(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.
