Tuesday, June 7, 2016

Loan Sharks

(Chicago Tribune Nov. 7, 1897)

Discussion about restricting payday lending has been in the news recently.

We first became interested in how states regulated attempts to collect debts from wage earners because bankruptcy rates look like this (see Hansen and Hansen 2012) Where it is easy to collect a large portion of someone’s wages people are more likely to file for bankruptcy.

As best I can tell, something like payday lending has existed about as long as paydays have existed. And as long as there has been payday lending, people have worried about the negative consequences of it and tried to place restrictions on it. In the late nineteenth and early twentieth centuries, many state legislatures restricted the ability to use garnishment or wage assignment. A wage assignment was a written statement that allowed the lender to collect from your employer if you did not pay. Some states prohibited wage assignments, others required spousal approval, or placed limits on the amount of wages that could be assigned. Some employers also attempted to prevent them. Armour, for instance required employees to sign a statement saying they would not assign their wages.
One problem states faced in regulating small lending was due process challenges. In addition to the due process clause in U.S. constitution many states also have due process clauses in their constitutions. The legal arguments involved substantive due process, which tends to raise fundamental questions about the appropriate role and operation of government. (See Hansen and Hansen 2014 on the evolution of garnishment and wage assignment in Illinois)

Due process clauses tend to say something like “no one may be deprived of life, liberty, or property without due process of law.” The first thing to note is that you can be deprived life, liberty and property. It just has to be done the right way. What does due process mean? There are two aspects: procedural due process and substantive due process. Procedural is what most people tend to think of when they think of due process. Did the state follow the rules? Did you, for instance, have access to an attorney? You will not find substantive due process in the constitution. It is a name given to what courts were doing. Consequently, people can disagree about exactly what it is. The description that best fits cases that I have read is that the court asks if the regulation is a reasonable means to obtain a legitimate public purpose. So, in the case of wage assignment restrictions, there was no question that the rights of the wage earner and the lender were being restricted. The problem to court faced was determining whether the restriction was a reasonable means to obtain legitimate public purpose. Some courts said that there was no state interest in interfering with how a grown man used his wages. Others said that there was a legitimate public purpose because loan sharks impoverished the working poor who then became a burden on the public. Behind the question of whether a regulation of “loan sharks” is a legitimate public purpose is an even more fundamental question: Who decides what a legitimate public purpose is?  Is it the legislature or the court? Courts went back and forth on this until the 1930s. Since the 1930s, courts have made a distinction between what they regard as economic rights and what they regard as civil rights. On economic rights they defer to the legislature. Consequently, cases like Kelo that may surprise the public should not surprise people familiar with American legal history.    I think legislatures are generally less restricted in their ability to regulate small lenders than they were in the early twentieth century. Moreover, the federal government been in the business of trying to eliminate loan sharks at least since the 1968 Consumer Credit Protection Act. 

On the other hand, I don’t think the fundamental economics has changed much. There are three basic problems: low income people often need to borrow money, they have no security for a loan other than their future wages (and sometimes a car), and it is expensive to lend to low income people. As I noted before, the problem is not new. People often focus on the interest rates and suggest that lenders are making extraordinary profits by exploiting the poor. The alternative explanation is that the interest rates are high because the cost of providing such loans is high. I tend to lean toward the second explanation. The primary reason I lean toward the second explanation is that I don’t see substantial barriers to entry in small lending. If a lender is making extraordinary profits by lending at an implicit rate of say 30%, why doesn’t another lender enter the market, charge 28%, attract all the customers, and make a real killing? Why don’t banks enter the market? They have reputation for liking profits. Moreover, why doesn’t someone start a non-profit payday lender? The non-profit should be able to easily cover its costs and provide lower cost loans to people. Actually, people have tried things like this and failed. They found that it was more costly than they anticipated. There are several good reasons why it is costly. First, the loans are small, which means the administrative cost tend to be a large fraction of the loan. Second, unlike banks that lend other people’s money, payday lenders lend their own money, and thus have a lower rate of return on capital.

So, what should be done? I don’t know. What I do know is that getting rid of payday lenders will not get rid of the need that low income people often have to borrow, and the more that you restrict legal options, the more room there will be for illegal options. What we shouldn't do is take away the option without providing an alternative and then pat ourselves on the back as if we solved the problem.

P.S. Usury laws have also restricted the ability to legally make loans to low income wage earners. They existed throughout most of American history (see Rockoff 2003 on the history of usury laws and Benmelech and Moskowitz 2010   on the political economy of usury laws. 

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