Loan Sharking: A Brief Defence
By Sean Gabb
The British Government has announced it will cap the rates of interest on the loans people take out to tide them over till payday. It will amend the current Financial Services Bill to give the planned Financial Conduct Authority the power to limit charges.
Now, some of the interest rates charged do look astonishing. The loan companies that advertise on Channel Five all charge about 2,000 per cent. Others are said to charge as much as 4,000 per cent. The last time I borrowed money, I paid five per cent. I avoid going into debt on my credit cards, because of the 22 per cent charged on them. It may seem heartless to defend the right to charge very high interest rates – especially as these are charged to the very poor, who then have trouble getting out of debt. However, limiting the rate of interest they can be charged is not the way to help the poor. Let me explain.
I will assume a reasonably open market in loans. We do not presently have a completely free market – lenders must be registered under the Consumer Credit Act 1974, and this Act and the common law do not allow complete freedom of contract. Even so, there are many lenders, and there is no evidence of systematic collusion. This being so, the analysis of interest rate formation given in the textbooks does apply fairly well to the actual world.
The demand for loans is determined by a combination of forces. At the commercial end of the market, there are calculations about the marginal productivity of capital. At the consumer end, there is how badly people want the things that loans will buy.
The supply is also determined by more than one force. Most fundamentally, there is what the Victorian economists called the “price” of money, and is nowadays called time preference. Even assuming zero risk, people will tend to give up present use of their money only if they can look forward to a return on it. For example, seen from today, £100 is worth more to me today than a year from today – I might be dead in a year, or the pleasure I can buy next year might seem rather shadowy compared with what I can buy now. If an extra £5 is the minimum that will persuade me to defer use of my £100, then the price of my money is five per cent. There are other considerations. This price of money will be different according to how much present use is being deferred. Also, most people will save something even without a positive return. And, of course, in the absence of a proper gold standard, and often for long periods, the monetary authorities are able to create loanable funds out of thin air. But price, or time preference, is an important underlying determinant.
We must then take account of risk. The reason I can borrow at about five per cent is because I have a known record of paying my debts. And, if I cannot pay them in future, I have assets that can be seized after the appropriate legal action. The reason other people are charged much higher rates is because they have a poor credit history. Or, if they have no history, they fall into one of the categories of people who cannot easily be made to pay their debts. These categories include the young, those without assets, habitual defaulters, those who are able to move about the world or to disappear without trace, and the generally feckless.
Loanable funds are perfectly mobile. A lender can do business with people like me, or with young men without assets who have already been made bankrupt at least once. He will expect to walk away from either class of deal with the same overall return. If lenders can make more overall from this second group, they will compete with each other for business, until the rate of return has fallen to the same as can be earned on loans to the first group. Therefore, someone who is charged 1,000 per cent on a loan is not necessarily being exploited. He is being charged a premium that takes into account his perceived risk of default.
Therefore also, any cap on interest rates to those at high perceived risk of default will result in a drying up of loanable funds. As said, these funds are mobile. They will move out of markets where overall returns are lower than elsewhere. If some people cannot be charged 1,000 per cent on loans, they will not be able to borrow at all.
Or they will be able to borrow – but not from people in suits who try to collect unpaid debts through letters sent in brown envelopes and through the courts. When these people vacate a market, because of legal caps on rates of return, their place will be taken by real loan sharks – the kind of people who collect debts by threats of violence, and who, because of the risk of punishment, and the limitation of competition, will charge more than the lenders they have replaced.
For this reason, limiting interest rates will not help the poor. Indeed, even without the criminality of the loans markets that emerge in the shadow of interest limitations, this kind of law is bad. A loan is an act between consenting adults. It is of exactly the same nature as any other financial or other transaction. Any restriction in one area on freedom of association will, by example, encourage restrictions in others. It will encourage further state socialism or moral authoritarianism.
This is not to say that all is for the best in the best of possible worlds. The case made above is general. It applies to any particular state of society. But not every society has to be one in which large numbers of poor people are encouraged to get into debts they cannot pay. In England, we have an established church. Its ministers would do more to justify their privileges if they stopped arguing about woman bishops and canting about racial equality, and began preaching the virtues of thrift and sobriety. In other times and places, the poor have borrowed chiefly to cope with natural disaster or to pay grasping tax collectors and landlords. In modern England, they borrow to buy things they cannot normally afford, or are not willing to buy after saving up for them. So far as they do not spell out the obvious truths of life, the religious and moral leaders of this country – and not only in the Church of England – are failing the poor.
Then there is real action the authorities can take to reduce dependence by the poor on credit. in this country, tax is payable on incomes of just a few thousand pounds. Shelf-stackers in Tesco pay income tax. VAT at 20 per cent raises the price of all taxable goods and services. So do excise duties and tariffs. So called product safety and other regulations generally increase prices, and work in much the same way as a tax.
Worse, there is government rigging of the energy markets, which raise electricity, gas and petrol prices directly, and which – because energy is one of the main costs of bringing goods and services to market – raise virtually all other prices.
According to Christopher Booker, writing, in October 2012, in The Sunday Telegraph:
[O]ver the next eight years, we need to spend £100 billion on building 30,000 useless, unreliable and grotesquely subsidised wind turbines…. [F]urther billions will need to be spent on new gas-fired power stations – not only to fill the gap left by all the coal-fired and nuclear plants that are due to close, but also to provide ever more expensive, “carbon”-emitting back-up for the times when the wind drops and our turbines are scarcely functioning…. [T]he declared purpose of George Osborne’s “carbon tax”… [is to] double our energy bills.
Giving up on the fraudulent claims about man-made climate change would allow millions in this country to lead something like the lives shown in television advertisements without having to go into debt.
Or there are various forms of corporate welfare, and a tax and regulatory system, that effectively prevent millions of people from running little businesses that would lift them out of poverty. For example, no one nowadays can become a – legal – minicab driver without spending thousands up front on licensing fees and regulatory compliance. Again, no one can become a – legal – childminder without OFSTED registration that closes that occupation to everyone without high standards of literacy and administrative skill.
Or there are the effects of state-sponsored mass immigration. In a free society, there would be few border controls, and there would be some movement of people across borders. What we have at the moment is a system in which, since about 1990, upward of twenty million unskilled and often illiterate – and even violent or subversive – aliens have been encouraged to settle among us. If they work, they drive down wages at the bottom end of the employment market. If they live on welfare, they add to an increasingly regressive tax bill. Whether they work or claim, they raise housing costs by the pressure of their additional demand in a market characterised by both natural and state-made inelasticity of supply.
I repeat, it is not a desirable state of affairs in which large numbers of people borrow at very high rates of interest. But caps on interest rates do not even begin to address this problem. We can accuse the politicians behind this plan of stupidity, or of a cynical shifting of blame for a situation they have done most to bring about. Most reasonably, we can accuse them of both.
And, dear me, I did think we had gone to the trouble, back in 2010, of electing a Conservative Government with a better understanding of economics than Gordon Brown and his dismal crew ever had!