Defining Ideas

A Progressive Plan That Aids Loan Sharks

Wednesday, May 15, 2019
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Senator Bernie Sanders and Representative Alexandria Ocasio-Cortez have announced plans to introduce legislation that would limit the interest rate that credit card companies are allowed to charge customers. Although there is currently no federal limit, some state governments have limits. Sanders and Ocasio-Cortez propose capping the annual rate of interest on credit card debt at 15 percent.

What could go wrong with this idea? Lots. Such limits, called usury laws, will make it harder for people without a good credit rating to get credit. That will move some of them to using the much less efficient layaway plans and pawn shops, and might even cause some people to borrow from loan sharks. The credit card caps will also push some people without a good credit history to get even higher-interest payday loans.

We don’t need to go far back in history to see what’s wrong with legal limits on interest rates. We need only go back to the early 1970s.

I’m an example of someone hurt by usury laws in the early 1970s. I moved to California from Canada in September 1972 to go to graduate school at UCLA. Shortly after arriving, I started a checking account at the Bank of America branch near UCLA. In early 1973 I applied for a credit card. To maximize the probability of being approved, I asked for the minimum credit limit: $250. I was always good at handling money but, at age 22, I had never taken out a loan. So I had no credit record. I bet you can guess what happened: I was turned down. I was upset but I was also well along to becoming an economist: I had already learned a lot in a year of self-study in economics and one intense quarter of economics at a great graduate school. So I had learned, as economists do, to put myself in the other guy’s shoes.

I realized that the credit card company that turned me down didn’t know much about me. I knew that I was a good risk. But how would the credit card company know? I had had to state some background information on the application form and that included the fact that I had lived in Canada until a few months earlier and so it would probably be hard to collect from me if I moved back to Canada. How had I gone through college without accruing debt? I had gone for a three-year degree in Canada and financed it with savings, earnings, scholarships, and penurious living. When I had completed my second year of college, my net worth was down to $20. So, to finance my last year of college, I hitchhiked from Winnipeg to northern Manitoba, where I worked for three months in an underground nickel mine and worked every hour of overtime I could, including double shifts. It paid off, and I graduated with zero debt.

But how was a credit card company to know all that? All it knew was that I had never repaid a loan.

One main way a credit card company can deal with the risk of lending to someone with no credit history is to charge a higher interest rate. There’s the rub. I was applying for a credit card in California, and California’s usury laws restricted the rate that could be charged. Given the risk, it simply wasn’t worth a credit card company taking the chance.

A few months later, my inability to get a credit card with even a modest credit limit made my life difficult. In the spring of 1973, I applied for, and accepted, a position as a paid summer intern with President Nixon’s Council of Economic Advisers. When I arrived in Washington, D.C. early Monday morning on a redeye, I had spent all but my last $20 on airfare. I was negotiating with various people I had contacted by mail to rent a room from them in D.C. or in Alexandria, Virginia, but nothing was firm. I was desperate. I pleaded with one of them, successfully, to let me stay with him and his roommates in Alexandria Monday night. I persuaded his roommates to let me stay a few extra days, but because I was responsible for my own food, I remember being very careful while shopping. My $20 left had to cover food and bus fare from Alexandria to the Old Executive Office Building until a few days later, when I managed to borrow another $20 from one of my Alexandria roommates.

Think about what I could have done with a credit card and a $250 limit. Room rentals at so-so hotels were going for well under $40 per night in those days. But, because I had no credit card and little cash, that wasn’t an option for me. Of course, as I built a work record, paid taxes, and lived in the United States longer, I finally qualified, in 1974, for a credit card. But I couldn't get one when I most needed it.

That’s my story. Probably a more typical story is about a young couple starting out and wanting to buy furniture and household appliances. With no credit rating, they would probably have gotten, at best, a credit card with a low limit.

But in the late 1970s, all that changed, due to one of the best Supreme Court decisions ever. I say “best” not as a scholar of the U.S. Constitution, but as an economist looking at economic effects. The decision was in the case of Marquette National Bank of Minneapolis v. First of Omaha Service Corp. First of Omaha, based, as the name suggests, in Nebraska, was subject to that state’s usury laws. These set an 18 percent limit on the interest rate on unpaid credit card balances up to $999.99. Minnesota law, by contrast, limited the interest rate to 12 percent. First of Omaha started aggressively advertising credit cards to Minnesota residents with the idea of charging up to 18 percent. Who complained? Marquette National Bank of Minneapolis, which didn’t like the competition.  

In oral argument, Justice Thurgood Marshall asked the Marquette lawyer if Minnesota residents could get a credit card with a 12 percent limit from Marquette’s bank. The Marquette lawyer answered yes. Then Marshall asked the Marquette lawyer if First National Bank of Omaha was soliciting potential credit card customers in Minnesota by mail. Again, the Marquette lawyer said yes. Finally, Marshall asked the Marquette lawyer, “You’re claiming that the Omaha bank is taking customers away from Marquette?” The Marquette lawyer said that was his claim, to which Marshall responded that the bank had a marketing problem, not a legal problem. Of course, Marquette had a legal problem, too: it couldn’t profitably compete for the higher-risk customers.

The Supreme Court, in a decision written by Justice William J. Brennan, voted unanimously to allow national banks to charge interest rates based on usury laws at the location of the lender and independent of the location of the borrower. That decision paved the way for a much freer market in credit cards. National banks set up in states with higher or no usury limits. Have you ever wondered why the address on your credit card is often South Dakota or Delaware? It’s because of that decision. Citibank, for example, persuaded South Dakota governor Bill Janklow to invite the bank to South Dakota. Janklow, in turn, persuaded South Dakota’s legislature to remove the state’s interest rate cap. Subsequently, Citibank moved its credit-card operations to Sioux Falls.

And that made many of us better off. On the one hand, we pay higher interest on credit cards. The average interest rate on people with poor credit scores is about 24.99 percent. On the other hand, it’s much easier to get credit.

What would happen in the unlikely case that Sanders and AOC got their national ceiling of 15 percent interest on credit card balances? Three practices would probably become more common. The first is layaway plans, in which the customer chooses the high-ticket item but doesn’t take it home. Instead she “lays it away,” saving money slowly until she has enough to buy it. This usually happens many months later, which means that the customer does without the item for months. And the item might be a washer/dryer combination. If she had bought it with a credit card, she would have saved weekly trips to the laundromat and many rolls of quarters.

The second likely effect is more use of pawn shops. When you take an item to a pawn shop, you get immediate cash. But if you want to buy the item back later, you pay a higher amount than you were paid upfront. There’s nothing wrong with that. That’s what the pawn shop owner has to do to stay in business. But the implicit interest rate you’re paying, on an annual basis, is typically well above 30 percent.

A third likely effect of the Sanders-AOC idea is a shift to borrowing from “loan sharks.” Loan sharks lend money illegally for interest rates that, annualized, are a multiple of 15 percent and who, if the borrower doesn’t pay, threaten to, and sometimes do, assault the borrower. Call me crazy, but that seems like a less appealing option than a 25 percent annual interest rate on a credit card. More important, borrowers think it’s worse, too, which is why they pay 25 percent on a credit card rather than head to a loan shark.

One other possible consequence of a federal ceiling on credit card interest rates is a shift by the most marginal borrowers to payday loans. With such loans, people turn over their right to their next paycheck in return for cash now. The implicit interest rate for a typical period of a week or two is quite high. Payday loans were not common before the 1978 Supreme Court decision but are fairly common now. With a federal interest ceiling, they would become more common.

I hasten to add that there’s nothing wrong with payday loans. They fill an important niche in the market. And if you think there’s something wrong with them, don’t ever let me catch you paying $3 to get $40 from an ATM that’s not in your bank’s network. The implicit interest rate you’re paying to get $40 today rather than waiting a day and using your bank’s ATM is 7.5 percent per day, which is way higher than the 15 percent for two weeks that is typical of payday loans. My point in decrying the likely shift to payday loans is simpler. The cap would shift some borrowers from an option that is no longer available to one that they rejected when both options were available. That means they would be worse off.

In a famous mid-19th century article titled “What Is Seen and What Is Not Seen,” Frederic Bastiat wrote that the bad economist confines himself to the visible effect of a policy while the good economist “takes into account both the effect that can be seen and those effects that must be foreseen.” The good effects of an interest rate cap are lower interest rates for some borrowers who still manage to get credit cards. The bad effects are reduced access to credit cards for medium and high-risk borrowers and more recourse to less-attractive options such as layaway plans, pawn shops, payday loans, and loan sharks. That’s not a good tradeoff.

Senator Sanders and Representative Ocasio-Cortez claim to be looking out for everyday Americans rather than the fat cats. But Sanders, a multi-millionaire, and Ocasio-Cortez, who now makes $174,000 a year, fail to take account of the harmful effects of their policies on people with so-so credit histories or no credit histories. Elitism, anyone?