There are two views of markets. In one view of markets, held perhaps most famously by my former colleague Senator Warren, markets are a place where people are trapped, manipulated, and made worse off. (1) If they borrow money, they'll probably borrow too much that they won't be able to repay, and then they'll be out on the street. If they were allowed to choose their own school in a market system, they'd make the wrong choice, and so we have to make that choice for them. The other view of markets is that markets offer a chance. All real market choices involve risks. Sometimes people will fail, but sometimes they will win. They build businesses, their kids get better educations, and they escape poverty and move up the ladder economically.
I am an economist, a lawyer, and a law professor, so I'll address both law and economics. Economics has taught us that the ability to access credit markets is an absolute prerequisite to the formation of new businesses. (2) Most new jobs come from new small businesses. (3) For example, from 1980 to 2012--over a 30-year period--average net employment growth in big businesses hovered around zero. (4) Net employment growth was entirely in smaller and newer businesses. (5)
The bad news is that employment in firms that are newer (less than five years old) fell from 18 percent of private-sector employment in 1981, and even 16 percent in 1988, down to twelve percent in 2012. (6) Why was that? There are a lot of factors, but certainly one factor has to be that we have not created conditions in credit markets, especially since the passage of the Dodd-Frank Act in 2010, that are favorable to creation of new businesses. Credit markets have tightened up and it has become much more difficult for new businesses to get outside capital. (7)
Most new businesses are not created by raising equity from friends and family. Outside capital is absolutely crucial to the creation of new businesses. (8) New businesses mean more jobs, and new businesses also mean new entrepreneurs. And entrepreneurship is a major way that people move up the economic ladder. (9)
So where do people get the capital? How do you get outside capital to start a new business? You need collateral and you have to be able to borrow. (10) What are two ways that economists know small businesses get going? The first important way businesses are started is by using collateral in homes: people take out home equity lines of credit. (11)
The second way is credit card debt. (12) A huge fraction--54 percent--of new businesses are using personal credit cards to finance the business. (13) Not business credit cards, but personal credit cards. Senator Warren looks at credit cards, and she sees people in bankruptcy who have made a lot of bad financial decisions including in how they use their credit cards. In response, the CARD Act (14) was passed. The CARD Act mandates certain terms in credit card contracts and forbids others. The net effect of these restrictions on contractual choice has been that it is more difficult for people to get credit cards. As a result, it is surely true that some consumers are paternalistically prevented from running up credit card debts that they can't pay. But another consequence, forgotten by parternalists, is that it is more difficult for people to get credit cards that can be used for starting new businesses. (15)
What about home equity? How do you get home equity? Well, you get a loan, a mortgage. What have we done with the Dodd-Frank Act? (16) As interpreted by the Consumer Financial Proetection Bureau (CFPB), that law's requirement that lenders make loans only to people with a reasonable ability to repay has wiped out the market for mortgages for young people, for minorities, and for anybody who doesn't have an established credit history. We have eliminated the subprime mortgage market. Is that a bad thing for income and wealth mobility and for the creation of new businesses? Yes, it is. (17)
A couple of very recent studies have reinforced this conclusion. During the 2000s, the rate of new business formation was the greatest in places where home prices were increasing. (18) Another study found that every ten percent increase in home equity increased the probability that a household would become entrepreneurial by fourteen percent. (19) When you restrict mortgages, you restrict the ability of people to acquire capital in their homes. (20) If people cannot acquire capital, a very important source of collateral for getting a loan to start a new business has disappeared. (21)
Why did Congress enact the Dodd-Frank Act? Because people looked around after the fact and saw that a large number of people defaulted on their mortgages at the end of the...