Monday, April 30, 2012

The Consumer Financial Protection Bureau: Reining in Greed

“It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.”

--Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations

The assumption behind Adam Smith’s concept of the “invisible hand of the marketplace” is that if participants in a free market seek to maximize their personal gains, society will benefit as a whole even though the individuals have no other motivation beyond their self-interest. The character of Gordon Gekko in the 1987 film Wall Street expressed the idea succinctly with his exhortation that “greed is good.”

However, in practice there have been a few problems with relying completely on “the invisible hand.” First, for numerous psychological reasons people do not always act according to their self-interest. For example, many people are greedy and greed is not the same as self-interest.  Greed is a self-destructive desire that is listed as one of the “seven deadly sins.” Second, people do not always know the course of action that is in their self-interest. In our modern complex economy the best financial decision for an individual is not always obvious. Most agreements concerning mortgages, consumer financing products, credit cards, and bank accounts are complex contracts that are difficult for anyone to fully understand. Without knowledge and understanding it is not possible for consumers to act in their self-interest.

The government can do little to change human nature, but it can put in safeguards against its excesses. For example, the government can require that financial contracts be written so that consumers actually understand the agreements. To better inform consumers, in 2011 the federal government created the Consumer Financial Protection Bureau (CFPB). The purpose of the bureau is to regulate consumer financial products so that the agreements are fair and transparent. But, since its inception, the CFPB has been excoriated by the banking industry, and the bankers have unleashed lobbyists in Congress in a successful bid to limit the CFPB’s effectiveness.

The irony of this hostile action against the CFPB is that the banks blamed consumers for the financial crisis. Consumers purchased homes that they couldn’t afford, falsified mortgage applications, charged too much on credit cards, and in general didn’t understand the obligations and consequences of the agreements they signed. In other words, consumers were greedy and greed isn’t good for the banks.

However the banks want to continue the same consumer lending practices that preceded the financial crisis. Without the obfuscation and one-sidedness characteristic of many of their lending agreements, the banks feel that they can no longer profit. In other words, greed is good for the banks, except for the fact that it wasn’t, which is why so many of them failed.

Complex contracts designed to disguise inherent unfairness, benefit neither party. If a contract is so one-sided that a clear understanding of its terms would not lead to an agreement, it is better for both parties that there be no agreement. The banks should actually be vocal advocates of the CFPB because adequate regulation would insure a level playing field.

Much like the role of drug testing in sports, in which no competitor should be able to get an unfair advantage by engaging in unhealthy practices, financial product regulation should serve the same purpose – keep all players healthy.

But the banking industry continues to push for unfair advantages because greed is good. In other words, greed drives the market. At least until the market crashes, in which case the destructive consequences of greed are everyone else’s fault and everyone else should have to pay.

What is often overlooked in Adam Smith’s quote is that the butcher, the baker, and the brewer all need each other if they are each to have a complete meal. If greed ruins anyone of them, it will ruin them all. In other words, greed is not good and it is not what Adam Smith meant by self-interest.