Marginal Revolution’s Alex Tabarrok has a good post responding to recent attacks on the extension of credit to poor borrowers (and in particular, this rant from Nouriel Roubini). Here is a taste:
Roubini and others generating hysteria about defaults in the mortgage market are credit snobs – they think credit is something that only the rich can handle. Just look at the language that Roubini uses to analogize borrowers – they are “reckless patients” who “spent the last few years on a diet of booze, drugs and artery clogging junk food.” Similarly, the Washington Post tells us that it’s the end of the “borrowing binge.”
Yeah, we get it. Credit is ok for us, the “sober” borrowers but poor people can’t handle credit. Too much credit among the poor generates decay and social pathology. Credit must be regulated. We can’t, for example, have credit stores in poor neighborhoods. Don’t you know that credit is bad for people without self-discipline?  Let the poor buy on installment credit? That’s unconscionable. Today’s furor over sub-prime mortgages is the same old story.
Basic economics says that people should borrow so that they can consume based upon their permanent income. Modern day financial markets are finally making this possibility a reality. Combine financial innovation, strong US economic performance and a global savings glut and it makes sense that credit should become easier to obtain. We see the benefits of financial innovation in bringing credit to the poor not just in the United States but around the world. Will Roubini next be calling for the retraction of Muhammad Yunus’s Nobel Prize?
Check out the comment thread too. It’s pretty good.
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Interesting point, although I think it might be the other way around–the payday loan places suffer through the responsible people to hit the “jackpot” on the continual rollover crowd.
Just wondering–does anyone’s conclusion that payday loans are efficient change when you incorporate sub-optimal risk preferences via prospect theory? In other words, someone might take out a payday loan to avoid a certain $10 late fee on a rent check, not realizing that they are facing a probablistic loss of hundreds of dollars from the payday loan place.
Relating to Josh’s second point, it’s likely that barriers to entry would, in part, be proportional to the amount of regulation of the business. Additional regulation of the credit market for poor borrowers would very likely increase their costs (and may have already, although I don’t have evidence for that assertion).
With regards to whether or not regulations or subsidies are warranted for borrowers with poor credit–that may be worth further study. Like MFRH, I, too, have witnessed behavior of lenders to poor, invariably underinformed borrowers sufficient to make me question the lenders’ business model–e.g., is it right to drive 20 percent of these borrowers to the brink of bankruptcy or beyond in order to profit from–and presumably benefit–the other 80? But, like Josh, I believe that these concerns are researcheable, and that the burden of proof for additional government intervention in the private sector should be on those who would advocate it.
I’m much more interested in the effects of payday loans on than I am in how we label them, or what the interest rates are when converted to APR. So to answer your question, I think the reasonable interest rate is the best one the borrower can get condtional upon his/her risk profile. The burden of proof lies on those calling for the regulation of payday loans to demonstrate, with real evidence, that there is a market failure.
A second and related point, it strikes me as implausible that competition between lenders would result in supra-competitive rates. I’m not sure what the barriers to entry into payday lending would be … but I doubt they are significant from the data that I have seen.
Not picking sides in this, but I’m curious–do you think that a 1,000% APR is okay, or are the numbers referenced above inaccurate? If they are accurate, is there any limit to what you’d consider a reasonable interest rate? Are there alternative lending mechanisms you think we should consider?
The DOD report “case studies” do not purport to establish a causal link between payday loans and bankruptcy, divorce, second-mortgages, etc. Nor does the other document you cite even attempt to establish causation.
The fact that many states are adopting payday loan restrictions does not establish anything about the consequences of such laws or their appropriateness. It does, however, give another opportunity for empirical study. I have my priors on what the effects will be. Hint: there is a substantial economic literature on what happens when you try to limit one path to credit access to the poor. Perhaps you will find the correlations from those studies, which no doubt will come, more persuasive. But I doubt it.
Manne: ad hominem attacks are not a valid form of argument. You’ll have to do a little better than that.
I’ve worked with poor people, and while I wasn’t raised poor, I’ve seen the personal devestation wrought from the downward spiral of debt caused by payday loans. You can call it racist, paternalistic, whatever, but the fact is that payday loans have ruined a lot of people’s lives, and I think we’d be better off with a more humane and reasonable alternative.
I’d concede that the popularity of payday loans indicates a need of some sort.
But I think a better option than the status quo would be for government to partner with (and subsidize, if necessary) established banks to provide loans at reasonable rates, with fees that bear some rational relationship to the risks and expenses involved, and a humane form of debt collection.
The Defense Dept. has already enacted a program of that sort, in response to the problems raised by payday loans. I believe that several states have similar plans.
Would you consider the possibility that payday loans aren’t so great, but regulating them out of existence might be worse?
If y’all think payday loans are so great, I suggest you read the case studies included in this Defense Department report to Congress. It talks about how payday loans lead to bankruptcy, second-mortgages, and divorce. (pp. 39-42)
http://www.defenselink.mil/pubs/pdfs/Report_to_Congress_final.pdf
If you find it hard to fathom, it is your failure of imagination and not the structure of the loans themselves that is to blame.
This kind of paternalistic pablum is insulting–and often tinged with a not inconsiderable racism, to boot.
Who on earth could you possibly be, “market failure,” to claim to know better than the the particular members of the “working poor” you purport to protect how to spend their money? It really is the height of hubris.
I was once “working poorâ€, as were all my friends, recent immigrants with bad English and no family money. We surely had mental capacity to control our urges, thank you very much. We also had tremendous difficulty getting credit. Laws that discourage financial institutions from lending money to the poor are nothing but a tax on people like I once was. The rich and the middle class won’t feel the pinch of this tax; their credit lines are not in jeopardy. Why the law should tax the conscientious poor to help the irresponsible poor, I have no idea.
Even if the correlation between payday lending homes and disaster recovery isn’t spurious, I’d suggest that it’s equally consistent with the hypothesis that payday loans create a large underclass, willing to work on reconstruction projects for depressed wages. This decreases the cost and therefore expedites the reconstruction.
The following article has some includes some devestating facts about payday loans. 99% of payday loans go to repeat borrowers, suggesting that many are trapped in a descending cycle of debt. They spend $3.4 billion per year in excess fees. African American neighborhoods have three times as many payday loan stores per capital as white neighborhoods.
http://www.abanet.org/irr/hr/summer05/predator.html
I find it hard to fathom how 500% APR loans can be considered “pro-consumer.”
“The working poor psychology is generally focused far more on the short-term than considering the long-term consequences of behavior, and therefore they are generally less able to sort through and properly weigh all of the implications of a payday loan.”
I think this claim is empirically testable. As is the claim that the “market” alternative is equivalent of serfdom. And I don’t think the empirical evidence supports either claim. On that note, Adair Morse has a very interesting empirical examination of the impact of payday lending on a communities’ financial condition post-disaster:
sitemaker.umich.edu/adair.morse/files/morse_payday061125.pdf
Extending credit on fair terms, with the proper disclosures is one thing, but payday lending is an entirely different phenomenon. Upper-middle class law professors should be careful about extrapolating from their own situations into what it’s like to be a member of the working poor.
The working poor psychology is generally focused far more on the short-term than considering the long-term consequences of behavior, and therefore they are generally less able to sort through and properly weigh all of the implications of a payday loan. These businesses also frequently target undocumented workers who have little command of English and for whom many of the typical disclosures would be meaningless. Once you figure in administrative fees and hidden charges, payday loans often exceed 500-1000% and sometimes even 5,000% APR. (see: http://www.slate.com/id/2059386/)
Given the parsimonious new bankruptcy laws, I think a little bit of paternalism with regard to payday loans is probably not a bad idea. The alternative is to allow “the market” to create a new form of serfdom.