April 1, 2009

Democratization of Credit

A reader writes in response to my post about Thomas Geoghegan's article in Harper's calling for bringing back anti-usury laws:
I'm confused about your argument re: usury.

Isn't the scam that they charged too little for loans? That would be the case with AIG for sure, that they insured banks' assets for far too little. Rarely, it seems, does a crisis occur because the lender was too aggressive about charging for risk. Unless I'm missing something with your argument -- if anything, we need more usury.

Let me try to put the question in a more general context of the "democratization of credit" in return for higher interest rates, which has been a major trend in my lifetime.

But, first, I'll admit that the risk premiums for subprime loans were low -- a few percentage points -- compared to the much higher risk premiums seen for other kinds of loans to marginal borrowers. Presumably, this was because lenders assumed that they could get the collateral -- the house -- back from mortgage defaulters much more easily and profitably than they could get collateral back from, say, credit card defaulters. So, Geoghegan was, to some extent, using the mortgage meltdown to ride a hobbyhorse of his.

Still, Geoghegan has revived a very old perspective on human affairs that has been all but forgotten over the last few decades when "the democratization of credit" was the byword, and it's worth seeing what we can learn from that viewpoint.

I don't think what follows is by any means the full story, but the downsides of the democratization of credit is a line of thought that I, personally, just didn't pick up on during a rather conventional education in contemporary economic thought -- BA in Econ in 1980, MBA in Finance in 1982, long time reader of the WSJ op ed page after that, etc.

I could tell you all the arguments against anti-usury laws, but I couldn't tell you the arguments for them. I just assumed that protests against "predatory lending" were just economically ignorant and probably anti-Semitic to boot.

Now, I'm a pretty skeptical guy overall, who usually isn't bad at figuring the tradeoffs, the pros and cons, in various practices. I'm a staff guy by nature, who spent years telling CEOs stuff like: "If we do A, we'll come out ahead on X but behind on Y, while if we do B, we'll be worse off on X but better on Y, so, which do you choose?" And I didn't have any financial stake in high-interest lending. So, if I was a chump for the reigning zeitgeist that assumed that only anti-Semitic know-nothings used the word "usury," then how can I blame people in the financial business for falling for their own propaganda?

Here's what I've only recently figured out, after decades of thinking about economics.

Traditionally, there were legal or cultural limits on interest rates. Even though anti-usury laws and traditions were often perceived as a populist issue, it actually meant in practice that finance used to be much more elitist. If people in Arkansas got their state legislature to cap interest rates that New York banks could charge them, well, the New York banks would then lend only to the least risky Arkansawyers.

So, if you couldn't qualify for a prime mortgage, you didn't get a mortgage. If your corporation couldn't issue bonds above junk quality, no reputable investment bank would issue bonds for it. If you had a bad credit record, you couldn't get a credit card.

(Of course, this meant there existed a nether world of pawn brokers for the broke and loan sharks for the truly desperate or deluded.)

For example, up through the mid-1970s, respectable Wall Street investment banks wouldn't involve themselves in the issuance of corporate junk bonds. It just wasn't done. Now, some corporate bonds at the time did fall to junk ratings as their issuers teetered near default. The young Mike Milken did a study and found that these formerly solid but now junk bonds tended to be profitable to own, as long as you owned a wide enough portfolio to diversify away the threat of gambler's ruin.

So, Milken recruited hard-chargers from the fringes of the financial world to bid for publicly traded companies and promise to issue bonds that were junk from the get-go to pay off the takeover price. If they made the payments, then they wound up owning a fancy company. If they defaulted, well, it was back to the fringes for them after a few fun years of being big shots.

Similarly, this "democratization of credit" went on in credit cards, mortgages, student loans, and the like. "Why should laws and traditions restrict credit to yacht club members when willing lenders and willing borrowers could work out a mutually beneficial deal, just involving a few extra points?"

This was a widely appealing argument. Libertarians thought it made perfect sense. Business liked it because it meant more lending and more buying. Liberals liked it because it let poorer people buy more stuff. Leftwing community activists often started out protesting against "predatory lending" but would eventually figure out that if they succeeded in cutting down on lending, that meant no money for them. So, they would negotiate deals with financial institutions to provide them with "regulatory cover" that would call for more lending minorities. At least this way, the leftist activists could get a cut.

And, indeed, for many borrowers, this worked out fine: some of the old restrictions and traditions were too restrictive.

The problem was that you just couldn't push this practice of extending credit all that far, because the higher interest rates increased the chances of default even higher. So, you rapidly ran out of borrowers who were just moderately too risky under the old system, and soon reached potential borrowers who were walking time bombs under the sky-high interest rates that their low chances of paying back those sky-high interest rates demanded.

But, in modern finance, everything profitable gets pushed too far. The sons forget what their fathers painfully learned. Moreover, the entire literature of anti-usury argumentation was dropped down the Memory Hole because so much of it was either explicitly (e.g., Henry Ford's) or implicitly anti-Semitic (or, in Ezra Pound's case, anti-Semitic and crazy).

The destruction caused by lending to walking time bombs was amplified by the fact that, in general, the higher reaches of the financial world have traditionally treated debt as something where defaults are the exception to the rule. In contrast, pawn brokers have a perfectly reasonable way to deal with likely deadbeats -- they hold on to the physical collateral. But a financial world where the laws, regulations, customs, and institutions were built assuming that borrowers aren't going to default because anti-usury laws and customs denied loans to marginal borrowers is extremely vulnerable to erosion of the quality of borrowers, which the relaxation of limits on interest rates made profitable.

My published articles are archived at iSteve.com -- Steve Sailer


anony-mouse said...

Before usury laws were changed or eliminated, there actually were people who lent money out at high rates. They were known as either 'pawnbrokers'(legal) or 'loan sharks' (illegal). The Harper's issue you mentioned (but not the article you mentioned) complains about the creation of payday loan operations, whose existence have made most loan sharks obsolete.

Put usury laws back in and its bye-bye Money Mart, hello leg breakers. (Think of the end of usury laws as analagous to the end of prohibition)

Anonymous said...

In two words: behavioral economics.

People, especially stupid people, don't behave like idealized economic actors. They can be expected to mess up contracts -- and other people can be expected to feel sorry for them, and spend your money on them.

Simple proof:

1. Classical models of rational man require solving optimization problems (viz. maximize utility subject to constraints)

2. Optimization problems are arbitrarily computationally complex (viz. traveling salesman)

3. Arbitrary computational complexity requires arbitrary energy (viz. physical limits on heat dissipation constraining clock speed in CPUs)

4. Human brains do not have access to an arbitrarily large power supply (viz. only so many kcals per day in a steak)

5. Hence human brains are bounded in terms of computational ability, and hence rationality.

Very simple.

B322 said...

Clearly stated and convincing. I fear that anti-usury laws may be the only way to go, since we can't seem to put the following genies back in their bottles:
A. The fiat money genie.
B. The fractional-reserve banking genie.
C. The unlimited liability in investment banking genie.
D. Ben Bernanke dressed like Barbara Eden.

I'm not sure anyone is going to tolerate anti-usury laws though ... not because of the "anti-Semitic!" angle but because delaying gratification has become as unhip as pulling your trousers up all the way.

jonathan holdeen said...

"Traditionally, there were legal or cultural limits on interest rates."

Steve, what's your starting point for what you consider "tradition"? 100 years ago in America? Your people have been around a lot longer than that, and have dealt with this problem for seemingly ever. I swear, amidst all the intelligent and insightful posts here, and the relevant and humorous comments to said posts, the lack of historical knowledge at your blog is jarring at times. Usury, with its attendant social (and biological) ramifications, has been dealt with by an enormous amount of the West's genius figures over the millenia, even before the Jewish involvement. It's taken you this long to question it? Where is your vaunted mathematics when it comes to this? Where's your physics? Zero sum games and energy not being able to be created or destroyed and all that?

Money was to be a means for exchange, that's it. One drachma equals a pig equals 100 eggs. The eggs put into a vault don't become two hundred eggs. The pig doesn't become a pair. The drachma, magically, does grow however, when compound interest comes into play - and GROWS FOREVER.

Antisemitic know-nothings. Yeah. There it is, that magic word. The relegation to "crackpot" status. Ugh. Did you ever consider the sociobiological function that term fulfills now? The stifling of debate. I mean, if it can keep a smart guy from questioning the validity of one of the most injurious concepts ever invented by man, then what's it do to morons?

There's a term we use in ecology (they also use it in psychology) - "habituation". It means the decline in an organism's response to a stimulus with repeated application of the stimulus. Draw your own conclusions.

Anonymous said...

Democratization of credit creates its own demand. Spending more than you earn may be a choice, but it comes to seem more like an obligation. Now any shlub can treat his girl to a fantastic vacation or a fancy restaurant - he can put it on his card! Lots of single guys end up competing with the assholes who go deep into hock for a BMW and a home theatre system. It doesn't matter. His girlfriend won't see his credit report until she marries him - if she marries him.

College kids can live that sort of lifestyle without holding a job, which makes their more frugal friends seem like chumps. So millions of college kids graduate - if they graduate - thousands or tens of thousands in debt. And the jobs they used to do; that American industry relied on them to do? Well, you know who...

The same holds true for housing, except that it's less of a choice. If you need or want to live in LA then you will pay X% more than you can afford to pay for a house, for that house. Of course, millions of Americans were smart enough not to overpay for a house, and chose to settle elsewhere. But easy credit was driving the demand, which drove up the prices.

It's led to a materialist culture that shuns savings. But no politician will ever try to rein it in. Not because of anti-Semitism, though, but because businesses - not just the financial industry - would put an end to any such discussion. The restaurant and hotel industries, who also happen to be big importers of you-know-who, who be overwhlemingly opposed. They will argue that politicians don't have the right to reshape our culture to a less materialist one - never mind that they try to shape our culture all the time.

Anonymous said...

"The problem was that you just couldn't push this practice of extending credit all that far, because the higher interest rates increased the chances of default even higher."

This isn't entirely true. There's an angle you're missing here: the highest interest loans are short duration ones that aren't onerous in absolute terms, so the high interest doesn't drive up the rate of default. This is the case, for example, with payday loans. A $15 fee to spot someone $200 until their next payday works out to annual interest of over 100%, but it's only $15 dollars in absolute terms, so the default rate remains relatively low. Most other "usurious" loans are of similarly short duration.


Anonymous said...

lenders and willing borrowers could work out a mutually beneficial deal, just involving a few extra points?"

I have agree with the above. I also think that the banks that have bad debt should simply file for bankruptcy instead of getting a bailout. In both cases the borrower and the lender should be on their own.

Colin Laney said...

Did somebody mention antisemitic know-nothings?

Canto LXV

With usura hath no man a house of good stone
each block cut smooth and well fitting
that delight might cover their face,

with usura

hath no man a painted paradise on his church wall
harpes et luthes
or where virgin receiveth message
and halo projects from incision,

with usura

seeth no man Gonzaga his heirs and his concubines
no picture is made to endure nor to live with
but it is made to sell and sell quickly

with usura, sin against nature,
is thy bread ever more of stale rags
is thy bread dry as paper,
with no mountain wheat, no strong flour

with usura the line grows thick

with usura is no clear demarcation
and no man can find site for his dwelling
Stone cutter is kept from his stone
weaver is kept from his loom


wool comes not to market
sheep bringeth no gain with usura
Usura is a murrain, usura
blunteth the needle in the the maid's hand
and stoppeth the spinner's cunning. Pietro Lombardo
came not by usura
Duccio came not by usura
nor Pier della Francesca; Zuan Bellin' not by usura
nor was "La Callunia" painted.
Came not by usura Angelico; came not Ambrogio Praedis,
No church of cut stone signed: Adamo me fecit.
Not by usura St. Trophime

Not by usura St. Hilaire,

Usura rusteth the chisel
It rusteth the craft and the craftsman
It gnaweth the thread in the loom
None learneth to weave gold in her pattern;
Azure hath a canker by usura; cramoisi is unbroidered
Emerald findeth no Memling

Usura slayeth the child in the womb
It stayeth the young man's courting
It hath brought palsey to bed, lyeth
between the young bride and her bridegroom


They have brought whores for Eleusis
Corpses are set to banquet

at behest of usura.

Anonymous said...

Hey Laney,

Didn't you read the post? Pound was crazy. Don't you know his stance on WWII? Don't you know where they put him in the aftermath? There's the proof.

I've actually read Steve described as "crazy" at some sites that tout the zeitgeist. It's a handy label for many.

josh said...

If we didn't socialize the risk this:

a) wouldn't effect me (have at it loan sharks and dead beats)

b) probably wouldn't happen that often.

Given that neither anti-usury laws nor privatization of losses is politically feasible, why not argue for the actual correct policy.

k@rt 18 said...

Pound was crazy because he supported the right side in World War II and they lost. So to cover up, the victors declared him insane!

The KGB used the same tactic with dissedents.

World War II; Britain and the US busily at war with their Allies, on behalf of their enemy.

Anonymous said...

Crazy, but a damn good poet.

Victoria said...

Sailer, you never questioned that something was wrong with a usury system that could charge 24%-30% on credit cards; when the creditors could go to Congress to get whatever deals they wanted against their debtors? When they could skewer the bankruptcy laws in their favor and against the schlemiel down below?

And when the Church, all kinds of denominations, once upon a time, railed against "usury," calling it sinful because of the imbalance between creditor and debtor and the possibility of enslaving the debtor forever, it was not an attempt to protect congregants, but was simply "anti-Semitic?"

Anonymous said...

I want a stone house. I also want grandchildren and gold to weave in my patterns.

David said...

I want a stone house. I also want grandchildren and gold to weave in my patterns.

No, you want vinyl siding, a big-screen TV showing basketball games and American Idol, a soon-to-be-or-already outsourced job, a darkening neighborhood, no grandchildren (i.e. either homosexual children or no children at all), Rush on the radio, filthy movies, XBox, and mountains of debt.

Trust me, you want these things.

They are the meaning of life and your validation as a "cool" hip regular non-weird American.

If you object to this lifestyle - publicly - you are a questionable person and should be watched by the authorities. For example, if you throw away your TV set, you are either a tree-hugger or a Nazi. Next thing we know, you'll want to educate your own children or something crazy and dangerous like that.

Keep working and buying things.

Opposition to high interest = hatred of Jews. Here. Here is his longer case. That's what passes for thinking on usury - it's primitive, wrong, and anti-Jew. You're irrational and have a bad metaphysics if you disagree. Is it a declarable interest (pardon the pun) that Mr. Brook served in the Israeli Army military intelligence?

Jim Baird said...

"But, in modern finance, everything profitable gets pushed too far. The sons forget what their fathers painfully learned."

This is basicially a summary of the work of Hyman Minsky:


Anonymous said...

I have a question why can't we all get direct low /no interest loans from the Fed, after all why should we have to pay middleman banks? (i just answered my own question)

Anonymous said...

Uh, I am considering buying a stone house in a small village in Europe, I don't own a TV, I haven't had a job since 1999, I already homeschool my children, and the authorities, truly, do not give a shit.

I am bad at weaving though. I tried on a WPA loom but it's not my thing.

RGH said...

Mark Steyn has a relevant article in the current National Review about the effect of demographics on lending: "A bank is a kind of demographic shorthand, by which old people with capital lend to young people with ambition and ideas. Unfortunately, the Western world is running out of young people." I wonder how much the percentage of our population under 40 that are good credit risks has dropped over the past few decades. Banks will have to lend to riskier borrowers, here and abroad, just to stay in business.

Anonymous said...

Money was to be a means for exchange, that's it. One drachma equals a pig equals 100 eggs. The eggs put into a vault don't become two hundred eggs. The pig doesn't become a pair. The drachma, magically, does grow however, when compound interest comes into play - and GROWS FOREVER.

Ever heard of sharecropping?
I know a guy who's Grandfather got rich loaning out cattle herds. He was repaid in cattle, with extra cattle for his profit.

Interest is not unique to money.