There’s a critical debate this country must have but isn’t. Is borrowing money a bad thing that consumers and small businesses should be discouraged from doing in part by restraining lenders? Or is credit essential to the well-being of consumers and small businesses and the growth of the economy? A Senate confirmation hearing over the President’s nominee for the director the Consumer Financial Protection Board could have provided an opportunity for that debate and put the Senate on record on how far they want this new agency to go in curtailing lending. Unfortunately, President Obama’s decision to bypass that process means the Senate won’t be considering a CFPB director for some time. Meanwhile, the companies that are in the business of lending have said little in their own defense. That’s too bad because if regulations restrict consumer and small business borrowing too much there’ll be a hefty price to pay in lower standards of living and higher unemployment for many years to come. We need to have this debate and that’s one of the things that the pymnts.com new Regulation Center will be trying to promote.
The Case Against Credit
Lenders have gotten a very bad rap as a result of the financial crisis. Banks according to some turned on the faucet of easy money and just about drowned consumers with debt they couldn’t pay back. Tricks and traps lured gullible people into taking out mortgages they could ill afford and racking up credit card debt that weighed them down. Even worse were payday loans and other expensive ways of borrowing. Longer term, excessive borrowing has led America to save too little thereby jeopardizing the ability of the country to compete with our more frugal Asian rivals. Responding to these concerns the President and Congress made consumer financial protection a centerpiece of its reform efforts. They created the Consumer Financial Protection Board (CFPB) and gave it extraordinary powers and independence to protect consumers from “unfair, deceptive, and abusive” practices.
What isn’t widely recognized is that the CFPB is designed not only to protect consumers from unscrupulous lenders but also to protect consumers from themselves. According to the leading academic proponents of this new federal agency, the root cause of the lending problem is that people just aren’t very savvy when it comes to borrowing money and unlike many other markets they open themselves up to exploitation. (See my review of Elizabeth Warren’s writings and my discussion of behavioral economics.) They are shortsighted and impulsive. They borrow today to get an immediate kick from that flat-panel television only to regret their profligacy later on when the credit card debts mount up. They also aren’t very good at doing present value calculations and get easily confused by credit terms. Not surprisingly, financial institutions design products that play to these weaknesses. As a result many households—and small businesses—borrow too much leading them into bankruptcy as Elizabeth Warren argued in The Fragile Middle Class.
In fact, many politicians from both parties and thought leaders share the view that there is too much borrowing and lending going on. That view helped get passage of the CARD Act with significant bipartisan support. In my experience hands extend across the aisle when it comes to criticizing the credit card industry for luring people into debt. A good example is Dick Morris’ Fleeced which appends a scathing critique of the credit card industry onto a largely conservative diatribe against President Obama and the Washington establishment.
The case against credit is hardly new as I discuss in more detail in my short history of paying and borrowing. Professor Warren and the modern critics of credit are in excellent company. The Catholic Church banned charging people interest rates to borrow (known as usury) altogether for many centuries. Islamic law often followed by banks in Islamic countries also places many restrictions on lending. In the United States, everyone from social critics to personal financial advisors have urged consumers to save and not borrow. Benjamin Franklin was one of the first in line of the credit disapprovers when famously warned that he who goes a borrowing goes a sorrowing.
Borrowing, however, is a basic personal and business necessity. Like laws involving many personal habits no matter what rule is put in place people find a way around it. When interest is banned lenders come up with another name for it. When a lender can’t legally extend credit borrowers and lenders meet on the black market. No religion or moral opprobrium has ever seemed to stop people from borrowing or from lenders supplying their demands. Like many laws against social behavior governments and even religions have eventually given up on trying to restrain borrowing and lending. I haven’t checked this but I don’t believe taking out a loan is grounds for ex-communication anymore.
The Case for Credit
People borrow largely because they live for a long time and their incomes fluctuate a lot over the lifetimes. It is well known that incomes increase over time mainly because people become more experienced and valuable to employers and then decline as people retire. In addition earning may vary from year to year because of economic conditions as well as idiosyncratic reasons. Without borrowing people’s living standards would essentially track this trajectory. Households would have some really great years in the middle and quite horrible ones earlier and later in their lives. People want borrow to even this out. Mortgages help them do that. Before credit cards were popular many merchants, starting in the 19th century, offered installment or other credit to meet these needs. Many people borrow because they are starting or running small businesses. They need credit for working capital and to make investments. They often take out personal loans for this as I’ve described in my article on the Consumer Financial Protection Act with Josh Wright.
Far from suggesting that lenders give people too much credit the economic literature largely finds that lenders give people and small businesses too little credit. (The technical jargon for this is that people face “liquidity constraints.”) Lenders have a lot of difficulty determining whether people they lend money to will pay it back. It is one thing to loan money to a big corporation where a lender can seize its assets it is doesn’t pay back its loan. It is another thing to loan money to people. If they can’t pay it back there really isn’t much that a lender can do: you can’t get blood from a stone. As a result lenders err on the side of extending too little credit.
These liquidity constraints have loosened somewhat over time as a result of the development of better risk scoring methods and securitization that allowed lenders to diversity their risks. That was one of the reasons lenders started extending credit to lower-income people and what are often considered to be socially disadvantaged groups. The standards of living for those people arguably improved considerably. The only thing worse perhaps than borrowing too much is not being able to borrow at all when you need to. For every story from The Fragile Middle Class about someone whose life was made miserable because they took on too much debt I suspect there are hundreds more of people for whom getting a loan pulled them off of the brink of misery.
Making loans available to small businesses has spurred economic development in several parts of the world. “Microfinance” involves making very small loans available to people to start businesses as well as to consumers. Muhammad Yunus won the Nobel Peace Prize in 2006 for his work in promoting this form of lending. This method has worked mainly because the lack of capital prevented poor people from lifting themselves out of poverty by starting their own productive enterprises. The same principles, though, apply to lending, much of it based on credit cards, to small businesses in the United States.
But didn’t too much credit cause the financial crisis? Well, no, actually. There is no evidence at all that credit-card or most other personal lending had anything whatsoever to do with the financial crisis and none of the serious accounts of the origins of the crisis say otherwise. Too much mortgage lending was definitely at the scene of the crime though. But even with stricter standards we would still have had the crisis which resulted from a housing and asset bubble. So long as everyone believed—and just about everyone did as stupid in retrospect as it was—that housing prices would keep going up forever there is little chance that more stringent lending criteria would have prevented the accumulation by the banks of soon-to-be largely worthless debt.
There are sound arguments that credit is a good thing and that the development of credit cards and other forms of consumer and small business lending are one of the most important financial developments of modern times. As I mentioned, I suspect for every borrower who goes a sorrowing there are many more whose lives are better for it. The folks who are in the business of lending money should be making that case. Unfortunately, as far as I can tell, they aren’t. Silence is seldom a good strategy in a debate.
The Importance of the Debate
It is widely understood that the CARD Act, passed in May 2009, has forced banks to reduce lending to high-risk individuals. The restrictions made it difficult to charge premium prices to people that had a high likelihood of not paying back the money. Banks cut off high credit risks and raised the prices of credit products since they couldn’t impose penalties as easily for engaging in behavior that tends to lead toa high risk of default. Proponents of the “borrowing is bad” view of the world argue that this was a good result. These high-risk borrowers shouldn’t have been taking on debt so it is a good thing now that they aren’t getting it. Unfortunately, that view simply ignores the realities of economic life. People often borrow money at high interest rates because they need to even though there is a risk they won’t be able to pay it back. Maybe they are between jobs or a critical expense has come up—a good one like getting married or a bad one like becoming very sick. Over our lifetimes most of us have been in one of these situations. Lenders help these people out but one of the risks they face—and the reason for the high interest rate—is that they won’t get paid back. If people can’t get loans from traditional lenders in these circumstances—because the lender is prohibited from lending or doesn’t want to make unprofitable loans—they may go into severe economic distress. Alternatively, they are likely to try to get money some other way. That’s how pawnbrokers and loan sharks have made their livings.
The CFPB may also raise the cost of lending money and make it more difficult to lend money precisely to the people who need it most. There will be push back on that assertion. After her appointment to effectively head the CFPB, Elizabeth Warren said on the White House Blog that the idea behind the new agency is very simple: “people ought to be able to read their credit card and mortgage contracts and know the deal.” But anyone who reads what Professor Warren has written will soon recognize that she is passionate about the problems that people fall into as a result of borrowing and that she wants to do something about that. It is therefore implausible that the CFPB simply will become the “Plain English, Please” police for the credit industry. Instead, under the current vision and leadership, it will probably adopt regulations that, as with the CARD Act, ultimately make it more costly for lenders to extend credit and more difficult for borrowers to get credit.
The debate over the mission of the CFPB is a vital one for our national interest. If the proponents of the agency are correct that too many people borrow too much money then the CFPB should act aggressively to prevent lenders from extending too much credit. If the proponents of the agency are wrong the CFPB could reverse much of the progress the lending industry has made in extending credit to the less well off and reduce the ability of small business owners who often rely on personal lending for startup and growth. This is a debate that the financial services industry should join not only for the well being of their businesses but for the health of the economy.
David S. Evans is an economist and a business advisor to payment companies around the world. His recent work has focused on helping companies create, ignite and profit from payments innovation. He is the originator of the Innovation Ignition Framework® , a tool provides a systematic way for companies to evaluate and implement innovative ideas and achieve critical mass.