11/30/2009 05:12 am ET | Updated May 25, 2011

Prediction Impossible: How Protecting Consumers Is Like Protecting the Environment

The financial crisis has left conservative policymakers on their guard. The notion that all financial innovation is good is not holding water and wonks on the right are scrambling to concoct viable alternatives to the Consumer Financial Protection Agency (CFPA) advocated by the White House and, in a weaker form, by Rep. Barney Frank's Financial Services Committee.

In testimony to that committee today, Heritage Foundation scholar David John suggested that a CFPA "would be a huge mistake that would hurt consumers far more than it helps them." Instead, John proposed the creation of the Federal Financial Institutions Examination Council (FFIEC). The Council would examine regulatory standards set by individual states and federal regulators in order to create uniform standards that apply to all financial institutions and meet "the challenges posed by complex new financial products."

Beyond the obvious shift away from consumer protections invoked by the name of the council and beyond the disingenuousness suggested by the unwieldiness of the name and its acronym (we all know acronyms cannot be longer than four letters), the FFIEC would continue to allow -- even encourage -- regulatory arbitrage (shopping among states for lax regulators); would give financial institutions continued access to their preferred mode of influence (rulemaking regulators); and would abandon any strong mandate to protect consumers first.

There are numerous other responses to the financial crisis being discussed, ranging from the G-20's peer review strategy to super-regulators and safeguards for systemically important institutions. One of the commonalities of these approaches, including the FFIEC, is that they are primarily strategies to prevent crises, not predict them. Unlike CrimeStat programs, for instance, that can reveal concentrations of criminal activity at which police forces target resources, these proposals target resources first.

This is primarily because the severity of financial crises is hard to predict. As the Federal Reserve Bank of San Francisco pointed out this week:

[Our analysis bodes] poorly for the success of early-warning models going forward...We conclude that constructing a plausible statistical model that can predict financial crises similar to the current one will be challenging.

The effort to address climate change involves a similar challenge. We know global temperatures are rising and we know the types of risks this poses to our economic and physical well-being. But it is extremely difficult to predict with certainty when or how serious these risks will be in, say, 20 years. Sure, the IPCC can formulate models that estimate impacts, but technological changes and government intervention will inevitably alter these impact estimates significantly. Again, all we can say with certainty is that climate change is happening and the impacts will be negative, just like we can identify, as the FRBSF also points out, "signals of rising levels of risk in the economy."

If we knew, say, that sea levels would rise only in City A, then perhaps our best and cheapest strategy would be to move City A and its residents to higher ground. Similarly, if we knew, say, that financial innovation A would cause a financial meltdown, we would do best to eliminate it. The problem, however, is that such predictions are extremely difficult (impossible) to make.

Instead, we must rely on strategies to create predictable, relatively stable conditions that can provide us a better idea of where, when, and even what type of good and bad things are going to happen. For instance, climate change legislation in Congress sets clear goals for emissions reductions that offer control of how quickly social costs of global warming are created, rather than permitting the private sector to create costless externalities at will.

The Consumer Financial Protection Agency, more than John's FFIEC and the other proposals for financial system reform, seeks to create such stable conditions in the financial sector. By using consumer well-being as a first principal, the CFPA will consider the social costs of financial innovations. Without consideration of these social costs (and benefits) in recent years, the financial services industry sowed the seeds of a crisis without even knowing it. Reforms like the FFIEC would do little to take these social costs into account.

Though regulators are unlikely to ever know whether a particular financial innovation will lead to financial collapse, the CFPA offers significantly more knowledge about whether financial innovations are hurting or helping the country as a whole.