Financial Regulation: Paulson Misses the Trial and Error Economy

This new regulatory proposal from Treasury Secretary Paulson reminds me of the Patriot Act.  The department has a laundry list of changes it wants.  Then there's a crisis.  At which point the department pulls out its laundry list and says, "This is the solution to our crisis."  In reality, it's just the plan that they had on the shelf for a year.  If it really would have prevented the crisis, then the Treasury Secretary should be fired for failing to push harder to get that plan passed earlier.  But of course, that's not the case.

The Wall Street Journal editorial has the key insight into financial regulations:  the market is doing its job.  People say to me, don't we need some regulation to prevent lending to people who cannot afford the loans?  Here's what happened.

1. Lenders experimented with loans to people of lesser credit quality.
2. It worked in the initial stages, so the experiments were expanded into programs.
3. The large-scale programs failed miserably, causing billions of dollars of losses to the people who invested in the loan program.

Now, do we need laws to keep these investors from lending money to subprime borrowers?  I don't think so.  It will be years before those investors will touch that stove again.

If investors won't participate in large subprime lending schemes again, what would be wrong with some regulations?  After all, a regulation that prohibited me from hitting myself in the head with a hammer would not really crimp my recreational choices.  Here's the rub:  entrepreneurs need to experiment.  Some folks who are subprime may really, truly, be good credits.  If we regulate that loans can only be made to people with good credit, then lenders cannot experiment to find out if maybe they should change their lending guidelines.

A key element of our trial and error economy is that good business practices cannot be fixed in stone.  Companies experiment, try tightening a little, try easing a little, look for under-served markets.  For example, take "stated income" loans, in which the lender took the borrowers stated income at face value, without verifying the facts.  Sounds pretty stupid in retrospect.  So let's make a law that income has to be verified.  However, you've just redlined those folks with income that is inherently unverifiable: strippers, street performers, flea market vendors, etc.  We should allow lenders to test the waters with these people.

(If you are not a regular reader of the blog, take a look at some of the articles in the "trial and error economy" theme.)

Insurance regulation?  Part of the plan is a new federal insurance regulator.  What's the problem here?  My car insurer, home insurer, life insurer, are now regulated by my state.  I have not heard of any crisis, scandal or problem here.  This is another case of a "crisis" being used to justify totally unrelated regulatory changes.

Secretary Paulson says the plan will "reestablish the federal government's role in regulating the insurance industry by reclaiming a portion of its delegation of insurance regulation to the states..."  Whoa.  I'm not a lawyer, but I'm stunned that the Treasury Secretary thinks this way.  The constitution does not grant to the federal government authority to regulate insurers, aside from the federal government's authority over interstate commerce.  There has been no delegation of power from the federal government to the states, because the federal government never had it.