I was going to put off writing this one for a while and address other topics, but as I see that the Obama administration may be considering the creation of massive consumer financial protection (if this page is to be believed, and I see no reason to doubt it -- thanks to Georgetwin for the alert), I think it is an apropos time to write about consumer protection in general, and financial protection specifically.

I have written before on this subject at great length, so to some degree this will simply be a repeat of what I wrote in "To Correct Debra Saunders", "When Help Hurts", "Government Efficiency", "High Cost of Medical Care", "Medical Reform, An Overview", "Professional Education", "Business Licensing and Regulation", "Medical Regulations", "Medical Regulation II", "Saving Us From Lower Prices" and others. However, as each of those addressed more specific topics, I hope this will be able to develop a more general description, though for examples I will tend to favor those coming form the financial sector, both as it is the area I have used most frequently and, now, because it appears to be targeted by the federal government for special attention in terms of "consumer protection."

One final note before I begin, this post is, in many ways, a companion piece to both Bad Economics Part 2and Bad Economics Part 3. It elaborates on part 2 as the arguments offered for consumer protection laws are often the very same ones offered for laws intended to "preserve competition". "Protecting the consumer" and "leveling the playing field" are popular causes, both sound noble and without a shred of self-interest, both appeal to our sense of fairness, and, in practice, both produce results exactly opposite of their claimed purpose. And it is a continuation of part 3 because the arguments against deregulation are, in essence, just the logical outcome of the arguments for the original intervention, making them very similar to the arguments we shall examine here.

Which brings me back to my main point. So, without more disclaimers and asides, let me begin.

Like all intervention, efforts at consumer protection are based on two premises. First, that consumers, and people in general, are either too incompetent to run their own affairs, or are susceptible to manipulation by sinister forces¹, in short, that consumers need to be protected form either their own incompetence, the malice of others, or some mix of the two. Second, that the free market, while desirable in the abstract², is flawed in specifics, and needs government tinkering to make it function in a "fair"³ manner. Thus there is a need for the government to step in and protect the consumer⁴. I am not going to debate that question here, as it is one I have addressed over and over again. If you want to see arguments about this question, check out the many articles linked in the footnotes, or wait for me to dedicate one of these Bad Economics entries to the question of human competence.

What I am going to address is the outcome of these "consumer protection" laws. At times I may make brief mention of the assumptions underlying them, as it is almost impossible to avoid them, but, for the most part, we will be engaged in "outcome based mockery" here, criticizing the results of such policies, arguing that, even granting many or all of the assumptions upon which the laws are based, they still leave the consumer in a worse position, not better.

For example, let us look at usury laws. These are very simple laws, and their populist appeal is undeniable. Bankers are never very well liked by the public, as they get rich while not appearing to labor. Even the heads of big corporations appear to be doing something, after all goods roll out of their factories. But bankers, they appear to sit in their offices, lend us small amounts of money, and then grow rich on what appears to be a never ending stream of interest assessed on principle that never seems to get smaller. So it is easy to see why populist types often target bankers⁵. They are familiar to most people, and are also easily maligned. It is why banking, of all the areas of human endeavor, tends to attract more, and more ill-considered, regulation than any other area of the economy⁶.

Usury laws take many forms, but in their most general form they prohibit asking for interest greater than a set rate. The rationale for this is that interest above this rate is "usurious", that, while borrowers might be foolish enough to borrow at this rate, somehow it will be harmful for them to do so.

However, this creates a problem. The thought of those passing this law is that bankers basically set rates arbitrarily, they just pick an interest rate and ask for it. The truth is, interest rates are set by the market base don average returns on other investments, as well as the risk of a given investment. Borrowers that have worse credit have to pay higher interest to make up for the higher default rate. The higher interest makes the average return (including defaults) come out the same as the overall market rate of return.

As interest is not arbitrary, the capping of interest rates does not result in bad credit risks getting a better, non-usurious rate, but instead means they cannot get a loan at all. The money that would have been given to a lender to loan to thos ebad credit risks instea dmoves into a slightly less desirable investment opportunity. In other words, the economy as a whole becomes just that much less productive while, at the same time, the potential borrowers do not get a lower rate, as the law makers expected, instead they lose the option of borrowing entirely.

The same takes place when options are either restricted or denied. For example, when the state of Maryland forbid "pay day loans", that is the short term, high interest loans, often backed by a post-dated check, that allowed workers to effectively get an advance against their pay. The logic was that such loans were given at an unacceptably high rate of interest, but the reality is that those taking such loans knew the interest was high, but they needed the money badly. With the state making such loans illegal, they no longer have that option.

Of course, if you think the government's purpose is to prevent people form making bad choices, and think they cannot decide for themselves, perhaps you have no objection to such practices. So let us move on to another variety of consume protection. Licensing.

Licensing is always promoted as a means to protect individuals from unscrupulous vendors. Of course there is nothing inherent in licensing that makes that so. Yes, licensing provides a complaint resolution method for those alleging fraud against licensed vendors, but there is one against unlicensed vendors as well, it is called the court system. There is no evidence that a licensed profession is any less fraudulent than an unlicensed one. In fact one licensed industry (home improvement) is the target of more fraudulent practices than any other, despite almost universal licensing. Nor do licensed professions show any great skill at self-policing. If you doubt me, think of the phrase "Lawyer Ethics Committee" and tell em you didn't either smirk or sigh. Yet that is a self-policing, licensed profession.

The truth is, licensing serves three purposes. It provides a source of revenue to the state, in the form of licensing fees. It also provides a means for the state to exercise a moderate amount of control over a profession without needing to take recourse to legislation. In fact, it allows them to regulate without leaving a trace, as threats to licenses allow them to rule by "suggestions" and "requests" without any official policy being created at all. And, on the private enterprise side, by keeping out competitors, it allows them to charge cartel prices.

And that is the truth behind most consumer protection laws, they serve to protect the interests of the industry, which enjoys reduced competition and higher profits, and the government, which gains regulatory power and licensing revenues, but does little to protect the consumer, who usually ends up paying higher prices for a service which is less responsive, as it does not have to face full market competition. Sometimes the government makes a show of regulating prices, but because there are few market forces driving prices lower, nor incentive for cartel competitors to engage in drastic price cutting measures, the prices still run higher than consumers would pay in a competitive market, and in any case, service still is much less adequate than in a market situation.

And that is the basic truth of consumer protection. The free market provides quite a few consumer protections. In cases of fraud, consumers have recourse to courts, which is as good as any protection they get under "protection" laws. They also have the ultimate protection of refusing to buy. Without government created cartels (often created through "consumer protection" laws), the consumers will always have competitors, and companies, aware of competitors, will behave as well as they can. They may not completely bend over backwards, they will balance the cost of goodwill versus the expected benefits, but companies will exist at all positions on the spectrum, low cost, low service all the way to high cost companies which cater to the every whim. When in the cartels formed by government "protection", these companies will answer more to the regulators than the customers⁷.

Consumer protection laws, while sold as favoring the consumers tend to not enact regulations that benefit the consumers, but which benefit a combination of the industry itself and the regulators. As in all regulatory environments, regulators often become close with the industry they regulate, and feel a need to "work with" the industry, resulting in many regulations which do not harm the industry, but advance the interests of existing firms. Even when there is no such "capture" of regulators, the cost and burden of regulation itself is beneficial, as it excludes most new entrants into the market, insulating existing firms and preventing too much innovation which might threaten more stagnant firms⁸.

Nor can consumers count on the regulators. As I described in "The Inevitability of Bureaucratic Management in Government Enterprises",  "Bureaucratic Management" and "The Bureaucratic Mind", the motives of regulators are largely to avoid blame. In the case of regulation this often takes the form of enacting the most innocuous regulations consistent with their own political biases and those of the group in power. Beyond that, they tend to do little, as upsetting either the consumers or the industry can bring down political wrath upon them. So, rather than protecting consumers, the regulation often ends up increasing costs, preventing competition which would truly benefit consumers, and instead imposes very little to benefit the consumers, while driving up costs.

That is the truth of consumer protection, that while the rhetoric may sound good, in reality it does very little, and at a great cost.

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1. I have written often about the way authoritarian intervention is based upon the assumption of either incompetence or susceptibility to outside, malevolent forces. To read more on the topic, the best place to start would be my previous posts "Those Other People", "Our View of Our Fellow Citizens", "Seeing People As Stupid", "Appealing to Arrogance", "The Citizen Dichotomy", "In A Nutshell", "Cognitive Dissonance Part 2", "Changing Incentives" and "Three Types of Supporters of Big Government".

2. No one would openly disparage the free market, it is always just specific "special cases" which require intervention. Even the most ardent "progressives" have learned this lesson and now espouse the "free market", asking that the government just be allowed to "fix some problems". See  "Special Cases", "Smaller Government , Fair Weather Friends and Special Cases" and "Inescapable Logic".

3. As I discussed elsewhere, the concept of "fairness" and "justice" are dangerous political tools, as such words tend to have no fixed meaning, yet allow the speaker to convince naive listeners that he means something other than what he intends. They substitute their own assumptions about the meaning of "just" or "fair", and so they instantly agree with him, even though his meaning is quite different from their own. This is the trick used by one particularly astute campaigner in the last presidential elections -- see "The Candidate as Inkblot" and "So, what is "change"?". See also "Protean Terminology", "A Question of Fairness" and "Life Is Not Fair - And Trying To Make It So Makes Things Worse".

4. I would argue that even with incompetent individuals and sinister forces, the free market would still be the best choice, as it does not rely upon the virtue of those participating the way other systems do, functioning the same regardless of the virtue or lack thereof among the participants. (See "The Wrong People", "Fairness and the Free Market", "Planning For Imperfection", "Symmetry and Asymmetry in Government", "Transparency, Corruption and Reform", "Why Term Limits Will Fail (And Should)" and  "Greed Versus Evil".) However that has become the most popular argument today, that the free market is somehow flawed and so the state must intervene to fix these imperfections. That the government "fixes" end up worse than the supposed flaws is never mentioned. (See "Utopianism and Disaster", "Cigarettes, Sudan and Abortion", "You Don't Drown in a Glass of Water - Vouchers Revisited", The Inevitability of Bureaucratic Management in Government Enterprises", "Recipe For Disaster", "How To Blame the Free Market" and "The Endless Cycle of Intervention".) (NOTE: The free market does rely upon individuals possessing for the most part some very basic rationality, that is pursuing their own interests, whatever they might be, and not trading something they value more for something they value less, but I don't think any political theory has postulated that the majority fails to pursue their own interests, only that their interests should be other than the ones they pursue. That is, judging their aims, not the methods - See "Drug Legalization", "Man's Nature and Government", "Government's Abusive Behavior", "Absolute Values", "The Intellectual Elite" and  "The Inherent Disappointment of Authoritarianism".)

5. Please note, I do not endorse this view. In fact, I find it offensive and foolish. Bankers perform essential services. Yes, banking is somewhat protected from market pressures and so banks often behave in ways not pleasant to consumers (see "The Free Market?"), but that is due to the government intervention, not the actions of bankers. Were the market truly free and unregulated, banks would operate like any other enterprise. That would not stop populists from maligning them, in fact such populism is why we have such a mess ("The Inflation Engine", "Explaining Past Crashes", "A Thought on the Clinton Surpluses"), but I am no fan of populists ("Beware Populist Deception", "Fear of the "Big"") nor of government intervention. Then again, it is interetsing how many problems we have with banking are the fault of government,  yet banks get the blame and even more government is all too often proposed a a solution.

6. Clearly this is an impressionistic assessment, but considering that money itself has been redefined by the government, it seems a valid position to take. Yes, other areas are also highly regulated, broadcast media, interstate transportation, public utilities, medicine, investment, but finance seems to be subject to just a little more regulation than even the most regulated of endeavors.
 
7. For an example from another field, see "Why Health Insurance Isn't Insurance and Related Topics".

8. The paradoxical benefit that companies may enjoy even from quite onerous regulation is described in "Anti-Business Businesses ".

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POSTSCRIPT

Here are the earlier installments in this series:

Bad Economics Part 1 - A discussion of how prices disprove theories of resource depletion
Bad Economics Part 2 - A debunking of the many theories based on "defective" or "damaging" competition
Bad Economics Part 3 - An examination of the many absurd claims about deregulation
Bad Economics Part 4 - An examination of problems with economic studies and empirical evidence

Please visit the blog regularly, as this series is updated regularly.

POSTSCRIPT II

As I provided a list a few days ago of upcoming posts, I figured I should provide an updated list of upcoming Bad Economics entries:

6. The Necessity of Farm Subsidies and Price Supports
7. What is Inflation?
8. The Truth About Monopolies (A Follow Up to Part 2)
9. Bankruptcies, Bruises, Fevers and Extinctions
10. The Role of Profits and Advertising in the Free Market (follow up to "Cutting "Costs"", " Misunderstanding Profits" and "Two Examples of "Inefficiency" in Capitalism")

Note, the order of these posts is subject to change.