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Tuesday, April 1, 2008

Banning Payday Loans Deprives Low-Income People of Options

Though Expensive, Sometimes Payday Loans Are the Best Option

In 2006 North Carolina joined a growing list of states that ban “payday lending.” Payday loans are small, short-term loans made to workers to provide them with cash until their next paychecks. This kind of borrowing is costly, reflecting both the substantial risk of nonpayment and high overhead costs of dealing with many little transactions. I wouldn’t borrow money that way, but there is enough demand for such loans to support thousands of payday-lending stores across the nation. They make several million loans each year.

But no longer in North Carolina.

Pointing to the high cost of payday borrowing, a coalition of groups claiming to represent the poor stampeded the North Carolina General Assembly into putting all the payday-lenders out of business. The reason I’m writing about this now is that the North Carolina Office of the Commissioner of Banks recently felt the need to justify the ban with the release of a study purporting to demonstrate that the politicians did the right thing. How do they know? Because payday lending “is not missed.” The preposterous lack of logic in this whole exercise cannot pass without comment.

Before we look at the defense that has been given for this Nanny State dictate, we should consider what I call Sowell’s Axiom: You can’t make people better off by taking options away from them. (It’s named for the economist Thomas Sowell, one of whose books drove this point home to me many years ago.)

An individual will act to further his self-interest, and in doing so, will choose the course of action that is most likely to succeed. Sometimes a person faces difficult circumstances and has to choose the option that’s least bad. But that doesn’t change the analysis. If he’s out of money and needs cash until his next paycheck, he will have to consider various unpleasant alternatives and choose the best one.

Obtaining money through a payday loan works like this: The borrower, after proving to the lender that he is employed and has sufficient income, writes a check to the lender postdated to his next payday for some amount, say, $300. The lender gives him a smaller amount of cash, say, $260. The lender then cashes the check on its due date. That is obviously a very high annual rate of interest if you consider the $40 fee as an interest charge. A payday loan is not an attractive option—unless all your others are worse. No one would do it unless every other course of action looked even costlier.

Nevertheless, the North Carolinians who worked to abolish payday lending are eager to say they did no harm. A group called the UNC Center for Community Capital conducted a telephone survey of 400 low- and middle-income families in the state about how they deal with financial shortfalls. Only 159 reported having had financial troubles they couldn’t meet out of their regular income. From this small number of responses, the people doing the study concluded that “Payday lending is not missed.” That’s because, based on the telephone surveys, “almost nine out of ten said payday lending was a ‘bad thing’ and “twice as many respondents said the absence of payday lending has had a positive effect on their household than said it has had a negative effect.”

There you have it. Most people said payday lending was “bad” and few miss it now that it has been banned. That certainly proves that the state did the right thing in getting rid of it. Or does it?

Completely forgotten in the rush to justify the ban are the people who said they think they are worse off for not having this option anymore. Yes, they were a minority of the respondents, but that is no reason to conclude that “payday lending is not missed.” An accurate conclusion would instead be, “Payday lending is missed by some people.”

Maybe the silliness of this approach will be apparent if we consider a hypothetical case that parallels it.

Imagine that a group of people in New York hates opera. They regard it as too costly and time consuming, and a bad moral influence. Using their political connections, they succeed in getting the city government to ban live opera productions. Out goes the Met, the Civic Opera, and any other companies.

A year later this group commissions a survey asking 400 New Yorkers if they miss having opera in the city. Since most people don’t care about or even dislike opera, the results come in showing that the overwhelming majority of New Yorkers agree “Opera is not missed.” Would that justify taking opera away from the, say, 5 percent who said they would like to have had the option of going?

My point is that the views of the people who don’t patronize a business or art form shouldn’t count for anything. The people who don’t like opera are free not to go, and the people who think payday lending is “bad” are free to avoid it. As long as anyone wants to attend an opera or needs a payday loan, the government has no business forcibly depriving them of those choices.

Returning to the North Carolina study, people were also asked how they respond when they have a money shortage. The results showed that people coped in various ways, including paying bills late, dipping into savings, borrowing from family or friends, using a credit card to get cash, or merely doing without things. Jumping on that information, North Carolina’s deputy commissioner of banks, Mark Pearce, said in the November 14, 2007, Raleigh News & Observer, “Working people don’t miss payday lending. They have a lot of financial options and they use them.”

We can only wonder why it doesn’t occur to Pearce that having one more option might be good. What if someone has already exhausted all possible money sources and faces serious consequences from either paying late (suppose the next missed payment means the power gets turned off) or doing without (you’ve got to have some car repairs so you can get to work)? A payday loan might be the best option left.

In an August 2006 paper on the payday-lending business (“Payday Lending and Public Policy: What Elected Officials Should Know”), Professor Thomas Lehman of Indiana Wesleyan University found that this kind of lending fills a market niche and concluded, “Preventing or limiting the use of payday loan services only encourages borrowers to seek out and utilize less attractive alternatives . . . that put the borrower in an even weaker financial position.”

A November 2007 study by two economists with the Federal Reserve Bank of New York (“Payday Holiday: How Households Fare after Payday Credit Bans”) came to the same conclusion. Authors Donald Morgan and Michael Strain found that a ban on payday lending results in increased credit problems for consumers. They wrote, “Payday credit is preferable to substitutes such as the bounced-check ‘protection’ sold by credit unions and banks or loans from pawnshops.”

So I maintain that Sowell’s Axiom holds. When government takes away options, it is bound to make some people worse off. Instead of acting like Big Nanny, government should stick to enforcing laws against coercion and fraud.

  • George Leef is the former book review editor of The Freeman. He is director of research at the John W. Pope Center for Higher Education Policy.