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SUPPLY AND DEMAND HURT THE POOR

October 26, 2008 12:16 am

CHATTANOOGA

In the past 30 years, the democratization of credit has been one of the most powerful forces for economic progress by lower-income groups in the U.S. economy. In the 1990s, as interest rates continued their deregulatory trend begun more than 10 years earlier, the number of homeowners in low- and moderate-income communities grew by 26.6 percent, which was nearly twice the growth rate of homeowners in high-income areas. The greatest gains accrued to the least-well-off consumers primarily because the removal of price restrictions in credit markets benefits highest-risk borrowers the most.

When interest-rate ceilings are imposed, they adversely affect the well-being of the very consumers they were intended to protect. For instance, in the 1960s, Washington state consumer loans from credit card companies were generally regulated at an annual rate of 18 percent. Believing that lower-income groups would be aided by lower rates, consumer advocates lobbied successfully for a 1968 referendum setting a 12 percent interest ceiling.

Unfortunately, the natural laws of supply and demand are not subject to repeal. At the lower 12 percent interest rate, the amount of credit demanded exceeded the amount supplied, and individuals with the weakest credit were the ones denied loans. Young earners, new families, individuals with unstable employment histories, students, recent divorcees, the elderly, and welfare recipients fell into this category.

Those who benefited most from the reduced rates were those with the most wealth, the best jobs, and the highest probability of being able to repay their loans. The volume of credit flowing to wealthy individuals frequently is equal, or even greater, under severe interest-rate restrictions than under free-market conditions. Low interest-rate ceilings prevent lower-income individuals from effectively competing for funds; thus, a greater share of available funds flows to lower-risk--and therefore generally higher-income--loan applicants.

CREDIT IS MORE EXPENSIVE

Today, faced with mounting losses, many banks and other lenders have curtailed or discontinued various forms of consumer lending. And nearly all lenders are far more careful about whom they will lend to, and on what terms. As a result, the supply of consumer credit has been reduced, and the available credit rendered more expensive.

There is significant academic and market evidence that high-interest lending, such as payday loans, despite its considerable--some would say astronomical--expense, increases the welfare of borrowers. Predatory loans, on the other hand, are loans obtained by the lender through deception or fraud, and do not enhance the welfare of borrowers. It is a disservice to the public to confuse loans that are truly predatory with those that are simply expensive.

The availability of even expensive short-term credit enables consumers to survive financial and other "shocks" that would otherwise cause them to seek bankruptcy protection, leave the workforce, or forgo crucial purchases, including medical care or auto repairs essential for a worker's commute.

The imposition of artificially low interest-rate ceilings will also drive legitimate lenders out of the market, as it has done in Washington, leaving consumers to borrow from Internet lenders and unregulated loan sharks. From an economic standpoint, this is no favor to consumers. The costs of operating outside the law are relatively high, and competition among such unscrupulous lenders is severely limited. Hence, interest rates on these loans may be several times the level that would have existed in the absence of legislated ceilings.

Interest-rate restrictions are the bluntest and least satisfactory instrument for regulation of the ills that are thought to be associated with high-interest lending such as payday loans. Specifically, if concerns exist that consumers may be trapped in a "cycle of debt," or may otherwise overuse payday or high-interest loans, other--non-interest-rate--regulatory restrictions can be invoked to restrict multiple or successive loans to individual borrowers.

As the supply of credit naturally contracts with the business cycle, the temptation to "protect" the least credit-worthy consumers through interest-rate regulation should be resisted. The secondary effects of harming the very populations such regulations were designed to protect should be considered more carefully.