The Volokh Conspiracy - Follow Up on Usury Post:

I wasn't following the comments on my "In Defense of Usury" post, since it was primarily just an excerpt from Karlan and Zinman's argument. I confess that I was surprised to see that there were so many comments and so much controversy about the study described in the Wall Street Journal column. Also, I apologize for the fact that I didn't realize that we had a spam filter that would interfere with comment postings (which apparently blocks out words like "loans"--looks what happens when I hang around with a bunch of constitutional law bloggers).

Several of the commenters raised the challenge that nothwithstanding the authors' conclusions, very high interest rates are still "immoral" and should be banned. But I don't really follow the logic of the critique--if there are no externalities, and those that borrow are better off as a result, what exactly is the argument for why high interest rate loans are immoral and should be prohibited?

The whole point of the column is that under a consquentialist theory, this is socially beneficial. It also certainly seems consistent with autonomy theory. And if the borrowers are generally better off overall from this and appear to understand what they are doing, I don't understand why it would be a problem under a paternalistic theory.

I've heard this argument pronounced previously--that certain interest rates are simply "too high" and shouldn't be tolerated. I'd genuinaly like to understand--what exactly is it that supposedly makes this transaction "immoral" such that it shouldn't be allowed? What is the theory?

Moreover, as the authors suggest, those who don't get this credit often will turn to even worse forms of credit, such as pawnshops or even illegal lenders. Or as one of the commenters notes, bounce a check, which may amount to as much as $50 in penalty fees. Paige Skiba's research suggests that those who use pawnshops often are those who wanted a payday loan and were turned down for it. So eliminating payday loans will force them to use pawnbrokers. And research by Gregory Elliehausen and others suggests that those who use payday loans are often those who can't get access to a credit card or are maxxed out on the credit cards they have. And Donald Morgan has found that increased competition in the payday lending industry leads to lower prices on payday loans.

Moreover, interest rates are just one of many price terms in a credit contract. Thousands of years of economic history has demonstrated one central point--if you regulate interest rates, then lenders will try to clear the market by repricing other terms of the contract, such as requiring larger downpayments, higher fixed underwriting fees, more onerous default criteria, etc. Retail stores, by contrast, simply bury credit prices in the cost of the goods they sell then increase the costs of the goods.

So usury regulations have three predictable consequences: (1) a cap on interest rates or regulation of other terms leads to a repricing of other terms of the credit contract to try to adjust, (2) Substitution to other, less-preferred credit products such as pawnshops and loan sharks, and (3) if none of that works to clear the market, credit rationing results. I discuss this extensively in my article "The Economics of Credit Cards."

For what it is worth, Karlan and Zinman have written a number of articles applying behavioral economics to consumer credit--that's the whole hook for the article. Notwithstanding the fact that people make errors, they are still better off by having access to regulated high-priced credit. At least some of those who are unable to get access to this regulated credit will end up borrowing in the black market from illegal lenders--at much higher cost (and perhaps not just financial).

Karlan and Zinman suggest, therefore, that we should avoid policies that end up forcing consumers to deal with illegal lenders. Instead we should focus on policies that will improve the working of the legal lending market, such as improving on the current disclosure regulation scheme (as suggested by the FTC's mortgage study published this summer). That certainly seems like a more sensible approach to me.

Once all of these unintended consequences are taken into account, and assuming that consumers are sufficiently well-informed that we can draw the sort of welfare conclusions Karlan and Zinman draw, it isn't evidence to me what the theory is that justifies prohibiting these sorts of high-cost loans.

	[Todd Zywicki, November 3, 2007 at 9:31am] Trackbacks Follow Up on Usury Post: I wasn't following the comments on my "In Defense of Usury" post, since it was primarily just an excerpt from Karlan and Zinman's argument. I confess that I was surprised to see that there were so many comments and so much controversy about the study described in the Wall Street Journal column. Also, I apologize for the fact that I didn't realize that we had a spam filter that would interfere with comment postings (which apparently blocks out words like "loans"--looks what happens when I hang around with a bunch of constitutional law bloggers). Several of the commenters raised the challenge that nothwithstanding the authors' conclusions, very high interest rates are still "immoral" and should be banned. But I don't really follow the logic of the critique--if there are no externalities, and those that borrow are better off as a result, what exactly is the argument for why high interest rate loans are immoral and should be prohibited? The whole point of the column is that under a consquentialist theory, this is socially beneficial. It also certainly seems consistent with autonomy theory. And if the borrowers are generally better off overall from this and appear to understand what they are doing, I don't understand why it would be a problem under a paternalistic theory. I've heard this argument pronounced previously--that certain interest rates are simply "too high" and shouldn't be tolerated. I'd genuinaly like to understand--what exactly is it that supposedly makes this transaction "immoral" such that it shouldn't be allowed? What is the theory? Moreover, as the authors suggest, those who don't get this credit often will turn to even worse forms of credit, such as pawnshops or even illegal lenders. Or as one of the commenters notes, bounce a check, which may amount to as much as $50 in penalty fees. Paige Skiba's research suggests that those who use pawnshops often are those who wanted a payday loan and were turned down for it. So eliminating payday loans will force them to use pawnbrokers. And research by Gregory Elliehausen and others suggests that those who use payday loans are often those who can't get access to a credit card or are maxxed out on the credit cards they have. And Donald Morgan has found that increased competition in the payday lending industry leads to lower prices on payday loans. Moreover, interest rates are just one of many price terms in a credit contract. Thousands of years of economic history has demonstrated one central point--if you regulate interest rates, then lenders will try to clear the market by repricing other terms of the contract, such as requiring larger downpayments, higher fixed underwriting fees, more onerous default criteria, etc. Retail stores, by contrast, simply bury credit prices in the cost of the goods they sell then increase the costs of the goods. So usury regulations have three predictable consequences: (1) a cap on interest rates or regulation of other terms leads to a repricing of other terms of the credit contract to try to adjust, (2) Substitution to other, less-preferred credit products such as pawnshops and loan sharks, and (3) if none of that works to clear the market, credit rationing results. I discuss this extensively in my article "The Economics of Credit Cards." For what it is worth, Karlan and Zinman have written a number of articles applying behavioral economics to consumer credit--that's the whole hook for the article. Notwithstanding the fact that people make errors, they are still better off by having access to regulated high-priced credit. At least some of those who are unable to get access to this regulated credit will end up borrowing in the black market from illegal lenders--at much higher cost (and perhaps not just financial). Karlan and Zinman suggest, therefore, that we should avoid policies that end up forcing consumers to deal with illegal lenders. Instead we should focus on policies that will improve the working of the legal lending market, such as improving on the current disclosure regulation scheme (as suggested by the FTC's mortgage study published this summer). That certainly seems like a more sensible approach to me. Once all of these unintended consequences are taken into account, and assuming that consumers are sufficiently well-informed that we can draw the sort of welfare conclusions Karlan and Zinman draw, it isn't evidence to me what the theory is that justifies prohibiting these sorts of high-cost loans.