07/06/2010 12:22 pm ET | Updated May 25, 2011

A Tale of Phrenologists and Predatory Lenders

In Tennessee, defendants won a court case in which prosecutors had attempted to stop them from marketing a service that was to be "inherently fraudulent."

No, the above is not the latest update on the battle over overdraft fees and payday loans. The embattled businessmen were not part of the banking industry currently trying to lobby their way out of regulation, but a group of fortune tellers, who were successful in striking down a local ordinance requiring all fortunetellers, clairvoyants, hypnotists, phrenologists, etc. to post a disclaimer if they attempted to ply their trade for profit.

The plaintiffs didn't seek to outlaw fortunetelling per se, they just wanted the psychics held to some standard of truth in advertising. If the psychics couldn't provide evidence to back up their own hype, well, that was just too bad.

Barbara Moss, one of the attorneys for the psychics, argued that selling is a form of protected speech. She said:

"A person is free to write or sell books saying that the earth is flat or the moon is made of green cheese. Our client should be free to make predictions, for fun or profit, without government interference."

This argument fails to recognize that there is a difference between claiming that the moon is made of cheese and selling your cheese to gullible customers by marketing it as genuine moon-cheese, shipped back by satellite.

The question comes up again and again for regulators and lawmakers. When is a product so harmful that it ought not be sold at all? When is a product so noxious that we can conclude that no one would freely choose to buy it if s/he was fully informed? This is what is at the root of many of our debates over cigarettes and other mostly toxic products. Companies argue that the existence of a market for the product shows that customers have judged what they're selling to be worth the risk.

This is the argument we keep hearing as the Senate lumbers toward passing a financial reform bill. The status quo is justified by its own existence, since no financial product or service would exist if there weren't an eager market of perfectly rational actors eager to buy. This assertion ignores the fact that, even if most consumers never used biased heuristics when making decisions, the choices of rational actors are only as good as the data they use to decide.

Efforts to refine and simplify the data available to consumers are the most important avenues of reform. A recent study found that, when the actual costs of a payday loan are added to the standard disclosure of APR, people turn down the loans. Payday loans, at least in part, are a problem of limited information and education.

The obvious solution is ensuring better financial education for all. But, given our current inability to make sure that high school graduates understand basic math, that day may be long in coming. Until we have a reasonable expectation that consumers are able to access and evaluate the data required to identify predatory loans, government regulation should fill the gap.

Government regulation of financial services does limit the choices of consumers. That is its purpose.

When we are unable to discern the correct choice, and the stakes are high, we ask other people to take the choice away from us and place it in the hands of people who know better. Just as the responsible drinker hands over her keys when she heads out to a party, we turn to regulatory limitations to prevent us from making choices that could harm us or others.
People who are misinformed do not know that their reasoning is compromised. If we were capable of knowing which choices we couldn't be trusted to make sensibly, we would be able to make them correctly in the first place. Psychologists call this problem the Dunning-Kruger Effect.

Paternalistic regulations exist to help you make the choice you would have made if you were fully informed, and the financial sector, with its tiny print and deceptive practices (how many pleas from banks to not let your overdraft protection lapse did you get this summer?) is crying out for reform.

Our banking system nearly collapsed because some quants claimed supernatural powers of prognostication. Let's see if we can hold consumer credit providers to a higher standard than street corner clairvoyants.