The Social Blessings of "Usury"
In a front-page article in the Birmingham News of November 22, staff writer Russell Hubbard reported that the Alabama Supreme Court has ruled that the high interest rates charged by payday lenders in Alabama from 1998 through 2003 were "usurious" and therefore illegal.
Though high-interest payday loans have been legal in Alabama since 2003 (albeit with a cap on the actual rate charged) an attorney named Mike Skotnicki suggests that possibly as many as 50,000 such high-interest (and apparently illegal) loans were made prior to the law change in 2003.
Specific legal issues aside, perhaps the most astounding element of the Alabama payday loan story is where Mr. Skotnicki is reported as making the following bold or even daring statement:
"Certainly, we all enjoy the constitutional protection of freedom of contract, but the state has decreed some contracts as unlawful or immoral, and payday loan agreements are immoral on their face."
Since the Birmingham News article ended with the above quote, we are left wondering whether or not Mr. Skotnicki thinks he can logically defend his suggestion that payday loan agreements are "immoral on their face." I would suggest he cannot.
On what moral ground could payday loans be judged immoral? We might generally think of an "immoral contract" as a contract that (1) is somehow fraudulent, or (2) requires one or more of the parties to do something untoward or evil.
The wonderful thing about voluntary loan transactions in the free market is that both the borrower and the lender benefit from such transactions. Loan transactions occur in the first place because borrows and lenders have different rates of time preference, and the fact that the agreed upon rate of interest is very high does not change that reality.
Many people, including some courts of law, tend to look at payday loan transactions at a distance and see the interest rates as too high. While these sentiments may be well intended in some cases, a look at the utter simplicity and straightforward nature of the payday loan contract suggests that the charge of "too high" an interest rate is absurd. In a typical loan transaction at thousands of payday loan shops around the country, a borrower gives a two-week post-dated check for $120 to the lender in exchange for $100 cash. Two weeks later the lender either deposits the check or renews the loan for another two weeks by collecting another $20. This turns out to be an annual interest rate of 520% if calculated in the standard way.
Yet clearly the borrower prefers the $100 today to the $120 in two weeks. While we may not know the specifics of why a person may have this preference, we do know that the preference is real. We can know it is real not because we can divine the borrower's specific utility function, but because we see him choose to engage in the very action itself.
There is little reason to think that there is any real possibility that these borrowers are being fooled by any sales gimmicks, side-products, high-pressure salesmen, or other distracting or confusing matters. In the case of some consumer products, the quality of the product to be delivered at a future date may be questionable, and so the possibility of fraud may sometimes be a valid concern. But in the case of payday loans, the product is cash now in exchange for a higher amount of cash two weeks in the future.
It is doubtful that there could be any simpler transaction, and it is doubtful that there could be any transaction where the quality and nature of the good purchased is any more straightforward and understandable by the individual market participants.
It seems, therefore, that the high interest rate agreed to jointly by the payday loan borrower and lender is a fair interest rate by virtue of it being agreed to by both parties that are fully informed and because they are dealing with the most liquid, most common, and most useful of all assets -- cash. The payday loan transaction is truly as close as we can get to a pure indication of one's time preference at the margin at which the borrower and lender are operating.
Perhaps Walter Block expressed the essence of payday lending best in his classic book Defending the Undefendable:
"Apart from the ability of money to buy goods and services, having money earlier rather than later provides an escape from the pain of waiting for fulfillment. It fosters a productive investment which, at the end of the loan period, even after paying the interest charge, yields more goods and services than at the beginning."
Block's statement, like Mr. Skotnicki's statement quoted earlier, is a bold one. It suggests that some people, under some circumstances, get more material or psychic benefit from $100 now than $120 in two weeks. While this may seem unrealistic to most of us under most situations, its basic truth is verified by the popularity of these high-interest payday loans. Perhaps an interesting task for some young economist would be to systematically observe payday borrowers as they walk out of these shops with cash in their hands. My bet is that these borrowers predominantly have a smile on their face.
A second observation would be to check to see whether borrowers generally say "thank you" upon taking their cash. Again, my bet is that most are quite grateful and more than willing to express their feelings in the customary way. Suggesting that payday borrowers are not better off from their borrowing transactions is absurd, and calling these transactions immoral amounts to yielding to the temptation to think that we know what is best for other people who find themselves in different circumstances.
Perhaps the biggest and most fundamental travesty in the payday loan story is the assault on private property rights that is at the heart of rulings that trash perfectly valid contracts between well-meaning adults. When courts of law throw out perfectly plain and simple financial contracts as unenforceable, those engaging in more complicated contracts for much larger stakes might have reason for worry.
Treating payday loan borrowers as victims by rearranging simple and understandable loan terms in their favor is likely to be no favor in the long run when lenders terminate high-risk lending in a wholesale fashion due to fears associated with these kinds of legal shenanigans.