Matt Yglesias and Justin Fox know what is up on finance

The blogosphere wrestles with the topic of the proposed Consumer Financial Protection Agency.

Felix Salmon, finance columnist:

Net-net, financial innovation is a bad thing: the downside, during times of crisis, is higher than the upside in more normal years.

Tyler Cowen, professional economist:

Maybe I am taking Felix and others too literally but I am genuinely puzzled by this attitude. I can understand that particular financial innovations might be bad, but financial innovation overall? Surely this claim was false in years 1200, 1900, and also 1950...We'll need more than better ATMs, which is not to say we need approve of every step along the way.

"Financial innovation bad!" "No, financial innovation good!" Not an amazingly constructive or insightful debate so far.

But here's Justin Fox, finance blogger:

[I]t seems like some sort of slowing and testing mechanism—akin to the FDA approval process for drugs—could bring more stability while still allowing for innovation. And that's what the Consumer Financial Protection Agency would be, right?

And here's Matt Yglesias, general well-read dude:

[I]t doesn’t require any esoteric or “left-wing” economic theories to predict that regulatory evasion will be the purpose of much financial innovation. Finance is regulated precisely because finance is substantially backstopped by implicit government guarantees. If you can manage to take advantage of those guarantees while slipping free of the prophylactic regulation, there are windfall profits to be made. And firms seek to innovate precisely in order to generate windfall profits. The moral of the story, pretty clearly, is that this—innovation as regulatory evasion—is something regulators should expect to happen, and should be extremely vigilant about.

Fox and Yglesias have it right. They are citing two big reasons for regulation: adverse selection and moral hazard.

"Adverse selection" means that if buyers can't trust the quality of the products they're being sold, they won't buy any products. In the case of the financial system, that means that if people believe that financial "innovations" are bogus, then instead of putting their savings into capital markets they will keep their money under the mattress. That deprives our economy of the investment capital it needs to grow. A Consumer Financial Protection Agency, as Fox points out, would exist to reassure people that financial products are in reality as safe as they look on paper - thus making people more willing to invest their money.

"Moral hazard" means, in this context, that if you promise to bail out companies that fail, companies won't be very worried about failing. The financial system is something that occasionally needs to be bailed out by the government (because of reasons only dimly understood by modern economic theory). Thus, financial companies have too much incentive to take stupid risks. Yglesias rightly notes that we can do one of two things: A) refuse to ever, ever bail out the financial system, or B) regulate the system so that the inevitable crashes aren't as bad and the inevitable bailouts aren't as costly. Now, as it turns out, (A) is impossible (because no government promise to avoid all bailouts in the future will be credible, so finance companies will take stupid risks anyway). So we're left with option (B) - financial regulation.

This goes way beyond cries of "innovation good!"/"innovation bad!". Financial innovation may sometimes be good and may sometimes be bad, but the key issue is whether finance companies are able to get away with passing off innovation as good when in fact they know it is bad. If the answer is "yes," our economy will suffer more debilitating crashes like this one, as people abruptly discover they've been fleeced. If the answer is "no," then financial innovation will do more good than harm. Regulation is what makes the difference.