Can we protect consumers and still be creative?
Leave it to Wall Street to give innovation a bad name. Americans prize out-of-the-box thinking in technology and culture, but they fear it in finance—understandably, thanks to innovative disasters like credit default swaps, collateralized debt obligations, and "negatively amortizing" mortgages whose principal grows instead of shrinking.
In spite of the public's mistrust, entrepreneurs and academics are plunging ahead. They're working on ideas they hope will help the consumer borrow more safely and build wealth more reliably. Some are ambitious, like reducing homeowners' exposure to declines in local housing prices. Others are fanciful, like an electronically rigged wallet that becomes harder to open when your bank account is low, an idea from the Massachusetts Institute of Technology.
The big problem: It's hard to tell the beneficial ideas from the ones that are self-serving or dangerous. Many top economists, including former Federal Reserve Chairman Alan Greenspan, once lauded subprime mortgages as a fantastic innovation. With this fresh in mind, there's a risk that government will overreact and suppress good ideas along with bad ones.
The lightning rod for the debate over innovation is the Obama Administration's proposed Consumer Financial Protection Agency, which would vet new financial products for safety. Bankers and laissez-faire economists object that government is bad at picking winners and losers. Andrew W. Lo, director of the MIT Laboratory for Financial Engineering, who trained the geniuses responsible for some of the exotic derivatives that blew up, favors letting markets work: "Financial technology is no different from any other technology. It goes through a maturation process. Version 2.0 is going to be better than version 1.1."
Guilty Until Proven Innocent?
Many free-market economists do acknowledge that some regulation is appropriate in the wake of the crisis. Lo, for example, favors both controls on new technologies with no redeeming social value and government-led safety testing of new financial technologies.
But some economists go further and argue that any financial innovation is guilty until proven innocent. Former International Monetary Fund chief economist Simon Johnson and James Kwak, authors of the popular Baseline Scenario blog, wrote in the summer issue of the journal Democracy that innovation often generates unproductive or even destructive transactions. "The presumption should be that innovation in financial products is costly…and should have to justify itself against those costs," they wrote. The two bloggers support the Consumer Financial Protection Agency.
A more productive approach may be that of Yale University economist Robert J. Shiller, who sees a role for government in guiding innovation. The father of the Case-Shiller home price indexes sounded alarms about the bubbles in tech stocks and later in housing. Shiller favors the CFPA but worries about overkill. He says he was dismayed by the bureaucratic hurdles his company, MacroMarkets, faced before launching house-price derivatives this year on the New York Stock Exchange.
Regulation complicates even the rollout of financial products and services that are seemingly pro-consumer. For example, prepaid debit cards allow people who don't have checking accounts to make electronic payments and avoid carrying around a lot of cash. But they're controversial with regulators because the convenience comes at a cost: high fees. On the other hand, fee-cutting innovations have also encountered difficulties. The hot trend of peer-to-peer lending, which matches small-scale borrowers and lenders on the Web, gives borrowers a way of avoiding bank charges. Still, peer-to-peer companies like Prosper, Lending Club, and People Capital were nearly killed in 2008 by a ruling that the firms had to restructure their loans as securities and register with the Securities & Exchange Commission. They have managed to soldier on.
Big Ideas Are Scarce
Assessing the usefulness of innovations can be difficult. Progress Financial in Mountain View, Calif., doing business in the state as Progreso Financiero, makes small, short-term loans to low-income Hispanic customers via desks in supermarkets and other convenient locations. California limits effective interest rates on such loans, factoring in fees, to around 36%. Sounds reasonable, but Progress Financial CEO James Gutierrez says the cap is stunting the growth of the sector, noting that firms like his are competing with payday lenders that can charge effective annualized rates of 400%.
Few people in either government or the private sector are thinking on the grand scale of President Franklin D. Roosevelt's brain trust in the Depression, which launched Social Security and federal deposit insurance. Yale's Shiller has encountered scant interest in some sweeping ideas he has for protecting consumers from needless risks. One is "home equity insurance"—a policy that would pay off if values of homes in your area fell (regardless of what happened to the value of your own house). Another is an income-linked mortgage: Your monthly payment would automatically adjust downward if salaries in your chosen profession fell (regardless of what happened to your own salary).
Shiller says the government should fund consumer-finance research and build indexes that could underlie new products like those income-linked mortgages. Shiller's ideas aren't the only ones out there, but giving government a role in nurturing financial innovation may be the best way forward.