Senate Democrats have tried for weeks to get Republicans to support the showpiece of their financial-reform package, a consumer financial-protection agency that would shield regular Americans from predatory financiers. But even the nimblest public agency cannot protect consumers from the biggest threat to their financial health: owing too much money. That threat will exist as long as the financial industry faces no ultimate market penaltythe consistent threat of failurefor lending too much too freely.
The proposed agency has a worthy goal. As Connecticut Senator Chris Dodd, who is leading the legislative effort with the White Houses support, sees it, the protection bureau would govern consumer financial products. Proponents, including economist Paul Krugman, say that such an agency could have helped America avoid the current crisis by prohibiting the most toxic mortgages.
But focusing on exotic products and fees misses the real problem: unfathomable debt levels. In the past quarter-century, the amount that families owe has risen more than sevenfold, from less than $2 trillion in 1984 to nearly $14 trillion, according to the Federal Reserve. Debt outran the cost of goods and services by nearly fourfold.
Many Americans cant afford their debt unless their lenders use complex finance to suspend all disbelief. Exotic mortgage structures, then, were a symptom of the disease, not the disease itself.
How did it come to this? The financial industry has encouraged Americans to borrow so much because Washington has allowed the financial industry itself to borrow so much without consistent market consequences.
Since 1984, when the Reagan administration bailed out lenders to the nations eighth-largest bank, Continental Illinois, investors have understood that if a big commercial bank or complex Wall Street firm runs into trouble, Washington will ensure that the bondholders and other creditors to that firm dont take losses. By creating this expectation of bailouts, Washington has subsidized lending to the financial industry. When government subsidizes something, it gets more of it. Over a quarter of a century, the amount of money that the financial industry has borrowed multiplied by more than 15 times. It should be no shock that banks and other institutions turned around and lent much of that money right back to consumers.
A financial-protection bureau could write thousands of rules. But it will never be able to overcome the signal that Washington continues to send. The message: lenders to financial firms will never lose money if the financial firms to which they lend, in turn, lend those borrowed funds irresponsibly to consumers.
Yet President Obama has continued to shield financial companies and their bondholders from the consequences of their poor decisions. Through mortgage-modification programs, for example, the White House has temporarily cut monthly payments for some homeowners. In doing so, the White House has enabled financial institutions to avoid cutting what people owe in line with house prices. Debt reductions, though they would mean more financial-industry losses, would be better for borrowers.
Shielding financial firms from market penalties has been a bipartisan effort. Half a decade ago, President Bush signed into law a bankruptcy reform act that made it harder for all but the poorest borrowers to escape credit-card debt. Financial institutions could more easily ignore the fact that consumers were borrowing beyond their means to repay. But you cant legislate solvency. Lenders must face the realistic risk that borrowers will default when debt becomes unbearable. Otherwise, theyll lend too copiously.
Congress and the president can protect consumers from impossible debt burdens by ensuring that lenders to financial firms, too, face the threat of borrower default. Only market discipline of bad behavior will curb behavior at the source.
To make it clear to the marketplace that no financial firm is too big to fail, Washington must put rules in place that make the economy better able to withstand financial-industry miscalculations and failureswithout bailouts.
Required cash cushions on stock purchases helped the government avoid financial-industry bailouts when the tech-stock bubble burst a decade ago. They would have the same effect in other asset markets. Washington should thus require home buyers and purchasers of other speculative assets to make consistent down payments of 10 or 20 percent. Under such rules, financial firms would have more cash on handcapitalto withstand the bursting of a future bubble.
This policy would directly benefit consumers, too. Fewer home purchasers would have taken on mortgages that they couldnt afford in the last bubble. Lenders and borrowers alike could not have gotten around a consistent down-payment rule. Exotic financing structuresthe kinds that the new bureau is supposed to policewould have been irrelevant.
The same principle holds for high finance. If Washington had required insurer AIG to trade its own exotic financial instrumentscredit-default swapson transparent exchanges and to put some consistent cash down at the outset to cover these bets, the cash cushion would have helped the economy to withstand AIGs bankruptcy, averting a bailout and forcing AIGs own creditors to take losses.
Just as important, such rules likely would have kept AIG from making such fanciful promisesin effect pledging to protect investors in tens of billions of dollars worth of mortgage-backed securities for a negligible costin the first place. If AIG hadnt promised investors in mortgageslendersthat they wouldnt lose money, or had charged handsomely for the promise, investors would not have felt so free to lend to homebuyers.
Senate Democrats should understand that they can protect consumers from bad financial products only by making it clear to the financial industry and own lenders that theres a consistent market penalty for bad lending.
If lawmakers absorb this lesson, theyll achieve an immediate political benefit, too. Dodds proposal, which needs GOP votes in a closely divided chamber, faces uncertain prospects at best. Republicans are wary of giving the government more power to micromanage consumer finance. However, they surely couldnt object to holding financial firms and their investors accountable in the marketplace for their ill-considered decisions.
Nicole Gelinas, author of After The Fall: Saving Capitalism From Wall Streetand Washington, is a City Journal contributing editor and Manhattan Institute senior fellow.