There is a brilliant column in today’s Wall Street Journal by Dean Karlan and Jonathan Zinman, “In Defense of Usury“. Here’s an excerpt, but of course the whole thing is worth reading.
The authors note the behavioral economics critique of consumer credit use, i.e., that consumer may lack impulse control and the like. But they observe:
But even consumers making flawed decisions may be better off when they can borrow from regulated financial institutions at “excessive” rates.
Our organization, Innovations for Poverty Action, tested this proposition. We worked with a successful finance company in South Africa to randomly choose some just-below-the-normal-approval-bar applicants to receive a four-month installment loan. The lender charged its normal rate: 200% APR. The remaining, just-below-the-normal-approval-bar applicants (the “control group”) were rejected in line with the lender’s normal credit policy.
We then tracked both groups over the next six to 27 months, measuring their well-being based on a range of economic, social, health and mental health measures. Applicants who were randomly approved for a loan had higher incomes, less hunger, better credit scores and more positive outlooks than their control group counterparts — even after paying the high interest rate. Though they had higher than normal default rates, the borderline loans were also profitable for the lender.
The new borrowers did report higher stress and depression levels than the control group. But overall, the borderline loans objectively did more good than harm. Our findings are striking because governments that restrict credit access do so on the premise that consumers make themselves worse off by borrowing at high rates.
How can it be that consumers get preyed upon in the market, yet still end up better off? One possibility is that returns to borrowing swamp the cost of consumer mistakes. Rolling over payday loans repeatedly might cost you big bucks; but it can turn out to be a good deal if you need the initial loan to fix your car, hold on to your job and avoid losing even bigger bucks in after-tax earnings.
Another possibility: The alternative to being gouged by a financial institution is being gouged more expensively by an unregulated lender.
Karlan and Zinman’s findings are consistent with those of Adair Morse, who found in her article, “Payday Lenders: Heroes or Villains?” that communities that allow payday lending are more resilient in responding to natural disasters in terms of the overall welfare of individuals who live there in terms of foreclosures, births, deaths, and alcohol and drug treatment.