Could Restrictions on Payday Lending Hurt Consumers?

When teaching about price ceilings and price floors, I often toss in a bit about usury laws as an example of a price ceiling. But the usury example never seemed to me very pedagogically effective: it has a whiff of anachronism. A much better example for connecting with students is to discuss payday lending. Kelly Edmiston of the Kansas City Fed raises many of the key issues in: \”Could Restrictions on Payday Lending Hurt Consumers?\”

A payday loan typically involves a borrower writing a check for, say, $200, and then receiving $170. The lender promises not to cash the check for a couple of weeks. As Edmiston says: \”While payday lenders often charge fees rather than interest payments, in effect these charges are interest. Comparing the terms of varying types of loans requires computing an effective, or implied, annual interest rate. For payday loans, this computation is straightforward. A typical payday loan charges $15 per $100 borrowed. If the term of the loan is two weeks, then the effective annual interest rate is 390 percent.\”

Many states have regulated or banned payday loans. \”By the end of 2008, 10 states and the District of Columbia had instituted outright bans on payday lending. Other states have passed regulations that indirectly ban payday lending by making it unprofitable. For example, in Massachusetts, the Small Loan Act Caps interest at 23 percent per year. In states that allow payday lending, regulations may indirectly restrict or effectively ban the practice. A variety of such regulations exists. Most states legislate maximum loan amounts, usually from $300 to $500. The limits that states impose on fees vary widely.\”

The key point for public policy in this area, and a useful theme for teaching about price ceilings and regulation, is that banning or limiting payday lending doesn\’t alter the underlying reasons why people seek out such loans. Restricting payday loans pushes users to other options, which have tradeoffs of their own. For example:

  • Running down available cash balances in a bank savings account is surely cheaper than a payday loan in the short run. But it leaves people exposed to other risks–like not being able to pay the rent. \”Some researchers argue that households recognize a need to have money readily available when using a credit card is not an option—for example, when making rent payments … Similar logic may explain why some borrowers resort to payday loans even if they have credit cards.\”
  • Cash advances on credit cards are pricey, too. \”Most credit card fees on cash advances, if considered short-term loans, are costly as well. The fee for cash advances on many credit cards has recently climbed to 4 or 5 percent …. In addition, higher interest rates, which average 25 percent, generally apply to cash advances … Thus, on a two-week loan, the effective annual interest rate would average from 129 to 155 percent. In addition, cash advances are typically not subject to the interest grace period associated with purchases.\”
  • Without a payday loan, the would-be borrower may end up paying late charges on other bills–or having to pay extra to have electricity or heat reconnected. They may exceed their limits for credit card borrowing and face penalties. They may bounce checks and face those fees.  \”In 2010, bounced check fees averaged $30.47. … One study calculated the median interest rate on these loans to be well in excess of 4,000 percent, or up to 20 times that of payday loans. … The highest rates result from bouncing multiple checks for small amounts, where a fee is charged for each bounced check. Further, knowingly passing a fraudulent check is illegal and could result in substantial civil and criminal penalties.\”
  • Loan shark often charge 20% per week, along with threats of violence.
  • Pawnbrokers are costly, too. \”A 2006 analysis of pawnbroking compiled a list of monthly interest rate ceilings for all 50 states and the District of Columbia. … The median cap on interest rates was 15 percent monthly, which is similar to the typical payday loan charge. Many of the caps were much higher, however.\”
  • Payday lenders typically don\’t report to credit agencies, so being slow in paying back a payday loan, or defaulting on such a loan, won\’t affect your credit score. Being late or defaulting on many other payments will.
  • Payday loans are much more convenient than trying to get a bank loan, or dealing with many of hese other alternatives 

Of course, these tradeoffs don\’t prove that banning or regulating payday loans in various ways is a bad idea. But they do suggest that advocates of regulations need to consider with brutal honesty what is going to happen if payday loans are less available or unavailable.

The lower-risk reforms of payday loans would be to increase information and options. For example, there is a suspicion that for a lot of people, paying 15% on a loan of $100 probably like 15% interest. But of course, a two-week interest rate is not an annualized rate! Requiring more clear information might help. In addition, helping low-income people build a better connection with the banking system, so that they have some flexibility to get short-term liquidity loans through their bank, would probably come at a lower cost than most payday loans. There may also be other options, like emergency assistance programs from the government in certain situations, or advances from employers, or alternative payment plans. Expanding the information and the choice set is often a more reliable way of having a positive result than limiting choices.

For those wishing to get up to speed on payday lending, I can recommend two other useful starting points. One is an article by Michael A. Stegman, \”Payday Lending,\” published in my own Journal of Economic Perspectives in Winter 2007. The other is a useful summary of the evidence in an October 2010 working paper from the Philadelphia Fed from John Caskey, called \”Payday Lending: New Research and the Big Question.\”

The Decade-Long Rise in Teen Summer Unemployment

The Wall Street Journal published an editorial last Friday bemoaning high teenage summer unemployment, and blaming the recent rise in the minimum wage from $5.15/hour in 2007 to $7.25/hour in 2009. This summer, about 24% of teenagers will have jobs.

If I was in Congress, I would have leaned against voting to raising the minimum wage in 2007. I would rather help the working poor through further expansions of the earned income tax credit. I suspect that raising the minimum wage by 40% from 2007 to 2009 did have a negative effect on teen employment. But even speaking as non-fan of the higher minimum wage, I don\’t think it\’s the main cause of the low rates of teen employment.

Theresa L. Morisi at the Bureau of Labor Statistics published a useful overview of the long-run pattern of teen summer unemployment patterns about a year ago. Here are some themes I took away from her article:

1) Teen employment rates have been falling since the early 1990s.

2) This decline in teen employment rates cuts across younger and older teenagers, ethnicity, and whether teens are enrolled in school or not.

3) There are a number of plausible reasons why teenagers are working less. Families are more affluent. Summer school has increased. The high prices of college means, counterintuitively, that student earnings for college are less potentially important. One interesting pattern is that the share of teens not in the labor force who say they \”want a job\” has fallen since the 1990s.

4) With these other social changes, wage rates for teenagers are probably not the main determinant. Remember that during much of this time, the value of the minimum wage after adjusting for inflation was falling. Measured in real 2007 dollars, the minimum wage was worth $6.50 in 1998 and $5.15 in 2007.But this didn\’t prevent teen employment from falling during this time. Here are teen wages over this time period.

The modest nudge upward in median wages for teens since 2007 is probably driven in part by the rise in the minimum wage. As I said before, the higher minimum wage probably has reduced jobs for this group. But the grim economy and the other factors given here suggest that the higher minimum wage isn\’t the main driving force for low teen employment.

The Accumulation of Regulations

In the Summer 2011 issue of Regulation magazine, Bruce Yandle offers some bracing concerns about the federal regulatory process in \”Forty Years on the Regulatory Commons.\” Here is a sampling:

\”Inspired by statutes directing action, our 60-plus federal regulatory agencies are somewhat like sheep with legislative guiding shepherds grazing on a regulatory commons, a resource space where there are no systematic limits on the number of rules that can be produced, the time required to read and abide by them, or the economic resources consumed in meeting the rules. Fed by growing budgets and expanded duties, the regulators write more rules. While budgets, congressional directives, executive orders, and benevolent forbearance partially constrain the commons, there is always room for one more bite by the sheep, one more regulation. …\”

\”What is it like on the regulatory commons? When one puts on a pair of externality-visualizing glasses, one sees endless opportunities opportunities to internalize external costs and maybe even render the world Pareto safe. Whether it be dealing with lead paint, mandatory inspection of catfish, energy efficiency for refrigerators and furnaces, minimum standards for drivers licenses, diesel engine emissions, advertising over-the-counter drugs, marketing practices of funeral homes, or ridding the market of noisy Hickory Dickory Dock pounding toys, the world is full of unhappy and dangerous situations that need fixing. But with externality glasses, it is much easier to see the flaws than to determine if all people taken together are made better off after the regulatory repairs are in place. And who has time to check? …\”

\”Years ago, when regulation was young, before we had published those 2.5 million pages of rules, economists spoke knowingly in tones of certainty about market failure and intervention to correct difficulties from such problems as market power, information asymmetries, failed institutions, and unspecified property rights. We spoke as though government and regulation were exogenous to the market process, that on occasions regulators would open a window, examine features of the economy, make some efficiency enhancing
adjustments, and then quickly close the window to leave the economy to operate in a more glorious way. Indeed, we used the word “intervention” and we referred sometimes to Michael Lantz’s 1937 FTC statuary metaphor where a powerful free market horse is being bridled by a benevolent plowman who
presumably serves the public interest.\”

\”But as regulatory windows opened and closed daily and agencies pumped out more rules, firms and industries became intertwined with government. Government was no longer exogenous to the behavior of firms in the marketplace; government became endogenous. While major regulations may have reduced some perceived market failure, they also cartelized industries and reduced competition. The strong horses and other special interests came seeking the plowman.\”

Via a post by Arnold Kling at EconLog

The Case Against Price Gouging Laws

Michael Giberson of Texas Tech University has written a nice readable essay on \”The Problem with Price Gouging Laws.\” Part of the essay rehearses standard economic arguments over such laws, but with a nice variety of examples and discussion from both economists and philosophers. The case for price gouging laws, of course, is that raising the price for selling necessary goods during an emergency is morally offensive. But economists are congenitally open to the possibility that, upon deeper reflection, people\’s first quick reactions about what is \”right\” or \”wrong\” may be misleading.  Price gouging laws have the following predictable consequences:

Discourage bringing supplies into certain areas. As one example, there is a chain of convenience stores in Tennessee called Weigle\’s. It sells gasoline, and it buys that gasoline on the spot market–not under long-term contracts. In 2008, when Hurricanes Gustav and then Ike tore through the Gulf of Mexico and shut down oil drilling, Weigle\’s ran out of gas. They trucked gas in from other cities, but the extra costs meant that they raised the price of gas by about $1/gallon. This let to an investigation by the state attorney general, which was eventually settle without an admission of wrongdoing, but with a mixture of payments  to the state and consumer refunds. The next time a similar  situation arises, one wonders whether Weigle\’s  will choose to pay the higher costs of trucking in gasoline from other cities. In South Carolina during the same episode, a number gas stations apparently just closed their doors, rather than risk facing charges of price gouging. More generally, if you want people from the cities surrounding a disaster area to bring in ice and food and batteries and other supplies for sale, then you need to be concerned that price gouging laws will discourage them from doing so.

Discourage conserving on key resources. If prices rise during an emergency, people have an incentive to buy only what they need, and not to stock up. As a result, supplies will run out more slowly and remain available for more people. Imagine a situation in which prices of hotel rooms are not allowed to rise, at a time when many evacuated families are looking for a room. A large family might reserve two rooms at the capped rate, but decide to crowd into one room at a higher rate–thus leaving a room available for another family.

Concentrate economic losses on certain economic actors. Price gouging laws often impose costs on merchants, whose costs rise in times of emergencies. They impose larger costs on smaller firms, who have a harder time getting resupplied, than they do on large national chains that have a built-in ability to shift supplies from elsewhere.

Concentrate economic losses on the disaster area. One study sought to analyze what would have happened in the aftermath of Hurricanes Katrina and Rita, if price-gouging laws had been in place. It found that such a law would have caused greater losses in the disaster areas, because if would have discouraged suppliers in neighboring areas from bringing in supplies. However, the neighboring areas would have moderated any costs to the neighboring areas, because supplies from those areas weren\’t being shipped to the disaster area. A web of economic transactions acts as a mechanism for spreading costs of shortages over a wider geographic area.

Before reading this article, I hadn\’t realized that the creation and spread of price-gouging laws is a relatively recent development. Giberson writes: \”The first state law explicitly directed at price gouging was enacted in New York in 1979, in response to increases in home heating oil prices during the winter of 1978–1979. …
Just three states passed similar laws in the 1980s: Hawaii in 1983, and Connecticut and Mississippi in 1986. Then, 11 more states added anti-price gouging laws or regulations in the 1990s and 16 states followed in the 2000s. When price gouging laws are revised, the tendency is for the scope of the law to be broadened, the penalties to become more punitive, and the conditions under which the laws are applied to become less restrictive.\”