Note: I use the word "state" in this post to mean "the state", government generally, not state as opposed to federal government in the US. Thanks to Richard Serlin for pointing out the ambiguity.

Tyler Cowen writes

Now it's dead, everyone else has been blogging it...

The first thing to note is that vanilla is not dead. State-defined vanilla products are not an idea narrowly applicable to this moment's consumer finance challenges. They are, or could become, an important part of the regulatory arsenal in a wide variety of contexts. They are a tool whose development people with libertarian impulses (including, though you may not believe it, me) should view with cautious enthusiasm. At its core, the purpose of defining a vanilla option is to offer an additional choice, a well-understood default that helps consumers to weigh the purported benefits of exotic alternatives against the uncertainty costs they carry. Libertarians might reasonably object to a requirement that private enterprises offer vanilla products (although the objection is less compelling for industries that are and will continue to be state subsidized and regulated). But first and foremost, vanilla products are about cajoling into existence products that, despite their complexity, can be credibly certified as functional and nontoxic. The idea is in the "libertarian paternalism" / "nudge" tradition of not-exactly-regulation which, however objectionable, is less objectionable than the unqualified paternalism that may result from continued dysfunction and crisis. (Tyler might note a familiar form to this argument.)

The crucial question is whether governments could deploy vanilla products well. Both Tyler and Ezra Klein make the usual sad-but-true public-choice argument that, while vanilla might be a good idea in theory, what compromised politicians and bureaucracies actually offer might, in practice, not be so great.

They are undoubtedly right to be worried. But public choice concerns should always be the beginning, not the end, of a conversation. It's both incorrect and intellectually lazy to frame the argument as many "pro-market" commentators do (not Tyler or Ezra!), that sure, markets make mistakes, but politician-run governments make "worse" mistakes, so we are better off letting imperfect markets have free reign.

Governments and markets are dissimilar in the form and causes of their mistakes, and the badness of their errors is not uniformly rankable. Imagine that "what is to be done" is a radio signal being sent over two channels, both subject to maddening (but nonidentical) interference. A dumb strategy for extracting the signal would be to just decide that one channel is cleaner, and then throw away the other signal. Smarter strategies combine the information from both signals, and using information from each signal to help correct the errors of the other. There are domains where history and reason suggests that even terribly flawed markets provide a better signal than government. There are other domains where terribly flawed political processes generate a better signal than status quo markets. We should weight the different signals accordingly. But we should always be alert for opportunities to exploit the different strengths and weaknesses of markets and governments to produce better results than either could alone. How to do so, in real life rather than radioland, is an art. But vanilla products have the potential to be a masterpiece of the form. We have to insist on just one point.

A vanilla product must be defined by a uniform contract that regulators write and publish and that varies in a single dimension.

Of course regulators would consult with industry and consumer groups, and of course industry lobbyists would struggle to capture the process and embed their spicy "tricks and traps" into our vanilla creme. But they'll have a hard time doing so, as long as authorship and responsibility for the terms of the contract and its evolution over time rest with the regulatory agency.

Here's why. If the contract is written by the regulator, when consumers get screwed, they get screwed by the regulator as much as by the firm that sold them the product. Think about the politics of that. Suppose Struggling-Mom-Of-Four finds her credit card interest rate skyrocket because she missed a phone bill, and the industry had slipped a universal default provision in the "vanilla" credit card terms. When that story gets on the local news channel, it's no longer a just a story about megacorp screwing ordinary family. It's a story of the government screwing Mom-Of-Four, directly and on behalf of megacorp. When megacorp screws someone via a private arrangement, the populist "do something!" impulse is blunted by concerns about liberty and contract and personal responsibility. Citizens are genuinely divided about when government interference in private affairs is justifiable, so politicians get conflicting signals from their constituents, and unconflicted signals from megacorp not to interfere.

But citizens are not at all conflicted that the government should intervene to prevent the government from screwing people. If a contract written and owned by regulators has not-well-understood characteristics that leave consumers surprised and unhappy, representatives' "constitutent services" lines will ring off the hooks. Politicians that refuse to intervene against well-publicized injustices will be quite vulnerable, since they'll lack the usual philosophical justifications to defend inaction. So politicians will act. State ownership of vanilla contracts provide dispersed consumers a means to challenge concentrated industries for ownership of regulators, by virtue of the hypersensitivity of elected representatives to charges that they fail protect their constituents from rapacious government.

Another benefit of a uniform, regulator-owned contract has to do with the legal system. Every contractual arrangement is attended by legal uncertainty. A freshly written contract is quantum mechanical — words imbue a probability distribution that collapses to determinacy only when observed at the tip of a judge's gavel. (Usually no cats are killed.) Vanilla contracts offer an economy of scale in dispelling legal uncertainty. Disputes over vanilla arrangements would be quickly adjudicated, by public courts, not private arbitrators (binding arbitration would be a political nonstarter). Since there would only be one contract, legal precedents would be portable across providers. The characteristics of vanilla contacts would quickly become well-settled and widely known.

Vanilla contracts may or may not be dead this cycle, with respect to regulation of financial products. There are many other policy domains where vanilla contracts might be useful. I'd like a bit of vanilla with my health care, thank you very much. The Washington Post has an an excellent article about the too-little-discussed problem of tacit cherrypicking by insurers despite a formal "community rating" requirement (ht Dean Baker). This bit caught my eye:

A straightforward way to reduce gamesmanship is to standardize benefit packages, Precht wrote in a July report. One issue lawmakers must resolve is how much latitude to leave insurers over what they cover and how.

Sound familiar?

Extra vanilla

I realize I'm on time-delay, and that this is all so very last week. (When I am only a week behind, it's like living in the future.) Anyway, here's my RSS reader's dump of vanilla related links, in reverse chronologil-ish order. As always, if I've missed you, that's my lameness, not yours:

For the econgeeky, be sure to check out Karl Smith's piece (via Mike Konczal), which describes the costs of tutti-frutti into familar microecon diagrams, and this very nice paper by Gabaix and Laibson, that formally models much of the problem vanilla products are intended to solve (via Mike Konczal, via Tyler Cowen, via Christopher Shea who outlines the argument in accessible terms).

Update History:
  • 06-October-2009, 11:10 p.m. EDT: Added note clarifying that by "state" I mean "the state", not state-level government in the U.S. (and thanking Richard Serlin for pointing out the problem!)
Steve Randy Waldman — Tuesday October 6, 2009 at 11:50am permalink
Richard H. Serlin (mail) (www):
An important point about state required vanilla products, and about state requirements in general, like having the public option in health insurance decided state by state, is that some of the states are enormous. If you got just two blue states, California and New York to go along, that would be close to 1/5 of the U.S. population. And success there could encourage many other states to go along.

Often, federal is much higher economies of scale (and economies of simplicity, an important but little thought about concept) and cheaper, and better. But if Republicans won't permit the smarter and better solution, state laws can still be a big improvement, and can encourage later federal action be demonstrating the benefits.
10.6.2009 9:52pm
Steve Randy Waldman (mail) (www):
Richard — Uh oh... you often write about how it's better to be precise than to write jauntily. I'm afraid I ran afoul of your good rule. I was using "state" in the sense of "the state", as a synonym for government generally, and with the Federal government primarily in mind. I'd have to think more carefully than I have before commenting on state-vs-federal issues, but my inclination is to be nervous about doing much at the state level, because if restricted to residents it adds bureaucratic complications to itinerant lifestyles and impedes labor mobility, but if 50 states offer "vanilla" products to everyone, some states will be captured, and residents will approve, because those sophisticated enough to know will just buy products from elsewhere and locals benefit from becoming a financial services magnet. I think I really do mean federal govt. I'll add a note.
10.6.2009 10:49pm
RamiroH (mail):
Whatever you mean by the vanilla thing, as long as you point it to the government those people who don't take personal sides with the government can understand it. Enduring the financial nuclear winter we're experiencing right now is forcing banks and other mainstream lending institutions to revisit their lending policy. The lending policy for mainstream credit sources and also their application processes are getting far more stringent, and they are less willing to lend. Non-traditional loans are also harder to come by, as there has been a retraction of credit in global markets, even capital for short-term loans. Credit card companies are also feeling the pinch, and hiking interest rates to keep suits in money – to keep their monopoly and all traces of accountability and competitive customer service away! Still, with mainstream lenders restricting lending policy, more and more consumers are turning to payday loans.
10.22.2009 2:09am
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