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Wednesday, August 08, 2007

Fed's Stern: "Painful and Belated Learning"

by Calculated Risk on 8/08/2007 06:25:00 PM

Minneapolis Federal Reserve President Gary H. Stern spoke today: Comments on Release of the Nation’s Report Card: Economics 2006

... I regret to note that today we are again witnessing some painful and belated learning, by policy-makers and consumers alike, in our consumer financial markets.

As you are probably well aware, consumers today have access to a wide array of borrowing and savings options. In itself, variety is good, because it expands choice and opportunity. However, variety also fosters complexity, which challenges both consumers in their decision-making and financial regulators in their writing and enforcement of rules.

... I view consumer regulation and consumer education as substitutes. If consumers are more educated and able to make good decisions on their own, regulations can be narrower and more focused on clearly abusive practices such as deceit and fraud.

This is valuable, because as the scope of regulation widens, so does the cost. ...

... In some cases it is necessary and appropriate that we bear these costs in order to prevent even greater abuses elsewhere. However, regulation involves a tradeoff between preventing harm to some and allowing innovation, gains from trade, and free choice for others. At any given time, we write regulations as best we can to balance that trade off. Over time, however, we hope that better economic education will soften the trade off and allow us to rely more on the informed decision-making of consumers and less on formal restrictions.
Stern's subject was economic education. He appears to suggest policy makers overestimated the skills of American consumers, and therefore underestimated the need for more regulation - obviously referring to the housing slump.

This assertion seems absurd.

It was the policy makers who didn't recognize rampant speculation in the housing market. While we joked about "liar loans" here on Calculated Risk, the policy makers were congratulating themselves on the "ownership society". I'd argue home buyers who used no money down option ARMs were making a rational choice: they were balancing the odds of a big payday with little financial risk - if the property continued to appreciate - with the stigma of a foreclosure on their record. Obviously many home buyers felt the stigma was worth the risk. I don't see that as a lack of economic education, rather a rational choice given the circumstances.

But I can't think of a good excuse for the inaction of the policy makers.