Posted by Todd Zywicki:
Tony Soprano's Solution to the Bankruptcy Crisis:
Syndicated columnist Debra Saunders has a confused [1]column today in
The Real Times about the bankruptcy reform legislation. Not only does
she seem confused about the impact of the bill, but she seems utterly
confused about economics of consumer lending. Like a vampire arising
from the dead, Saunders invokes new usury restrictions on credit cards
as the solution to the consumer bankruptcy crisis:
Consider this: The Senate rejected a measure to cap credit-card
interest rates at 30 percent. Now, I ask, why should Washington
want to protect lenders, who charge desperate people as much as 36
percent in per annum interest?
The lending lobby � Big Borrow-mongers � claims it needs
protections against deadbeats, who file for bankruptcy without even
trying to pay off their debts. I would sympathize ... if the money
lenders weren't so rapacious � shameless, really � about fleecing
the poor.
Why doesn't Washington cap credit-card interest rates at 30%? Because
Washington apparently realizes what Saunders does not--that usury
restrictions usually hurt those who they purportedly are intended to
help, and injure "desperate people" the most. Since Ms. Saunders
apparently missed Introductory Economics in college, herewith a very
brief primer on the effects of price controls in consumer credit
markets.
The analysis presented here draws heavily on a major article that I
published a few years ago, "[2]The Economics of Credit Cards," which
contains a more in-depth analysis of the issue.
Imposing price controls on credit card interest rates will have three
predictable consequences: 1. Term repricing: First, regulating some
terms of a consumer credit contract will lead to repricing of other,
unregulated terms. So, for instance, prior to the Supreme Court's
decision in Marquette National Bank in the late-1970s, many states had
strict usury regulations on the interest rates that could be charged
on credit cards. The result was a variety of repricing of other terms,
to offset the inability to charge market rates of interest. So, for
instance, credit card issuers charged high annual fees for ordinary
credit cards--usually $30, $40 or higher, in order to make up for the
losses on the rate of interest they could charge. In fact, when usury
restrictions were effectively repealed by Marquette, the first thing
that disappeared were these annual fees (today, only "reward" cards,
such as frequent flyer cards, have annual fees, which are used to
cover the administrative costs of the reward program). Credit card
issuers also changed the way they measured the grace period for
consumers to pay their bills, adopting a new measurement of the grace
period that effectively shortened the time in which a consumer must
pay his or her bill in order to not be late. And, of course, credit
cards offered very little in the way of the sorts of benefits we see
today--car rental insurance, 24 hour customer service, etc. Limiting
interest rates can be expected to result in term repricing of other,
less transparent terms of the contract.
Finally, usury restrictions provided a competitive benefit for
department stores and other companies that directly extended credit to
their customers. A store like Sears, for instance, could simply jack
up the price of the goods they sold to make up for the losses that
they suffered on their in-house lending activities. If you regulate
the cost of credit, but not the cost of goods (like a refrigerator or
washing machine), then all you have done is shift around the credit
costs to a less-obvious source. And, of course, it is again the "most
desperate" who are likely to have to use store credit to buy an
appliance or the like.
Note also, that to the extent that interest rates are limited and
annual fees are adopted, this will have the exact opposite effect of
what Sauders wants to happen--this will encourage greater borrowing
for consumers and a subsidization by transactional users who pay their
bills every month to revolvers.
Are consumers as a whole--including poor consumers--by having an
interest rate cap, but a $40 annual fee? Or no annual fee and higher
interest rates? Its not obvious, but the evolution of the market
suggests that most consumers would rather have no annual fee and a
higher interest rates. And, of course, transactional users
unambiguously prefer that. 2. Product substitution: Making it harder
for "desperate people" to get a credit card doesn't make their need
for credit disappear. If they can't get a credit card, then they have
to turn somewhere else for credit, such as payday lenders,
check-cashers, pawn shops, or loan sharks. And the cost may be much
higher than 36%. If your transmission blows, you still have to pay for
it, regardless of whether you are rich or poor. Are "desperate people"
made better off by having to rely on payday lenders, pawn shops, or
Tony Soprano to make ends meet? Doesn't seem like it to me.
In fact, the empirical evidence of the effect of usury restrictions
indicates that exactly this sort of substitution takes place under
usury restrictions. So, for instance, in the 1970s, Arkansas had the
strictest usury restrictions in the country--and was also the pawn
shop capital of America.
Similarly, as I noted in an earlier post, the rise of credit card
borrowing over the past two decades has been primarily a substitution
for other, less-attractive forms of credit, such as high-cost personal
finance companies (which have even higher interest rates than credit
cards), and retail store credit (such as described above), rather than
an increase in overall indebtedness. This pattern of credit card
substitution for other debt has been equally applicable to
lower-income households. See Wendy M. Edelberg & Jonas D. M. Fisher,
Household Debt, 123 CHICAGO FEDERAL LETTER at 3 (1997)(�[I]ncreases in
credit card debt service of lower-income households have been offset
to a large extent by reductions in the servicing of installment
debt.�). 3. Credit rationing: To the extent that borrowers and lenders
cannot reprice the terms of their credit contracts, and to the extent
that poor and high-risk consumers can't shift to other forms of
credit, such as pawn shops, rent-to-owns, and layway plans, they will
suffer a reduction in credit overall. It is not clear how this helps
poor people. On the other hand, usury restrictions do appear to be
good for the middle class and upper-middle class, so perhaps that is
why they are popular with those like Saunders. To the extent that
usury restrictions make lending to poor people less profitable,
empirical evidence indicates that the supply of money for consumer
lending tends to shift into prime lending markets, thereby reducing
the borrowing costs of low-risk, high-income borrowers. So while a lot
of us higher-inocme folk might be pretty keen on making poor people
subsidize our mortgages and credit cards, it is not clear to me how
that improves the lot of the "desperate" poor out there. See William
J. Boyes, "In Defense of the Downtrodden: Usury Laws?, 39 PUBLIC
CHOICE 269 (1982). The Normative Tradeoff: So there is a clear
tradeoff here. Yes, capping interest rates on credit cards will
certainly cause credit card interest rates to go down. But it will
also cause other fees (such as annual fees) to go up, will force the
most desperate borrowers into into the arms of pawn shops and payday
lenders to make ends meet, and will tend to decrease the amount of
credit available to poor borrowers (although subsidizing middle-class
borrowers).
And sure, you could add regulation of additional terms--such as late
fees, or whatever. But that doesn't change the fundamental underlying
tradeoffs, because every consumer credit contract has dozens of terms
that can be repriced and there are a panoply of competing consumer
credit products out there in the market.
So, in the end, there is a normative tradeoff--do we think that
consumers as a whole, or poor consumers, are made better off by price
controls of some of the terms of a consumer credit contract, knowing
that it will be impossible to regulate all of the terms and that in
the end, poor people need credit just as much as anyone else? As with
all such normative tradeoffs, our moral intuitions will
differ--Saunders quite obviously thinks she would sleep better at
night knowing that poor people won't have to pay high credit-card
interest rates (its not clear what she thinks about pawn shops). Quite
plainly, I think such a tradeoff is outrageous and will hurt poor
people more than it helps them. Moreover, the overwhelming conensus
among economists, going back until at least Jeremy Bentham, is that
usury restrictions are bad economic policy. "Toadying to Big
Business"? More fundamentally, given these tradeoffs, it is plainly
the case that the Senate acted reasonably in rejecting the price-cap
amendment that Saunders is so lathered up about. It would have been
reasonable for the Senate to accept the price-cap as well. But
obviously the Senate decided that the costs of a price cap exceeded
the benefits and acted accordingly. Certainly, Saunders's assessment
seems absurdly overblown:
As a Republican, it disappoints me to say this, but I understand
why people call the GOP the party of big business. When Washington
pushes for more responsibility among debtors, but not
loan-shark-like lenders, when its "ownership society" principles
don't make big corporations own up to their role in the bankruptcy
problem, the GOP is toadying to big business. (Ditto the 18
Democrats and one independent senator who voted for the bill.)
Her criticism of "loan-shark-like lenders" seems especially misplaced
given that one possible result of her proposed solution would be to
increase business for real loan sharks. What the Bill Does: Instead,
Sections 1301-1309 adopt a disclosure-based compromise to the problem.
These sections require new and enhanced disclosures related to various
aspects of credit cards, such as introductory rates, late payment
deadlines and penalities, and Internet-based credit card
solicitations, as well as enhanced disclosures on "credit extensions
secured by a dwelling." While some might want to do more,
notwithstanding the harm it would cause to the poor, under the
circumstances, enhanced disclosures certainly seems like a reasonable
compromise, and certainly is not mere "toadying to big business."
References
1. http://www.washingtontimes.com/commentary/20050412-095321-9153r.htm
2. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=229356
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