely. If people are scared of mortgages, then even customers who can afford good solid mortgages will be wary of buying them, and the economy will suffer.

"But wait," you say. "The danger of a toaster exploding is different than the danger of a mortgage interest rate getting raised. Faulty toasters don't say 'may explode' in the fine print. When a customer buys an exploding mortgage, the information is right there on the page."

This is true. But sometimes the cost of finding and interpreting that info is very high. Before buying a toaster, you could take it to a mechanic and have him take it apart and inspect every component for safety. But that might cost so much time and money that you just say "forget it" and leave the toaster on the shelf. Most mortgage buyers have no more skill in reading the fine print on 30-page contracts than they do in toaster repair. Instead of hiring a lawyer to comb through the contract, many mortgage buyers will just delay or cancel their purchase.

Also, the way information is presented is important (a "framing effect"). If the mortgage company printed all the risks in big bold letters on the front of the contract, people might be less willing to buy mortgages that raised rates 20% in certain circumstances. And then, companies would have to stop selling these mortgages, and start selling safer mortgages, because customers would start demanding more safety.

In the end, as Warren says, the proof is in the pudding. America has a lot of product safety regulations, and our economy has done exceedingly well. Consumers here aren't afraid to consume. And note that the housing market is one of the biggest components of our economy. I'd suggest that regulations that keep mortgage buyers confident that they're buying a safe product would not be scary at all.