Tony Soprano's Solution to the Bankruptcy Crisis:

Syndicated columnist Debra Saunders has a confused 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, "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 In fact, when usury restrictions were effectively repealed by Marquette, the first thing that disappeared were these annual fees (today, only "reward" cards, such as frequent flyer cards, have annual fees, which are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."