Thursday, October 4, 2007

Payday Loans

Here is a topic which is a good example of the occasional enormous chasm that divides economists from non-economists and makes 'normal' people think that we just don't 'get it.' The argument for the regulation of the payday loan industry in Oregon (which, among other things, limits the amount of interest that can be charged at 36%) seems overwhelming: these businesses are praying on the poor and vulnerable and indenturing them into debt servitude, furthering their misery and contributing to their poverty. Yet, I don't buy it and I worry that the poor and vulnerable will be made worse off with such regulation, not better.

Let's begin the analysis with the root problem: access to credit for the poor and/or those with poor or no credit histories. This is a considerable hardship because credit provides flexibility when dealing with limited and often transitory income. Access to credit can also be a key to escaping poverty by allowing investments in productive assets (like education) that can increase future incomes. This is what I would call the disease.

Here is a symptom: Because credit at (for lack of a better term) mainstream financial institutions is inaccessible, a host of businesses have cropped up to provide credit to this population. They have been criticised for having exorbitantly high interest rates and short repayment periods. The subtext to this critique is that they are abnormally profiting from other's misfortune. Given as evidence of the scale of the problem are the vast numbers of payday loan shops. But these critiques strike me as completely misguided. The fact that there are many payday loan shops suggests to me that the industry is highly competitive, and therefore that the interest rates they charge are reflective mostly of the costs of doing business in small-scale loans and high delinquency rates. So the proposed cure will cause firms to exit the industry - worsening the disease by further limiting access to credit to the poor. For those that remain and are limited to 36% interest, they will impose more stringent requirements to limit their credit to only the least risky of their clients - again limiting access to credit for the poor.

So I find this a totally misguided policy. I think that payday loans are a problem, but that the problem is with access to credit for this population. What government could do that would be more appropriate perhaps is to mandate that banks, credit unions and thrifts extend credit to this population. To do so these institutions would end up charging more for credit for all and thus this would be a type of transfer from the relatively well to do to the relatively less fortunate. But it would be aimed at the disease and not the symptom.

Finally, one argument that really bothers me (and I am perhaps typical of economists) is that these payday lenders are predatory because borrowers are naive and don't understand what they are getting into when they borrow money. I find this incredibly patronizing - basically "the poor are dumb." While it is true that education and socio-economic status are highly correlated, intelligence is not. And even if people (in general) are not too savvy about understanding the implications of these loans, they tend to be very small and short and one experience is likely enough for borrowers to learn (unlike, say, sub-prime mortgages). It would be one thing if these lenders were accused of fraud (like, say, some sub-prime lenders) and I would be in favor of any sanction against such practices, but the argument is not fraud, but the failure to comprehend. But you don't have to just take my word for it, the issue of whether payday loans are really predatory has been studied very carefully by economists at the fed who find that, in fact, the population of payday loan customers looks very similar to customers of mainstream financial institutions in their delinquency rates and that the payday loan industry appears to be quite competitive.

So, in my view, here is a policy that just gets it wrong - it attacks a symptom, not a disease and is likely to hurt the very people it intends to help.


Jeff Alworth said...

Your analysis is in accord with a lot of the discussion I saw, and I don't have a major beef with it per se. Particularly as we agree on the diagnosis: "[T]he root problem: access to credit for the poor and/or those with poor or no credit histories."

I'm all for your suggested solution (mandating extension of credit) in a vacuum, but the issue rests in a political free-for-all, so it's likely out of the question.

A few further thoughts:
An extenuating burden for users of payday loans is that we have removed one avenue of getting out of debt--bankruptcy. So the danger grows when someone risks using these.

On this issue of patronizing the poor, I agree lazy people could slide into that space. Where I come at it from isn't patronizing, but one of basic fairness: since our society has so few supports and so many risks--all of which have been transfered to the individual--how can payday loans be said to be anything but more of the same? People can't afford education, so they're stuck in bad jobs. They can't afford healthcare and don't have time off anyway, so their incomes are not stable. And now, we're putting a financial burden of transacting business on them which they can ill-afford.

The payday loan industry serves the poor almost exclusively. It's not patronizing for leaders to ask if this is the best service a government can offer.

Anonymous said...

I disagree with the idea that this policy is flawed. In a market economy, shouldn't the market dictate the rate a individual with credit should pay for a loan? If we can assume that we want it to be market driven, what we are seeing is essentially government protectionism in place for a adverse class of borrowers to prevent more long term harm to society as a whole.

Here is my logic: The fundamental duty to the government is to allow the function of society with as few restrictions as possible to allow for the greater good. Those with good credit will have access to market driven money at market driven rates. However, the concept of 'moral hazard' creates an issue for providing credit to those who have already shown themselves to be a credit risk, or those who do not have resources to lose (for a better word 'poor', though I think this is misleading).

Due to this moral hazard, markets rates are anticipatorily much much higher for this class, leading to payday lending types of services. This is however where I think where we see a larger hazard. The assumption is made (the disease) that credit to this class will and can be overall beneficial, even at higher rates in a competitive industry. However, while credit can encourage otherwise unattainable growth, it also (by reflection in the rates) clearly leads to a higher debt level, and correspondingly a greater need for high interest credit. While a very few may be helped out in this situation, the greater whole on average will expend more of their limited income to compensate for this credit level. Thus, societally, credit in this range may NOT be a overall good.

As such, we see a net transfer of monies from the already disenfranchised, to the lenders. This governmental policy does not prevent low income lending, but what it does do is sets a more difficult rate discouraging this practice. This should, though removing this market service from the economy, net in a result of less wealth transfer from the poor to the rich (horrible generalization). So, in the end, given my limited understanding of the situation, we see a slow but upward rise of the overall wealth of the lower credit class.

To create this same effect by mandating banks make loans with a known moral hazard seems to be much more governmental interference in the market economy, and takes a much shorter term view on wealth growth than should be approached at a governmental level. (i.e. government should be less concerned that i have a new plasma display than that I pay my monthly bills).

Patrick Emerson said...

Good point. The adverse selection and moreal hazard arguments say that rates will go up for all if more risky people try and get loans and this will cause the lower risks to exit market (and that people will engage in more risky investments if offered access to credit which they may default on rather than their own money). Meaning that if we mandate that traditional banks offer credit to the high risks, we could end up excluding (or overcharging people with great credit). Also moral hazard suggests that we encourage risk taking by offering loans to clients with poor credit.

This leaves me back at the "leave it alone" argument I started with. Payday loans exist because of a missing credit market, and high interest is appropriate and a good way to combat moral hazard.

Anonymous said...

While I think that the market does recognize a missing credit market and try to address it, pure market supply and demand fails to account for societal ramifications for a failed loan. In a society which pressures the consumption and acquisition of goods over the betterment of long term planning (see the comment by the payday loan owner who felt that a troops deserved to be able to get into debt for 18" chromes on their car) governmental regulation has a societal imperative to discourage overzealous consumerism to try and create a more realistic market equilibrium.

If credit suppliers are limited in the overall hazard they can except (by restricting real interest charged), they will institute a policy of eliminating the 'extremely' hazardous loans, thus preventing 'on average' poor money management, and thus possible future societal burden.

Anonymous said...
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Christopher Farrell said...

Ability to figure out good financial decisions and socio-economic status are highly correlated. That's what is important. How many high-class rent-to-own stores can you think of?

I'm glad the payday lenders are more strictly regulated now. But I like the idea about extending credit in other ways. Also, the poor are looking for these loans because they are in bad shape from any number of trends that have been exacerbated by the policies of Bush, like cutting taxes on the rich and cutting social programs. There is also the bankruptcy law change, which was a big mistake.

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Kara said...

I agree that taking out payday loans regularly can be a bad habit to get into, but in times like these it is necassary for a lot of people. As long as these people are paying back their loans on time, the interest rates aren't above normal credit card rates. The 500% rate is for the year, and hopefully if you take out a loan you're planning on paying it back in the time allotted. If you pay it back on time the interest rate is 36%, which is still expensive, but much more reasonable.

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Unknown said...

good example of the occasional enormous chasm that divides economists from non-economists and makes 'normal' people think that we just don't 'get it.'

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