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Thursday, July 15, 2010

In Defense of Payday Lenders and Their Customers

Being kind can be cruel.

Almost 40 years ago Walter Block wrote a fun little book called Defending the Undefendable.  In it he explicated the libertarian arguments in defense of all sorts of people and practices that most observers would find objectionable: drug dealers, pimps, and the like.

One such group he defended was loan sharks, who charge high interest rates, normally on short-term loans.  The common objection is that they are predatory lenders taking advantage of the poor and less creditworthy by charging them “usurious” interest rates.  Walter quite rightly argued that such lenders were simply providing a service that customers voluntarily contracted for and that there was no victim.

Here we are in 2010, and the same objections are being raised, but this time backed by the force of law.  According to CNN, Arizona has now become the 17th state to ban payday lenders by capping their effective annual interest rate at 36 percent.  Payday lenders specialize in short-term loans, usually two weeks to a month, at high annual interest rates, often to borrowers who can find no other source of credit.  These lenders provide liquidity to borrowers to carry them over until payday, when the loans are repaid.  CNN reports that an interest charge of $17 per $100 borrowed on a 14-day loan is typical.  This comes out to about a 400 percent interest rate if the loan is carried a full year.  The usual suspects see these practices as “predatory” and “abusive.”

But who exactly is hurt here?  No one points a gun at the heads of the borrowers.  Clearly they perceive a need for that additional liquidity and, to use a little economic jargon, their time preference is high enough that they are willing to pay the high rate for the very short-term loan.  Their willingness to do so is most likely a consequence of their poverty; they lack the assets and collateral, and even the human capital, necessary to get a standard loan or a credit card.  For such people the payday loan option is better than going hungry between paychecks.

High Default Rate

Obviously, high interest rates make payday lending look like a big bucket of profits for the lenders, but CNN also reports that the default rate within the first 12 months is about 50 percent.  The reporter makes this seem like evidence for the abusiveness of the practice:  Somehow lenders are forcing loans on bad credit risks.  But the reality is that these are bad credit risks, which is why they are using this type of lender and why the interest rate is so high! As one of the lenders comments, they can’t make money at 36 percent with a 50 percent default rate.

Credit card companies’ default rates are in the high single digits — high enough that they need to compensate for the risk of unsecured loans by charging 18 percent or more.  Even now, mortgage default rates are half that of credit card rates, and since mortgage loans have assets backing them, lenders don’t need to charge high rates to compensate for the default risk.  With a default rate of 50 percent, it is understandable that payday lenders would want to charge very high interest rates.

A 36 percent cap, which is nothing more than a standard price control, will have the usual effects. It will limit the quantity of credit supplied and increase the quantity demanded, producing a credit shortage.  In fact, the payday lenders have left states that have enacted such laws, creating the shortage.  Moreover, in Arizona a hundred jobs will be lost when the major lender leaves.

Ironically, the law will probably be praised by those on the left who have (rightly) criticized Arizona’s crackdown on illegal immigration.  It’s ironic because research shows that payday lenders are most commonly found in areas with high immigrant populations, such as Arizona, suggesting that immigrants, legal and otherwise, are a large part of their customer base.  Without citizenship and the relevant ID, and with limited economic assets, they likely have only one borrowing option.  Pushing these lenders out of the state is completely consistent with the state’s anti-immigrant bias.  Rather than preying on immigrants and the poor, payday lenders offer them a service that would otherwise be unavailable.  Sending them packing makes Arizona that much more inhospitable to people seeking freedom and opportunity in the United States.  The leftists who claim to support immigrants, illegal or otherwise, but who praise this law need to see the harm it will do.

What’s really undefendable are not the loan sharks and payday lenders but the politicians who callously deny the poorest among us access to credit that might enable them to put another few meals on the table or buy medicine for their kids now rather than later.  We should be closing down the Arizona state legislature not the payday lenders.

  • Steven Horwitz was the Distinguished Professor of Free Enterprise in the Department of Economics at Ball State University, where he was also Director of the Institute for the Study of Political Economy. He is the author of Austrian Economics: An Introduction.