The Market for Lemons — and Financial Products

Elizabeth Warren recently won the Massachusetts Senate election against incumbent Scott Brown, receiving about 54% of the vote. One of the key issues in the race was how the federal government should regulate the finance industry, specifically with regard to Dodd-Frank and the Consumer Financial Protection Bureau (CFPB), Warren’s brainchild. Senator Brown favored giving Wall Street more leeway in regard to government oversight, a position which earned him significant campaign contributions from the finance sector. Warren, on the other hand, is a liberal academic who is well known for her criticisms of Wall Street. Most notably, she formally put forth the idea for a CFPB-type government agency in a 2007 article for Democracy: A Journal of Ideas, an article that launched her into the political arena.

I was first alerted to the article by Ezra Klein via Twitter on election night, and after reading Warren’s work, I am happy to see that she won election to the Senate. The piece is a cogent argument for why we need to regulate financial products just like we regulate any other products —  to protect consumers from harm. The crux of her argument is easily grasped from the following excerpt (though do read the whole thing):

Consumers can enter the market to buy physical products confident that they won’t be tricked into buying exploding toasters and other unreasonably dangerous products. They can concentrate their shopping efforts in other directions, helping to drive a competitive market that keeps costs low and encourages innovation in convenience, durability, and style… Just as the Consumer Product Safety Commission (CPSC) protects buyers of goods and supports a competitive market, we need the same for consumers of financial products–a new regulatory regime, and even a new regulatory body, to protect consumers who use credit cards, home mortgages, car loans, and a host of other products.

Warren goes on to give a brief history of consumer finance and how the industry has become more complex over the years. Though her argument in favor of tougher regulation is persuasive and well thought out, Warren misses the key economic insight on which her argument is based: asymmetric information. Economists say that a market has asymmetric information whenever the buyer or seller knows more about the product than the other party. We generally assume the seller has more accurate information than the buyer because it makes intuitive sense that the owner of a product would know more about it than a prospective customer. This idea about an imbalance of information was first proposed by George Akerlof in 1970 in his famous paper The Market for “Lemons”: Quality Uncertainty and the Market Mechanism, in which he cites the used-car market as prime example of this phenomenon. He finds that:

There are many markets in which buyers use some market statistic to judge the quality of prospective purchases. In this case there is incentive for sellers to market poor quality merchandise, since the returns for good quality accrue mainly to the entire group whose statistic is affected rather than to the individual seller… As a result there tends to be a reduction in the average quality of goods and also in the size of the market.”

The resulting reduction in the average quality of goods and the size of the market implies there is a role for government intervention to increase total welfare. If through government regulation the information known to buyers and sellers becomes more symmetric, then the adverse effects previously mentioned will be reduced.

This is exactly the problem that has been growing in the finance industry over the years. When Warren says that lengthy credit card contracts with footnotes and legalese are bad for consumers, she really means that they increase the gap between what the sellers (banks) and the buyers (consumers) know about the product. As shown by Akerlof’s work, this asymmetry of information hurts both buyers and sellers in the end because people will be more hesitant to engage in exchange. In other words, if you want to sell me that collateralized debt obligation so badly, then why would I want to buy it? Something must be wrong with it, right? And when people don’t have the education or expertise to properly evaluate financial products, they will either make poor decisions or no decisions at all (i.e., abstain from exchange). A new regulatory regime of common-sense rules for banks and investment firms, as outlined by Warren, would decrease information asymmetry, thus strengthening the market and improving consumer welfare.

Now we just have to wait and hope that Warren gets a seat on the Senate Banking Committee so she can affect this change.


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