Warning Labels – Not for Everyone

Peter Wallison, an economist from the American Enterprise Institute, has taken to criticizing the proposed Consumer Financial Protection Agency in a new Washington Post editorial.  He argues that the new agency would hurt the poor.  Yes, that’s what he is saying.

The nut of his logic is that the CFPA, in limiting access to exotic financial instruments like option-ARM mortgages, reduces the choices available to consumers.  He suggests that the CFPA will intimidate the less-sophisticated.  Savvy experts with deeper understanding of money might go ahead and ignore the government warnings, he opines, but many people will be scared off.  He assumes that a good deal of those “scared-off” folks will come from the ranks of the poor or gullible, and that’s not fair, he says.

Now, hmmm….if the government is proposing regulation that amounts to something like a “warning label,” then isn’t it working when it alerts people who might otherwise fall into a trap that they didn’t understand.  Cigarettes bear a warning label.  Those words on the side of your packet probably don’t change the minds of long-time users.  They probably have a greater effect on first-timers and younger people.  Now, they hardly restrict choice, because no one is prevented from death sticks.  That said, they add information to decision-making.

Conservatives are quick to argue that regulation harms choice.  In this instance, they are ignoring another aspect of the free markets – the need for perfect information.  In the last year, it has become obvious that many consumers made “choices” when they did not understand the implications of their actions.  For example, how often have you heard of mortgage borrowers who took it at face value that they would always be able to refinance out of a mortgage before the interest rate reset? Those people, who may not have studied the unpredictability of interest rates, were operating without an adequate understanding of finance.

Even the captains of finance assert that they didn’t understand the implications of their choices:

• Alan Schwartz, CEO of Bear Stearns, says that his balance sheet is strong on 3-13-2008.  Two days later, Bear goes bankrupt.
• John Mack, head of Morgan Stanley says that risk-aversion amounted to a “culture of no” that leads to lost opportunities.

So, maybe these titans would have benefited from a government warning.

The conservatives would have a better argument if what the CFPA was proposing to do was to eliminate some mortgage products altogether.  Then, it would be a case of choice being hindered.  Here, though, its really an example of guaranteeing that information informs decision-making.

Its fine to argue that economics should inform policy.  Wallison, though, is choosing to only listen to economics that were derived a long time ago.  He, and others like him, shouldn’t ignore the wisdom that behavioral economics can offer.  That’s certainly where the Obama administration is drawing its inspiration from when it proposes consumer warnings and the plain vanilla mortgage.