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.
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Comment by ronald eddy on 15 July 2010:
Instant Payday loans in 1 hour hold high interest charge but this interest charge is rather practical, as the lender offers these loans without challenging several needless entropy or feature.
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Comment by Speedmaster on 15 July 2010:
Great column, well-stated!
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Comment by Jameson Graber on 15 July 2010:
In the Wealth of Nations, Adam Smith expressed support for regulating the amounts for which banks could print promissory notes. He says, “To restraint private people, it may be said, from receiving in payment the promissory notes of a banker, for any sum whether great or small, when they themselves are willing to receive them; or, to restrain a banker from issuing such notes, when all his neighbours are willing to accept them, is a manifest violation of that natural liberty which it is the proper business of law, not to infringe, but to support. Such regulations may, no doubt, be considered as in some respect a violation of natural liberty. But those exertions of the natural liberty of a few individuals, which might endanger the security of the whole society, are, and ought to be, restrained by the laws of all governments…”
If even Adam Smith believed certain regulations are necessary for the public good, why do you consistently disparage all regulations? The classical liberal tradition has always been known for being able to base its conclusions from critically examining the facts. The fact is, desperate people are not in a position to take out a loan responsibly, for the precise reason that they are desperate. The transaction that takes place is not rationally thought out, and therefore it is not the kind of free transaction that benefits society. The fact that there is a 50% default rate simply illustrates this point.
What is needed is an alternative for people in dire straits. Friedrich Hayek said we ought to have some baseline support to keep people out of abject poverty. If people are taking out payday loans in order to eat, we have done something wrong as a society. We can certainly afford to give people food to live on in between pay checks.
I am more or less in agreement with the economic philosophy expressed by libertarians, but on certain issues it just doesn’t make sense to be so hard line.
Comment by lenderchick on 15 July 2010:
Payday lenders do not loan to illegal immigrants.
To get a payday loan, you have to have a job, a social security card and a checking account.
Banning payday lenders is a boon to big banks.
New York Federal Reserve researcher Donald Morgan has shown that after Georgia made such loans a criminal offense in 2004, bounced checks at the Atlanta Fed rose 13%, generating $36 million in additional income for banks.
Two bounced $75 checks (the national average is $66) at $29 apiece equals an annual interest rate of 1,000%, versus 300% for the typical payday loan. But banks got 21% of their operating profit from bounced-check fees in 2008, and credit unions got 60%, according to the Federal Deposit Insurance Corp.
I work in the payday advance industry, and I’m wondering just who these legislators are trying to protect. The banks?
Comment by Daniel Shapiro on 15 July 2010:
Here is yet another example of how political force and spurious economic ideas have continually weakened productivity and voluntary exchange through intervention and a monopolistic state money system based on counterfeiting. Payday loans and other such businesses are an effect of the political state – commercial banking alliance which have a monopoly on the issuance of new money.
Anyone who wants a deeper comprehension of money, exchange, and other related social phenomena should read E.C. Riegel.
Pingback by Another Credit Market Regulation, With a Twist | Austrian Economics Blog on 16 July 2010:
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Comment by Ike on 16 July 2010:
Jameson Graber: Like Adam Smith, you overlook the fact that banks may only exist by having a government license, hence their scarcity. Given how profitable it is, banking is certain to be politically corrupted. Your argument pre-supposes that those who use payday loans being desparate are therefore irrational and incompetent to properly manage their own affairs. Proof?? I suspect only your own prejudices about the poor and those who are not credit-worthy by bank standards. There is no authority in the Constitution to protect those who are popularly believed to be incompetent; banking regulation again is one of those powers reserved to the states.
Comment by Pat Fields on 17 July 2010:
The Principal/Interest co-generation system comprising virtual ‘money’ is its self-destructive feature. It is mathematically inescapable that at a point certain, the Interest Service on the ‘money’ float will supercede the economy’s productive capacity to keep pace with the compounding. It appears we’ve crossed that ‘event horizon’, globally
The only way to ‘reset the game’ is to calculate the residual real value left in the ‘money’ and realize it in specie. U.S. Reserve Bank Notes, for example are known to have depreciated 97% in purchasing power, so all the notes and digital ‘credits’ can be converted to 10 gram copper pieces. (This is quite doable!)
In that scenario ‘poor’ folks can literally make their own money by scavenging old motor windings, radiators and such, to ‘make money’ independently and productively contribute to the overall wealth of their communities.
As copper is sequentially brought into a rational relationahip with silver (copper STILL trades at about a 100:1 ratio against silver making BOTH tremendously undervalued traditionally) and then gold, these ‘poor’ folks will have a discernable path to better living conditions without any artificially interposed hindrance.
Some may be surprised to learn that this exact same plan was executed by the Chinese in 1450 when their ‘flying money’ imploded. It kept China from disintegrating into its old warring fiefdoms and it can prevent a similar fate from befalling our current socio-political structures.
Comment by Maya on 18 July 2010:
The logic here is designed to tug at the heart strings, but is flawed. If “such people” are really weighing their options, and finding that “the payday loan option is better than going hungry between paychecks,” this implies that such persons are spending their money wisely each paycheck only on necessities such as food and have run out, having to worry about food at the end of the pay period. If so, then whatever money they had that pay period for food and other necessities was not sufficient, and there is a very low likelihood that the situation will change during the next pay period. It’s entirely ridiculous to say that these people do not have a gun pointed to their heads, or that they “perceive a need for additional liquidity.” Liquidity implies there are some assets that are not liquid today. No, these people have no assets or collateral, remember? They are simply looking into the faces of their hungry children. A payday loan is merely borrowing from the next pay period for which the available funds are already not enough for necessities, putting the person in a worse position for the next pay period in addition to the lousy position they are in during the current pay period. In particular, the situation very likely causes the loan to be carried out much longer than one pay period so that the extremely high interest “if the loan is carried a full year,” comes to pass, or the loan is likely to end up in default. You imagine everyone has perfect information and is perfectly rational, but these people lack not only assets and collateral, but education and sophistication about financial matters. How then, does the payday loan help them?
If “such people” are spending their money on things that are not necessities and get to the end of the pay period without enough for food, then the options they are weighing are not really between the loan and food at all – those people already made a lousy choice between food and some other non-necessary item earlier in the pay period, and the payday loan merely encourages this unwise behavior by making it possible to eat even after making bad choices earlier in the pay period. How is that payday loan good for these folks?
No, the basis of your argument doesn’t hold up. The majority of payday loan customers who you describe as weighing between the loan and food would go hungry between paychecks *anyway* – the payday loan only puts them in a worse position than they would be without it, not a better one.
Comment by Craig Wright on 20 July 2010:
I started poor. I paid for some of my education gutting chickens and then later as a chef, warehouse floorman etc.
At this point in my early 20′s I was diagnosed with cancer. I had 2 options. Private hospital the next day to start treatment or public and a 6-9 month wait. I was informed that I could expect the cancer to spread to my lymph nodes and bones within 2-3 months without cancer. I had applied for insurance but was in the wait period (by 2 weeks) and was not covered at that point.
I took out a loan at a 38% to cover my treatments and surgery. For the next 4 years I did little other than pay back my loan and study (having no free cash is a good incentive to work hard at ones studies) and visit doctors. I lived in a $55 a week 1 room apartment for much of this time. I used payday loans and credit to pay bills.
I was (and AM) happy that I could pay exorbitant rates. If these services did not exist, I cannot say that I would be here now. In fact, it is unlikely I would have been alive the last 15 years without these services.
I do not simply see this as a belief of a rational choice, I know it was rational. I knew what I was risking. I knew the costs. The interest rate that I could obtain was based on a combination of my having a low income with no credit history coupled with a good chance of default if the cancer progressed.
So Maya, please tell me how I was irrational in accepting and repaying loans at rates others consider excessive?
Comment by Sabastian Miller on 20 July 2010:
While i do think they provide a service and are legally allowed to do so i totally agree that these should be a last resort and ideally avoided throughout your life.
Comment by Jerome on 20 July 2010:
I totally agree with Craig Writh. I even think 400% a year of interest rate is not enough. Actually I even think those guys should not be paid at all to start with. Zero, nil. Be slaves for someone else who would pay for their expenses like in the good old days. And in their 20s’ NO! That’s much too old to learn how to work really hard. I would start the whole program at 5. You would see how they would f*cking go to work everyday. And if those useless unproductive kids refuse, I think it would be ‘rational’ as Craig is saying to whip them hard. That’s rational because at least it would push them to work, and hence allow their master to pay for their bills – like buying them a ball of rice everyday. Now we’re talking.
Comment by Craig Wright on 20 July 2010:
It is always interesting how a personal decision is twisted. Jerome is like so many statist apologists. At no point did I say anyone is forced to. I stated that I, without threat from another made a choice.
It is interesting how some people manage to twist personal choice into violence.
These ARE a last choice. NO person with the ability to obtain credit at 5% will decide to obtain it at 40% for the sake of it.
At the interest rates I had to accept, I ended up paying over $100k for something that would have been less than half that amount at a low interest rate. I also took payday loans as I did not have sufficient income to save. I knew and could plan my needs, I was working full time and doing a University course full time by distance.
Books needed to be purchased. To wait would mean having less time to study. Working 55 hours a week with overtime average and having a full time study load meant that I did not have the luxury of saving and buying books half way into the course. This would have courted failure and extended the time of the course as well as the cost (as one pays for failed courses too).
Of course, the alternative was save and wait a few more years. My preference was to do as much as possible early. It is interesting how cancer in ones early 20′s changes time preferences. These are however MY time preferences.
As for Jerome’s comment on slavery, I did not want another person to usurp my my rights. I took my own obligations as my own. I did not try and have others assume my debts and now did I wish at any point to have another take responsibility for my life. Interesting how this type of argument is twisted out of another.
This may be an argument from analogy, but it is one that I understand well. It is fact and it was my life. My time preferences have allowed me to be at the point I am now. I am a director of several companies and am working on my 8th post-grad degree. This is also something that is simple enough to verify. With the web not a great deal of our lives is private.
My cancer was not the fault of anyone and I do not expect that any person should be responsible for it or the cost other than myself.
If lenders had been restrained (in order to protect me), I would have likely died a long time ago (15-17 years). My death would have cost the taxpayer a large amount of money. The companies I formed and the jobs I created would never have existed.
So again, and although my case is more extreme than most, please explain how banning such services would have aided me or another in a time of need?
Maya wrote: “You imagine everyone has perfect information and is perfectly rational, but these people lack not only assets and collateral, but education and sophistication about financial matters. How then, does the payday loan help them?”
Here is of course the rub. The paternalistic nature of the crusader. Maya expresses the common fallacy and ignorance that all crusaders have in abundance. They assume that they are better than others. They are more able to judge and decide than the individual. Having lived in abject poverty and having worked out from it, I can state, we do not want your “help”.
Comment by Jerome on 21 July 2010:
I know what you mean Craig and indeed the slavery stage was a step too far. And I completely agree, I find that extremely stupid to ban those shark loan agencies (seriously). So let’s just push the individual choice problem a bit further. I want to be able to do whatever I want, freely, with no State barrier. So for example, what is the point of forcing kids going to school? Actually what is the point of segregating kids from the rest of the population? How artificial is that. I think we should allow kids to work from the age of 5. And what is the point of having a retirement age as well? Let’s just get rid of that and let people choose when they want to leave. What else… hmmm… yeah let’s just get rid of the lows banning people to kill each other. That’s completely artificial since rationally people will not kill each other (that’s generally not the optimal choice).
Okay so we are back to wild wild west times. Or maybe better, Africa! Yeah that’s how it works in certain countries in Africa. No rule, no State intervention, no nothing. Just individuals fighting for their domination against each other.
Hmmmm… now I feel good and free! And most of all, am proud of the society I live in which some kids going to work at the age of 5, and my 80 year old grand parents dying in their factory. You know what? If you have kids, I wish them all the best. Maybe they too in a society like that, could become unfortunate and have not enough money to go to school, have to work from the age of 5 and die at doing their job (for someone else’s profit). And if not them, their kids… Actually I would love to see that happen to them. You cannot guarantee it will not since their is no barrier anymore! And you cannot say it’s bad for them, since at least they will live in a ‘free’ society! What a joy!
In fact do you want to see with your own eyes what sort of country that would be? Take a break and fly to Mumbai with your wife for a week or two, a country which is a 100% free market economy since the 19th century. A great combination of no State intervention, pure market competition, 100% pure laissez-faire and extremely low corporate and income taxes. Really really free, as you like it. Please send me a postcard telling me how proud you would be to live in a country like that, and see your kids work to survive, and sleep on the street – that’s quite common there. By choice of course! Because they chose to live in a free society! Between you having to pay 400% interests on your shark loan and that, it is only a matter of scale…
To finish I will remember you just one fact about your country (am not American). The high of the US grandeur, as a country, was probably reached around 1970 – 1980. Economically, politically, socially, culturally. In many aspects of everyday life you used to be admired and loved at that time. Does this period coincide with a free-market economy? Tell me. Let’s take a quick example. The top tier income tax averaged 82% between 1932 and 1980. Yes in the US, we are not talking about a communist country, that’s the US. You would have to be a bloody Bolchevic to seriously think that 82% top income tax is a free market economy. So how can you explain to me that India who is a pure free market economy (no social services, hardly any civil servants, very small State budget, no minimum wage at all etc.) is still such a useless country compared to yours, which went through a 50 year period where at the same time the Federal State WAS the economy and it reached such a tremendous level of progress and domination across the board? By the way 98% of Indian represent 1% of the Indian economy. If you keep pushing the competition between them and the rich and individualism a bit further in this country you will probably end up with 2 guys possessing 100% of the country. How lucky should your kids have to be, to be one of them Craig if you lived in India? Tell me.
Or maybe you think African and Indian have reached the purest form of liberty and grandeur?
Comment by Craig Wright on 22 July 2010:
I spent time in Mumbai consulting to Mahindra. I walked the slums. I have also been to Hyderabad, Pune,…. First, it is far from free market. It is more open now, but I think you have to actually read what a free market is.
Mumbai has property tax, a wealth tax, income tax, company tax (larger for foreign companies to ensure “internal growth” – an idea doomed to fail and which ignores even their own evidence), capital gains, wealth tax, gift tax, fringe benefits tax…. Taxes exist at both the local and state as well as the national levels. The state also has a sales tax. But why let the truth get in the way of a story.
India has a large public service. In large companies it is nearly impossible to fire people (this has improved of late). This is to the point where employees expect a bonus to work (a wage being just being there). Generally in the past, employees brought in family and caste associates and open employment did not occur. Courts can take years to process a case in India and most justice is misapplied even now. The government corruption is FAR better than it was 2 decades ago, but is still one of the lowest ranked for government corruption (see World Economic Forum, WEF).
India has one of the worst bureaucracies in Asia. [1]
I worked on having computer equipment imported for work I was doing in the 90′s and for the implementation of VSat links. Not an easy process. In Australia and the US, this is a service that can be provisioned in a week. In India, this could take 18 months with no guarantee of success.
It is far better now in India. This is a function of freer markets. Since the 90′s the markets have been made progressively more open and the market has provided opportunities from that point.
India was socialist from independence until recently. This experiment cost million of lives and is the source of much of the still existent poverty. Other aspects are cultural. The Brahma castes still have an idea of how society should be constructed and social mobility is a dream for most.
Africa is a different matter. It is a continent. A collection of countries with separate and distinct issues and problems. Some (a small few) African nations are actually growing and prosperous. Most are not. This is exactly the opposite to your assertion however. It is precisely the lack of trade that is the biggest loss.
It is not the loans that are an issue, but the leadership (mostly dictatorial) that results in a depressed economy with corruption being systemic in most places (not all). Worse is a lack of property rights (which incidentally do more to protect the poor than the rich) and an over arduous system of licensing and controls. In places where people squat and cannot expect to be able to own land, their is little incentive for long term capital improvements.
Finally, the rule of law is an integral part of a free society. This does not mean excessive interaction with a market, but rather
The fallacy you find as an argument is that the market has to be perfect or it is a failure. This is far from true. It only needs to be better than the options. This is, intervention into the market makes it less efficient. The cost of intervention has to exceed the loss generally. This is yet to occur and is the flaw with this line of argument. Expending resources in intervention would only be an acceptable option if the resulting growth was larger than it could otherwise be. This has never been demonstrated (please feel free to prove me wrong with an example).
“To finish I will remember you just one fact about your country”
I am also NOT a US citizen. I am Australian. Thanks for checking. My wife is Canadian. I have spent time in the US (as well as Canada).
The US is not free market, it is freer than India. Please ignore the stories and fact check your argument first.
It is simple to make up stories to suit your argument, but this is all they are.
[1] http://timesofindia.indiatimes.com/India/Indian-bureaucracy-ranked-worst-in-Asia-Survey/articleshow/4612918.cms
Comment by Craig Wright on 22 July 2010:
Also, India started a minimum wage through the The Minimum Wage Act, 1948. So, please fact-check your fairytale. What you likely mean is that 422.6 million Indian workers are in the “informal” black market employment sector. This is 94% of the working population.
This is not a choice but a bureaucratic enforcement. The rule of law is developing, but remains overly socialist.
I have an LLM (Masters degree in law) from Northumbria University (UK) specializing in International Commercial Law. Not that an argument from authority is an acceptable logical argument, but I do understand Indian law and the problems that result from its failings.
If you actually want to learn the truth, I am more than happy to send a number of reference sources through to you.
Comment by cry_aboutit on 25 February 2011:
Craig, I’ll take you up on the reference offer. Not to attempt to refute what you’ve said, but to learn more. Excellent response.
In
Comment by Danica Flippin on 5 February 2012:
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