Vanilla finance and the public option (28 Sept 2009)

Steve Waldman has a great post about the Consumer Finance Protection Act, which has just had what's known as the "vanilla" provisions taken out of it -- these are the no-frills straightforward financial products (think 30-year fixed-rate mortgages and low-interest, low-fee credit cards) that banks would have been required to provide alongside of the complicated hidden-option-laden mortgages and the teaser rate cards and all that other junk for suckers who can't understand financial trickery, i.e. just about everyone. As Waldman explains, the market for financial products is rife with information problems. Consumers don't understand the market but are compelled to enter into anyway if they want to live "the American dream" of owning a house, just like the hegemonic ideology insists we should.

Consumers know they are at a disadvantage when transacting with banks, and do not believe that reputational constraints or internal controls offer sufficient guarantee of fair-dealing. Status quo financial services should be a classic "lemons" problem, a no-trade equilibrium. Unfortunately, those models of no-trade equilibria don't take into account that people sometimes really need the products they cannot intelligently buy, and so tolerate large rent extractions if they must in order to transact.
The price of assuring that one is not taken advantage of by financial service providers is not participating in the modern economy. You cannot have a job, because payments are by check or direct deposit. You cannot buy a home or a car, because for the vast majority, those purchases require financing. Try travelling with only cash for plane tickets, hotel rooms, and car rentals. People will "voluntarily" participate in markets rigged against them for the privilege of being normal. And we do, every day.

This is a lot like the health care market, in which consumers are procuring a service about which they must defer to the expert they are procuring it from, trusting that their ethics are sound.

With a vanilla option in place, consumers would able to take some solace that they weren't being exploited, that instead they would pay a fair, explicit cost for a loan rather than being taken advantage of. Waldman:

Instead of tolerating rent-extraction as a cost of participation, consumers put up with one-size-fits-all products in exchange for peace of mind. Most consumers benefit very little from exotic product features, and I suspect that many are made deeply nervous by the complex contracts they can neither negotiate nor understand, but nevertheless must sign. Vanilla financial products would be extensively vetted and and their characteristics would soon become widely known. Inevitable malfunctions would be loudly discussed in the halls of Congress, rather than hushed-up in rigged private arbitrations. Vanilla products would face discipline both from private markets (no one is suggesting we forbid other flavors) and from a very public political process. Politics and markets are both deeply flawed, but they are flawed in different ways, and we should take advantage of that.

The rationale for a public option in health care is similar -- a simple insurance plan that sets a base line that assures that individuals are reasonably covered and won't be denied coverage when they need it on a technicality. If you want more elaborate coverage, you can do the research and get it. But if you want what has been deemed the basic acceptable standard (with the government protecting you from exploitation) without wading into the intricacies of the insurance market, you can do that too. Of course, if you think government is always the villain and has some incentive in exploiting you, you might be wary of this. But you still have the ability to go the for-profit route if you believe that will guarantee better service.

As Waldman says about the vanilla financial products, "Rather than being anti-market, vanilla financial products would help correct very clear market failures that arise from imperfect information and high search costs. It is the status quo that is anti-market." The status quo protects the information asymmetries that allow banks and insurance companies to extract rents -- that is, earn money simply by being pitiless gate-keepers or by locking people into non-optimal contracts with hidden fees and options that can be exercised against them. With a vanilla option (or public option), as Waldman explains, there is a "commoditized" offering that forces more overt competition from providers (or more unmistakable collusion otherwise). It forces a market for "ostentatious simplicity" as Waldman calls it -- forces banks to compete on providing the simplest product for customers craving simplicity. Currently banks have no incentive to do this; it's more lucrative to take advantage of customers' confusion. (The same is true of health insurance, and cell-phone service to some degree as well.)

Some might complain that vanilla options incentivize ignorance, or at least remove the penalties for it. It may remove advantages that savvy consumers might be able to take advantage of at the expense of their fellow citizens. But is that the kind of society we want? Personally, I don't. I don't want to save a few bucks on my check-ups while other people die of swine flu.