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 penalty—the consistent threat of failure—for 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 House’s 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 can’t 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 nation’s 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 don’t 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 can’t legislate solvency. Lenders must face the realistic risk that borrowers will default when debt becomes unbearable. Otherwise, they’ll 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 failures—without 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 hand—capital—to withstand the bursting of a future bubble.

This policy would directly benefit consumers, too. Fewer home purchasers would have taken on mortgages that they couldn’t afford in the last bubble. Lenders and borrowers alike could not have gotten around a consistent down-payment rule. Exotic financing structures—the kinds that the new bureau is supposed to police—would have been irrelevant.

The same principle holds for high finance. If Washington had required insurer AIG to trade its own exotic financial instruments—credit-default swaps—on 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 AIG’s bankruptcy, averting a bailout and forcing AIG’s own creditors to take losses.

Just as important, such rules likely would have kept AIG from making such fanciful promises—in effect pledging to protect investors in tens of billions of dollars’ worth of mortgage-backed securities for a negligible cost—in the first place. If AIG hadn’t promised investors in mortgages—lenders—that they wouldn’t 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 there’s a consistent market penalty for bad lending.

If lawmakers absorb this lesson, they’ll achieve an immediate political benefit, too. Dodd’s 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 couldn’t object to holding financial firms and their investors accountable in the marketplace for their ill-considered decisions.


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