Legal Commentary

How Much government Regulation to "Protect" Consumers?Becker

By becker

The consumer protection issue has been thrust into public attention by the housing debacle because many families have had lenders foreclose on their homes, while other home owners are in serious arrears on their mortgage payments. Ye neither consumer ignorance nor cognitive defects in consumer decision-making had much to do with the housing bubble. Many home owners with low education and earnings, and with limited financial acumen became homeowners toward the end of the bubble period. They tended to lose little from the bubble since they put almost no money down, and they were given low ("teaser") interest rates on their mortgages. They frequently walked away from their homes when prices dipped below the value of their mortgages, and lost little.

On the other hand, highly sophisticated lenders, including giant companies like Bear Stearns, Citibank and UBS, lost billions of dollars through paying too much for their mortgage-backed securities. Many top executives of these banks were out millions of dollars because they owned lots of shares of their companies, and they had generous options that went under water. Government regulators, not private incentives, created the important asymmetry between gains and losses to the executives of these companies. Financial leaders know that when many banks get into financial difficulties at the same time, the "too large to fail" principle of bank regulators would be applied, so that equity owners would be at least partially bailed out. Bear Stearns' equity investors lost a lot when JP Morgan purchased the company, but they would have lost more if the Fed had not guaranteed $29 billion of BS assets.

The consumer ignorance and cognitive defects stressed by Posner did not cause the housing bubble, for it was due to a belief that rising housing prices and the general good times would continue for much longer. Allan Greenspan, probably the greatest central banker of the past several decades, recognized that it is not easy to distinguish legitimate increases in prices from excessive price increases. The fact is that during price bubbles, regulators, including central bankers, usually get caught up in the same optimistic frenzy that drives participants. How would greater regulation have helped when commercial banks, one of the most heavily regulated of all industries, did so badly during this housing bubble?

I am not trying to deny that consumers often have very imperfect information about the products they buy, but they do not have to rely only on their own information. The advantage to companies of getting and maintaining their reputations as they compete for consumers is a powerful regulator of the quality of products that consumers receive. Shoppers, for example, rely on Whole Foods, Safeway, and other supermarkets to do much of the information processing for them, and consumers hold the supermarkets responsible for bad-tasting foods, and other products that do not live up to claims of their suppliers. It is not the diligence of regulators but the reputations of companies that are mainly responsible for all the high quality merchandise consumers purchase without having to know all the details.

I agree with Posner that companies do not want to "foul their nests", but still companies have had no hesitation in saying that they do not use trans fats-a purely voluntary provision of information to consumers not required by regulations- or that their cereals use oats that may be good for the heart, or that their products are lower than before in salt and fat, or that their airlines have better on-time records or more comfortable seats than competitors, or that their cars have better repair records or better hold their value as they age than cars of competitors, or that their drugs can prevent erectal dysfunction, lower cholesterol levels, treat pain better because of more powerful ingredients than in the past, or have other positive effects on the health and pleasure of consumers.

Posner seems to believe that consumers have less information than in the past because their time is more valuable and they are busier. Their time is more valuable in large measure because they have greater levels of human capital that increases their skills, and enables them to use and process information more effectively. The Internet has also made an enormous difference in enabling consumers to acquire information more easily, whether through offering comparisons of hotel rates and prices of cars being offered for sale, or through the provision of information about effectiveness and side effects of different drugs and medical procedures. The same factors that make time more valuable to consumers make it easier for them to acquire and process information about the products they buy.

Various groups have pushed in recent years for greater regulation of all types of consumer choices, including smoking, eating of fast foods, the ingredients allowed in foods, such as trans fats, the drinking of alcoholic beverages, and many other products and services. This pressure toward greater regulation of consumer choices is not the result of consumers finding it more difficult to get information about products and the consequences of consuming them. Nor have the cognitive defects referred to by Posner become more prevalent or harmful. Instead, the movement toward increased regulation of consumer choices reflects in large measure greater reluctance among some groups to accept these choices. It is unacceptable to many persons both inside and outside the medical profession that some individuals want to smoke or eat a lot and become overweight, even if they knew and possibly exaggerate the negative health consequences of smoking and overeating. The increase in weight of teenagers, for example, is not explained by cognitive biases, but by sharp declines in the cost of fast foods, and the development of Internet and other sedentary games.Increasing intervention in consumer choices also reflects the erosion of individual responsibility (see my discussion on March 16), so that consumers and their advocates blame others when consumer choices turn out to be harmful and costly.

I do not deny that regulations may be required when the consequences of mistakes are very serious, and when the forces unleashed by competition provide inadequate protection. One example is the permissibility of lawsuits against surgeons who make obvious mistakes during their surgeries, such as leaving sponges in a patient's body. Another possible example is the regulation of airline safety, although airlines suffer a lot when they have accidents, regardless of regulatory measures, and government safety regulations have often been inadequate and misleading.

Important exceptions notwithstanding, the overall trend toward greater regulation of consumer choices is disturbing. Consumers make worse decisions when they are not responsible for their decisions, or when they can sue or otherwise get compensated when they make bad decisions. Consumers make mistakes, but they learn from them when they have to bear the consequences of their decisions. They are generally far more competent to make decisions in their own interests than are regulators or lawmakers as long as consumers are the ones who benefit from good choices and are hurt by bad choices. This is why I continue to be a minimalist on government regulation, and greatly prefer the controls over behavior that stem from consumer responsibility and the discipline of competition.

Full post as published by Becker-Posner Blog on May 18, 2008 (boomark / email).