All Commentary
Thursday, October 27, 2011

Safe Toasters and Toxic Financial Assets

Quality assurance through competition.

I recently wrote a letter to the editor (as yet unpublished) responding to a prior letter that engaged in a series of dubious claims about the causes of the financial crisis. At the end the author argued that since government already helps to assure that our toasters don’t explode, why can’t it exercise the same diligence in protecting consumers from shoddy financial products?

It’s a nice homey analogy but it is wrong on multiple levels. As I pointed out in my reply, the author has apparently never looked at the back of his toaster. If he did he would have noticed that what actually assures him that his toaster won’t explode is not the regulatory power of the federal (or any) government, but the competition in the private sector. Specifically most small appliances in the United States have the stamp of quality assurance from Underwriters Laboratory (UL), which is a private (nonprofit) organization that has tested such appliances for over a hundred years. UL is unaffiliated with the government and provides this quality assurance so manufacturers can to say to their customers that their toasters or clock radios or televisions are safe.

Not the Only One

UL is not the only organization that provides this service, though it is very much the largest. In other sectors of the economy similar groups provide market-produced quality assurance. For example, since 1972 auto repair technicians can be certified by the National Institute for Automotive Service Excellence (ASE). ASE requires that technicians pass a series of tests to get certified; customers are informed by a wall display at the repair shop. Like UL, ASE is a nonprofit that is independent of government. The Professional Association of Diving Instructors (PADI) certifies scuba divers in a similar, though for-profit, fashion.

What’s great about these organizations is that they emerged from the demands of both consumers and producers, not government. Consumers want a way of knowing that they are getting products that won’t explode, mechanics who know their stuff, and scuba instructors who won’t get them killed (not to mention gear that won’t leak). Sellers want to be able to signal to potential buyers that their products and services are of high quality. Solving this problem requires an independent intermediary such as these certification organizations, and sellers are glad to pay to acquire the signal of certification. The certifiers are happy to provide it, and most (though not all) are run as private nonprofits to alleviate any concern about conflicts of interest.

What is also important here is that there is genuine competition via freedom of entry into the certification business. Certification organizations cannot afford to make mistakes since there’s nothing preventing either an existing competitor or new entrant from offering a higher quality alternative. Even if there is no actual competitor at any given time, the threat of competition via new entrants, and consumers’ and sellers’ option to “exit” and use that new firm, keep established certifiers on their toes.

So contrary to the letter writer, it’s not the federal government which helps to assure that his toaster won’t explode, but the competitive forces of the market.

How’s Government Doing?

However, that is only one problem with the argument. It’s also worth asking how well government has done at “certifying” financial products. One of the fascinating questions in the financial crisis is why all those toxic mortgage-backed securities got AAA ratings from Standard & Poor’s, Moody’s, and Fitch? The answer is that starting in 2003, those were the only three agencies allowed by the Securities and Exchange Commission to rate certain types of securities for regulatory purposes. This included many of the mortgage-backed securities that were at the center of the financial crisis.

In other words, the government’s quality assurance providers were a protected cartel (though the law has changed since the crisis). Without freedom of entry — and the threat of competition — these three firms faced reduced incentives to do their job well. More important, without the competitive pressure and the possibility of buyers and sellers exiting to other firms, the discovery process of competition was cut short, preventing the agencies from learning they were making mistakes and how they might do better. The agencies wound up stamping assets “AAA” that were the financial equivalent of an exploding toaster.

The lesson is that  if we want our financial system to be as reliable as our toasters, we need more market competition and less of the heavy hand of the State.

  • Steven Horwitz was the Distinguished Professor of Free Enterprise in the Department of Economics at Ball State University, where he was also Director of the Institute for the Study of Political Economy. He is the author of Austrian Economics: An Introduction.