Independence at the CFPB and the Fed

One of my major motivations in starting this blog a few years ago was to have a space to grapple with the topic of central bank independence and accountability. One of the most important things I have learned since then is that independence and accountability are highly multi-dimensional concepts; different institutions can be granted different types of independence, and can fail to be accountable in countless ways. As a corollary, nominal or de jure independence does not guarantee de facto independence. Likewise, an institution may be accountable in name only.

A recent ruling by the U.S. Court of Appeals for the District of Columbia about the independence of the Consumer Financial Protection Bureau (CFPB) highlights the complexity of these issues. The CFPB was created under the Dodd-Frank Act of 2010. On Tuesday, a three-judge panel declared that this agency's particular form of independence is unconstitutional. Most notably, the Director of the CFPB-- currently Richard Cordray-- is removable only by the President, and only for cause.

The petitioner in the case against the CFPB, the mortgage lender PHH Corporation, which was subject to a large fine from the CFPB, argued that the CFPB's structure violates Article II of the Constitution. The Appeals Court's decision provides some historical context:

"To carry out the executive power and be accountable for the exercise of that power, the President must be able to control subordinate officers in executive agencies. In its landmark decision in Myers v. United States, 272 U.S. 52 (1926), authored by Chief Justice and former President Taft, the Supreme Court therefore recognized the President’s Article II authority to supervise, direct, and remove at will subordinate officers in the Executive Branch.

In 1935, however, the Supreme Court carved out an exception to Myers and Article II by permitting Congress to create independent agencies that exercise executive power. See Humphrey’s Executor v. United States, 295 U.S. 602 (1935). An agency is considered “independent” when the agency heads are removable by the President only for cause, not at will, and therefore are not supervised or directed by the President. Examples of independent agencies include well-known bodies such as the Federal Communications Commission, the Securities and Exchange Commission, the Federal Trade Commission, the National Labor Relations Board, and the Federal Energy Regulatory Commission... To help mitigate the risk to individual liberty, the independent agencies, although not checked by the President, have historically been headed by multiple commissioners, directors, or board members who act as checks on one another. Each independent agency has traditionally been established, in the Supreme Court’s words, as a “body of experts appointed by law and informed by experience."

The decision goes on to add that "No head of either an executive agency or an independent agency operates unilaterally without any check on his or her authority. Therefore, no independent agency exercising substantial executive authority has ever been headed by a single person. Until now."

Although the Federal Reserve, unlike the CFPB, has a seven-member Board of Governors, several aspects of their governance are similar: the CFPB Director, like the seven members of the Federal Reserve Board of Governors, is nominated by the President and approved by the Senate. The CFPB Director's term length is 5 years, compared to 14 years for the Governors-- but importantly, both have terms longer than the 4-year Presidential term. The Chair and Vice Chair of the Fed are nominated from the Governors by the President and approved by the Senate for a 4-year term. Both the CFPB Director and the Fed Chair are required to give semi-annual reports to Congress. See these resources for a more detailed comparison of the structure and governance of independent federal agencies.

I find it striking that the phrase individual liberty appears 32 times in the 110-page decision. The very first paragraph states, "This is a case about executive power and individual liberty. The U.S. Government’s executive power to enforce federal law against private citizens – for example, to bring criminal prosecutions and civil enforcement actions – is essential to societal order and progress, but simultaneously a grave threat to individual liberty."

Even though both the CFPB and the Fed have substantial financial regulatory authority, the discourse on Federal Reserve independence does not focus so heavily on liberty (I've barely come across the word at all in my readings on the subject); instead, it focuses on independence as a potential threat to accountability. As I have previously written, "the term accountability has become 'an ever-expanding concept,'" and one that is often not usefully defined. The same might be said for the term liberty. Still, the two terms have different connotations. Accountability requires that the institution carry out its responsibilities satisfactorily, while liberty is more about what the institution doesn't do.

Accountability is a key concept in the literature on delegation of tasks to technocrats or politicians. In "Bureaucrats or Politicians?," Alberto Alesini and Guido Tabellini (2007) build a model in which politicians are held accountable by their desire for re-election, while top-level bureaucrats are held accountable by "career concerns." The social desirability of delegating a task to an unelected bureaucrat depends on how the task affects the distribution of resources or advantages-- and thus, on the strength of interest-group political pressure. As Alan Blinder writes:

"Some public policy decisions have -- or are perceived to have -- mostly general impacts, affecting most citizens in similar ways. Monetary policy, for example...is usually thought of as affecting the whole economy rather than particular groups or industries. Other public policies are more naturally thought of as particularist, conferring benefits and imposing costs on identifiable groups...When the issues are particularist, the visible hand of interest-group politics is likely to be most pernicious -- which would seem to support delegating authority to unelected experts. But these are precisely the issues that require the heaviest doses of value judgments to decide who should win and lose. Such judgments are inherently and appropriately political. It's a genuine dilemma."

The Federal Reserve's Congressional mandate is to promote price stability and maximum employment. Federal Reserve independence is intended to promote these objectives by alleviating political pressure to pursue overly-accomodative monetary policy. Of course, as we have seen in recent years, the interest-group politics of central banking are more nuanced than a simple desire by incumbents for inflation. Interest rate policy and inflation affect different segments of the population in different ways. The CFPB is supposed to enforce federal consumer financial laws and protect consumers in financial markets. The average benefits of the CFPB to individual consumers is probably fairly small, while the costs of regulation and enforcement to a smaller number of financial companies is large. This asymmetry means that political pressure on a financial regulator like the CFPB (or on the Fed, in its regulatory role) is likely to come from the side of the financial institutions. In Blinder's logic, this confers a large value on the delegation of authority to technocrats, while at the same time raising the importance of accountability for political legitimacy.

Tyler Cowen writes, "I say the regulatory state already has too much arbitrary power, and this [District Court ruling] is a (small) move in the right direction." It is not the reduction of the regulatory state's power that will necessarily enhance either accountability or liberty, but the reduction of the arbitrariness of the regulatory power. This can come about through transparency (which the Fed typically cites as key to the maintenance of accountability), making policies and enforcement more predictable and less retroactive and reducing uncertainty. I don't know that the types of governance changes implied by the District Court ruling (if it holds) will substantially affect the CFPB's transparency or make it any less capable of pursuing its goals, as I tend to agree with Senator Elizabeth Warren's interpretation that the ruling will only require “a small technical tweak.”

Behavioral Economics Then and Now

“Although it has never been clear whether the consumer needs to be protected from his own folly or from the rapaciousness of those who feed on him, consumer protection is a topic of intense current interest in the courts, in the legislatures, and in the law schools." So write James J. White and Frank W. Munger Jr. in a 1971 article from the Michigan Law Review.

Today, it is not uncommon for behavioral economists to weigh in on financial regulatory policy and consumer protection. White and Munger, not economists but lawyers, played the role of behavioral economists before the phrase was even coined. They managed to anticipate many of the hypotheses and themes that would later dominate behavioral economics-- but with more informal and colorful language. A number of new legislative and judicial acts in the late 1960s provided the impetus for their study: 

"Congress has passed the Truth-in-Lending Act; the National Conference of Commissioners on Uniform State Laws has proposed the Uniform Consumer Credit Code; and many states have enacted retail installment sales acts to update and supplement their long-standing usury laws. These legislative and judicial acts have always relied, at best, on anecdotal knowledge of consumer behavior. In this Article we offer the results of an empirical study of a small slice of consumer behavior in the use of installment credit. 

In their recent efforts, the legislatures, by imposing new interest rate disclosure requirements on installment lenders,  have sought to protect the consumer against pressures to borrow money at a higher rate of interest than he can afford or need pay. The hope, if not the expectation, of the drafters of such disclosure legislation is that the consumer who is made aware of interest rates will seek the lowest-priced lender or will decide not to borrow. This migration of the consumers to the lowest-priced lender will, so the argument goes, require the higher-priced lender to reduce his rate in order to retain his business. These hopes and expectations are founded on the proposition that the consumer is largely ignorant of the interest rate that he pays; this ignorance presumably keeps him from going to a lender with cheaper rates. Knowledge of interest rates, it is believed, will rectify this defect…”

Here comes their "squatting baboon" metaphor:

“Presumably, consumers in a perfect market will behave like water in a pond, which gravitates to the lowest point-i.e., consumer borrowers should all tum to the lender that gives the cheapest loan. We began this project with a strong suspicion-based on the observations of others-that the consumer credit market is far from perfect and that water governed by the force of gravity is a poor metaphor with which to describe the behavior of consumer debtors. The consumer debtor's choice of creditor clearly involves consideration of many factors besides interest rate. Therefore, a metaphor that better describes our suspicions about the borrower's behavior in a market in which rate differences appear involves a group of monkeys in a cage with a new baboon of unknown temperament. The baboon squats in one comer of the cage near some choice, ripe bananas. In the far comer of the cage is a supply of wilted greens and spoiled bananas, the monkeys' usual fare. Some of the monkeys continue eating their usual fare because they are unaware of the new bananas and the visitor. Other monkeys observe the new bananas but do not approach them. Still others, more daring or intelligent than the rest, seek ways of snatching an occasional banana from the baboon's stock. The baboon strikes at all the brown monkeys but he permits black monkeys to eat without interference. Yet many of the black monkeys make no attempt to eat. One suspects that a social scientist who interviewed the members of the monkey tribe about their experience would find that many of those who saw and appreciated the choice bananas would be unable to articulate the reasons for their failure to eat any of them. The social scientist might also discover that a few who looked at the baboon in obvious fright would nevertheless deny that they were afraid. In addition, he might find that some were so busy picking fleas or nursing that they did not observe the choice bananas at all. We suspected that consumer borrowers had similarly diverse reasons for their behavior.

We presumed that some paid high interest rates only because of ignorance of lower rates and that others correctly concluded that they could not qualify for a cheaper loan than they received. Others, we suspected, were merely too lazy or too fearful of bankers to seek lower rates.”

Suggesting that people are just lazy, or comparing them to monkeys, has (understandably) fallen out of fashion. But pointing out that consumers are not Homo economicus has not. The authors interview people in Washtenaw County, Michigan who had purchased a new car in 1967. Most of the lenders in the area loaned money at the legal maximum add-on, while Huron Valley National Bank (HVNB) loaned at a significantly lower rate. They interview an HVNB loan officer to determine whether different borrowers would have received a loan from HVNB in 1967 and at what terms. They find that most of the consumers in their sample could have borrowed at a lower rate.

A majority of the sample did not know the rate at which they had borrowed. Most had allowed the auto dealer to arrange the loan rather than shopping for the lowest rate. Even if they knew that lower rates were available elsewhere, they declined to shop around. The authors find differences in financial sophistication, education, and job characteristics between consumers who shopped around for lower rates and those who did not. They conclude:

“The results of our study suggest that, at least with regard to auto loans, the disclosure provisions of the Truth-in-Lending Act will be largely ineffective in changing consumer behavior patterns. Certainly the Act will not improve the status of those who already know that lower rates are available elsewhere. And we discovered no evidence that knowledge of the interest rate-which, even under the Act will usually come after a tentative agreement to purchase a specified car has been reached-will stimulate a substantial percentage of consumers to shop for a lower rate elsewhere.”

The authors come down as pessimistic about the Truth-in-Lending Act, but make no new policy recommendations of their own. If they were writing today, instead of just predicting that a policy would be ineffective, they might suggest ways to design the policy to "nudge" consumers to make different decisions. The Truth-in-Lending Act has been amended numerous times over the years, and was placed under the authority of the Consumer Financial Protection Bureau (CFPB) by the Dodd-Frank Act. Behavioral economics has played a central role in the work of the CFPB. But the active application of behavioral law and economics to regulatory policy is not universally accepted. For example, Todd Zwicki writes:

"We argue that even if the findings of behavioral economics are sound and robust, and the recommendations of behavioral law and economics are coherent (two heroic assumptions, especially the latter), there still remain vexing problems of actually implementing behavioral economics in a real-world political context. In particular, the realities of the political and regulatory process suggests that the trip from the laboratory to the real-world crafting of regulations that will improve consumers’ lives is a long and rocky one."

Zwicki expands this argument in a paper coauthored with Adam Christopher Smith. While I'm not convinced that their rather negative portrayal of the CFPB is warranted, I do think the paper presents some provocative cautions about how behavioral economics is applied to policy--especially the warning against "selective modeling of behavioral bias," which I have heard even top behavioral economists caution against.

Emporiophobia!

For Christmas, my husband gave me a game called Forbidden Island. It is a "collaborative game," as opposed to a competitive game, created by "cooperative game master" Matt Leacock. Everyone wins or everyone loses. As my relatives and I puzzled our way through the rather lengthy game instructions, there was no end to the jokes about an economist playing a non-competitive game. I'm sure you can imagine.

The game, it turns out, is quite fun, and I've already been subjecting house guests to it (so be forewarned.) Forbidden Island came instantly to mind when I just came across a new article by Paul Rubin, an economics professor at Emory University. I was attracted to the article by the title, which introduces a fun new word: "Emporiophobia (Fear of Markets): Cooperation or Competition?" (Southern Economic Journal, forthcoming.) Though I find plenty to disagree with in the article, it is very thought-provoking and an enjoyable read. From the abstract:

Widespread emporiophobia (fear of markets) has important policy implications, as it leads voters to demand anti-market policies. There are many reasons for this anti-market attitude; however, economists could reduce emporiophobia if we stressed cooperation rather than competition in writings and policy discussions. In a sample of introductory textbooks, competition is mentioned on average eight times as often as cooperation. The fundamental economic unit is the transaction, and transactions are cooperative. The benefit of a market economy - increased consumer surplus - comes from cooperation through transactions, not from competition. Competition in a market economy is competition for the right to cooperate. Competition is important because it guarantees that the best cooperators will win and because it establishes the efficient terms for cooperation, but cooperation is fundamental. For most people, competition has negative connotations as it focuses on losers, while cooperation implies a win-win situation.

Emporiophobia is a made-up word, and my first instinct was to wonder if it described a made-up problem. Actual fear of markets isn't something I see much-- even in Berkeley, subsistence farming hasn't gotten trendy. But Rubin says fear of markets is "all around us."  He directs readers to Bryan Caplan's book, The Myth of the Rational Voter, for evidence of rampant emporiophobia. He also cites a recent article, "Economic Experts versus Average Americans" by Paola Sapienza and Luigi Zingales, and articles on anti-market bias in movies. When he begins to describe examples of emporiophobia, I realize that the term means something different than I thought:

"The statute books are full of laws limiting or restricting markets (minimum wages, farm price supports, occupational licensing laws, tariffs, numerous entry restrictions, anti-gouging regulations following disasters). Washington is packed with regulatory agencies whose purpose is to limit the functioning of markets. (I myself worked for two such agencies, the Federal Trade Commission, in the 'consumer protection' area, and the Consumer Product Safety Commission.)"

In other words, he classifies any desire to limit or regulate markets as fear of markets-- a fear that Rubin himself overcame. Rubin describes his own conversion from a young person who was "quite leftist, and even socialist, as was consistent with my demographic" to a "hard core believer in markets."

While I do not agree that  minimum wages, consumer protection, and the like exemplify a fear that needs to be alleviated, I do find discussions of the language and metaphors of economics very interesting. Rubin cites Deirdre McCloskey's classic work on rhetoric and metaphors in economics, and contributes his own analysis of the language in popular economics textbooks. He looks at the relative frequencies of the words "competition" and "cooperation" in a number of microeconomics texts.

Tyler Cowen and Alex Tabarrok's Modern principles: Microeconomics mentions competition 8 times as often as cooperation, which is about average. The highest ratio, 20.43, is Robert Frank and Ben Bernanke's Principles of Microeconomics. Greg Mankiw's Principles of Microeconomics and Paul Krugman and Robin Wells' Microeconomics have the lowest ratios, at 5.45 and 4.45, respectively. I don't find these ratios terribly surprising, since these are micro texts so they likely include multiple chapters on market structure: the differences between perfect competition, monopolistic competition, and monopoly. It would be interesting to look at macro texts. In my blog, which is more or less macro-focused, I can't recall using either term very frequently.

Why does Rubin care so much about the terms competition and cooperation? He explains, in a thoughful passage:

People engage in economic activities in order to maximize utility, and winning or losing (for example, having the largest market share, or the largest profit, or the highest income) is incidental to the actual goal, although some may gain utility from having the largest market share. Then characterizing behavior as competitive is metaphoric, and is not in general the best metaphor. “Competition” is a metaphor borrowed from sports, and it is not an appropriate metaphor for the economy.

The most fundamental economic act is the transaction...Moreover, as economists we know that all parties expect to benefit from a transaction, else it would not occur. Thus, a transaction is a cooperative act–an act benefitting all who voluntarily participate in it. The essence of economics is cooperation through transactions and markets. 

He also adds a smart discussion of the zero-sum thinking that can accompany the idea of competition. Zero-sum thinking, when applied inappropriately, is indeed a harmful misconception. Some of his applications, however, I find problematic. "It is natural for people to observe those who are unsuccessful (e.g., the poor, the homeless, failed businesses) and assume that these people are the losers from economic competition, and that their unfortunate position was caused by competition," he writes. He adds,

"Why are some people poor? The competitive metaphor says they are poor because they were outcompeted, and perhaps their wealth was expropriated by the rich. (The folk saying “The rich get richer and the poor get poorer” implies causality.) But economists know that this is not why people are poor. They are poor because they have little or nothing worthwhile to sell–no capital, no valuable marketable skills. That is, the poor are poor because they are unable to enter into cooperative relationships with others. We may feel sorry for someone who is poor, whether this is because they have lost in a competitive contest or because they are unwilling or unable to cooperate successfully with others...There is no external agent to blame for poverty if the poverty is caused by a lack of things to sell, rather than by losing in a competitive contest. The solution to poverty caused by a lack of something to sell is to increase the human capital of the poor, generally through increased education. 

This is an important point. Much harm is done by seeking villains who have caused poverty, generally by being viewed as outcompeting others. For one example, consider that the poor may not have much to sell, but they may have something. But if we view poverty as being caused by successful competitors exploiting the poor in markets, we may restrict the markets in which the poor do cooperate (for example, through usury laws or minimum wages) and actually reinforce their poverty."

First, increasing the human capital and education of the poor is certainly a noble goal, but is an unrestricted market likely to attain it in the near future? I find that unlikely. Second, exploitation and expropriation can and do exist, even in a free market. Even if we describe markets as cooperative, there is no guarantee of fair play. Third, even if we describe markets as cooperative, unreasonable levels of inequality still result. "Lack of things to sell" or inability to cooperate are unsatisfactory explanations of poverty, and I see no explanation of how an unrestricted market would address them. I can't say that I have a fool-proof solution to poverty, but I do think that seeking and implementing better policy solutions is necessary. In that sense, a healthy fear of markets is a good thing.

One final note. If I think back to my own introductory economics education, the "c" word that stood out most to me was neither competition nor cooperation, but coordination. After all, the invisible hand is one of the profession's most famous metaphors.

Regulation: A Nation Divided

An immersion blender is a kitchen gadget most people never encounter until receiving one as a wedding gift.  My husband and I had dinner with another newlywed couple and got into a discussion about the merits of this wonder tool and the vats of cream of vegetable soup we have been creating. Our friends warned us that immersion blenders are a danger in disguise, according to the New York Times, and have resulted in numerous traumatic hand injuries.

More informative than the Times article is its comment thread, which is 335 comments long and reveals a nation starkly divided on regulatory philosophy. Comments range from this:

It's articles like this that often cause Americans to be the laughing stock of the world. Would you reach inside a blender with your hands? Pluck a twig from a powered chainsaw? Lick the blade of a knife? Wash your dog in the washer? We all do silly things and get hurt in stupid ways (don't I know it!), but really, do these things really need to be spelled out?
Sometimes there's just no cure for someone's careless mistake, it's no one's fault but one's own, and it's where Darwin intervenes.

To this:

Accidents happen and one must always be careful around such potentially dangerous tools, but this is clearly a case of irresponsible product design. They need to fix this and prevent any more of these frightening occurrences. As for the people in this thread that think this only happens to "stupid" and "careless" people, think again. Accidents happen for many reasons and they may very well happen to you one day... It is clearly a badly designed product and needs to be changed. If it takes lawyers and lawsuits to do that then I'm all for it.

Economists tend to think that the main challenge when it comes to regulation is to properly understand the system to be regulated and properly design the regulations so that they effectively alleviate problems with the system without causing undesirable side effects. The immersion blender story is so striking because this is not the case at all. It is a simple mechanical system that is perfectly well understood. The proposed regulations requiring interlocks or a different handle design are also perfectly understood because they are also simple and mechanical. Everyone can agree that requiring a design change would prevent some of these finger injuries. And yet they cannot agree about whether a design change should be required. The comment writers vehemently defend their pro- or anti-regulation stance. Some argue that accidents can happen to anyone and we need protection against scenarios that make accidents more likely. They want regulations requiring safety features added to the blenders and clearer warning labels. Others argue that the blender is not the problem; stupid people who do stupid things with the blender are the problem. Presented with the same facts, people tell different stories.

We will never be able to understand the workings of the economy or the financial sector as well as a mechanical tool. But we think that, as long as we work toward that goal, we can come closer to perfect regulatory design. Unlikely. Even when people agree on what regulation will do, they disagree on what it should do.