Geoghegan identifies the beginning of the instability and bubble/bust cycle that has come to dominate American finance as being a product of the United States essentially abandoning usury law in the 1970s. As Geoghegan points out, usury law (laws that regulate the kind of interest rates lenders can charge to their lendees) have been around in almost every civilization that has had a currency, stretching back thousands of years. And he points to this current crisis as a demonstration of the basic wisdom of [anti-]usury [laws].
Say the interest rate for prime customers is five percent. What higher interest rate would it take for lending to nonprime borrowers, with a substantial risk of default, to be profitable? For some it might take eight percent, for others 12 percent, for others 20 percent. You can see, though, that this interest rate starts heading upward at an ever-growing pace because the chance of default goes up as the interest rates go up.
Let's consider, for the sake of simplicity, a consol, a rare interest-only bond of infinite duration for which the principal is never paid back. Say I have a 10% chance of failing to make my 5% per year interest payments. So, nobody is going to lend to me at the prime rate.
What about charging me 15% per year to cover your 5% profit margin and my 10% chance of default? Swell, except now my risk of defaulting isn't 10%, it's a higher number, so I need to be charged an even higher interest rate, which in turn gives me a higher default likelihood. And so on.
This tree doesn't grow to the sky, but the interest rate and, more importantly, the default rate gets to be rather high rather quickly.
Now, what's the harm if two adults come to an agreement about a fair price?
Well, the problem is that defaults can have widespread costs to people who weren't parties to the agreement -- another case of privatizing profits and socializing costs.
For example, Joe Cassano of AIG bet Goldman Sachs that Goldman's mortgage-backed subprime securities wouldn't default, and now I and my descendants unto the 7th generation are supposed to pay off the damn things.
More subtly, if a firm lends money to people who have nothing to lose, there can be collateral damage. If the house next door gets bought by deadbeats who don't have a prayer of paying off the mortgage, but are just going to live in it rent-free until the sheriff finally kicks them out, I'm harmed. A foreclosure next door lowers my property value. Moreover, I had to live for two years next to deadbeats who shouldn't have been able to afford to live there. Very easy credit with very high interest rate opens up the door to all kinds of fraud and abuse.
Also, a generation freed from limits on interest rates is typically going to push them too far, with widespread damage. We saw that with Mike Milken's junk bonds back in the 1980s, which worked pretty well at first, but generated so much profit that ever junkier junk bonds came out, culminating in the 1991 recession.
So, it can make sense to have some maximum interest rate allowed to prevent the more egregious of this kind of thing. (Or, it could be that we just have to live through a crash to learn from our mistakes and lenders will be smarter next time.) I don't have a strong opinion on whether or not we should have legal limits on interest rates, but I do agree with Geoghegan that the subtle costs of not having any limits are too widely ignored in economics classes.
These are old lessons which we are relearning at painful cost.
Unfortunately, Geoghegan's article is kind of a mess at explaining the history of how anti-usury laws became a dirty word in modern upscale America. As a lawyer, he traces it back to a 1978 Supreme Court decision, but then he's baffled by the fact that it was written by his liberal hero William Brennan.
Because I was an economics major back then, it's easy to fill in what Geoghegan misses in his attempt to explain the triumph of anti-anti-usury:
First, the inflation of the 1970s made the old anti-usury laws impractical. If interest rates were capped at, say, 9% and prices were expected to rise 10% over the next year, then nobody would lend. So, getting rid of the old interest rate cap laws was justified as simply a practical expedient for adapting to an era of high inflation. (Of course, the laws weren't put back in place when inflation came back down.)
Second, the historical link between usury and Jews (e.g., The Merchant of Venice) meant that opposition to usury was increasingly seen as historically anti-Semitic (e.g., Henry Ford's kulturkampf against New York banks), so it became politically untenable after, say, 1967. Anti-anti-usurism and anti-anti-Semitism triumphed together.
This isn't to say that Jews were the only ones charging high interest rates, nor even a majority. For example, a key move toward higher interest rates on credit cards, which allowed banks to issue credit cards to anybody with a pulse, was the move by John Reed's Citibank to running its credit card business in 1981 out of South Dakota, which had just eliminated its interest rate caps. This legislation made South Dakota very attractive during a time of high inflation rates.
Still, since everybody knew that many of those pushing for elimination of legal and/or traditional limits on interest rates, such as Milken and countless economists, were Jewish, Geoghegan's kind of views were widely seen as antiquated and unenlightened and, to be frank, anti-Semitic.
Indeed, it might be worth exploring more generally how the ascendancy of Wall Street and the paucity of criticism of finance in recent decades was related to would-be critics' fears of being accused of anti-Semitism. As I pointed out recently in reply to a Maureen Dowd column based on her outmoded stereotype that Wall Street is run by WASPs, when you sit down and tote up the names of Wall Street big shots, it turns out that Wall Street isn't as Jewish as some might assume. Bigshots in the financial world come from a wide variety of backgrounds. Nonetheless, Jews obviously make up a striking fraction of the most aggressive players in the financial world, so criticism of aggressive financial tactics was often denounced by, say, the Wall Street Journal editorial page as more or less anti-Semitic. A perusal of WSJ editorials and op-eds defending Milken in the 1980s and 1990s might be eye-opening.