Dec 29, 2011

Why we should require a license to borrow money

Photo by George Marks
While having conversations about the political economy I often bring up the following scenario:

Actor #1: Mike Consumer, the head of a lower-middle class American household

Actor #2: Worst Buy, a big box electronics retailer
Actor #3: Skyhigh bank, a national credit card lender

Mike works 50 hours a week and earns enough money to pay his mortgage and support the basic needs of his two-child family.  His mortgage, student loans, and credit card debt overwhelm the combined value of his assets, mostly made up by the home he purchased seven years ago.  In an effort to keep up with Joneses Mike decides to replace their old, but still functional 24" CRT television with a new 42" plasma.  Mike has seen on TV and in the newspaper that Worst Buy is having a Black Friday sale on plasma TVs and decides that now is the time to make the switch.  Mike has been carrying a $5,000 balance on his Skyhigh bank credit card (15% APR) for quite some time but decides that another $700 is manageable.

* Worst Buy receives payment from Skyhigh's credit card division and earns a profit from the sale of the TV.
* Skyhigh bank extends an indefinite $700 loan to Mike for which it earns $105 per year in interest so long as Mike is solvent.
* Mike and his family upgrade their television at the cost of incurring $700 of additional debt.  The incremental interest on this debt is $105 per year.  This is on top of the $750 of yearly interest they are currently paying on their $5,000 balance.

First, two impossible-to-answer questions:
1.) Will Mike and his family be better off in the long run by making this purchase?
2.) As a society, will we be better off in the long run if purchase decisions like this are being made?

The answer to #1 will vary depending on a number of immeasurable factors relating to Mike's personal cost/utility function.  My own feeling is that the answer is "no," he won't be better off.  This is because many conditioned-to-consume Americans including Mike have a difficult time gauging opportunity costs and
the long term mathematical implications of borrowing money at high interest rates.  There are certainly many cases where individuals would be better off with MORE debt, but that's a topic for another time.  Question #2, also impossible to definitively answer, has more to do with personal values, societal game theory, and one's political beliefs.  I would again answer "no."  As a society we are collectively worse off if too many of these decisions result in instant gratification at the cost of deferred hardship, whether sustained directly by the individual or indirectly by society at large.  This applies not only to financial decisions but also to issues regarding health and the environment. 

The value judgment one casts upon this scenario will
depend on their politics. A staunch libertarian would surely be fine with this hypothetical transaction so long as the creditor, Skyhigh bank, were allowed to "fail" in the event that Mike was unable to make payment.  Caveat emptor and regulation be damned!  A stereotypical conservative would also likely approve.  Personal liberty is important and spending money is good for companies which is good jobs and the economy.  Someone with a strong liberal viewpoint might have some objections.  They could see Mike as being taken advantage of by both the credit card company charging usurious borrowing rates and by Worst Buy who is only out to maximize profits even if it means putting Mike's family in financial peril.  This person might feel that tighter regulations are appropriate in order maximize social good.

My opinion falls partly outside these three oversimplified creeds.  As mentioned before, I don't believe that transactions like this benefit society in the long run.  This
is because the unintuitive optics of measuring opportunity costs relating to credit lead to a suboptimal distribution of societal wealth.  In transactions like these I believe corporations, and to a lesser extent banks, are disproportionately benefiting due to the difficulty of understanding the long term implications of borrowing. 

How would one who agrees with my value judgment alter the framework in order to stop these transactions from happening so often?  Which of these three actors should be restrained and how?  A countless number of studies and books have been written on the topic of regulating corporations and banks so I'll just make a few brief comments. I am generally for tighter regulations on corporations, especially when it comes to their use of public goods and treatment of workers.  Without knowing more about Worst Buy's business practices I'd simply leave them alone in this case.  For Skyhigh bank I'll just make a simple point that's been echoed by many others in recent years: a banking system that lends to whomever, invests in whatever, and levers up to wherever, should be designed so that its banks can fail without challenging the integrity of the financial superstructure.  Even the SLIGHTEST amount of explicit or implicit government subsidy should be matched with comprehensive regulations. The "too big to fail" conundrum continues to be an enormous hurdle in the path towards a more sustainable financial system.

My main intent in writing this note is to focus on a proposed
"regulation" of actor #1, Mike Consumer.  In America the choice form of regulation on individuals is education.  I am convinced that this is a key ingredient to the long term solution and remain puzzled to why the Obama administration hasn't done more on this front.  But when the safety of others is concerned we many times regulate individuals more explicitly, choosing to limit personal freedom for the sake of protecting the individual or public at large.  Seat belt laws are written to protect personal well-being.  The Patriot Act and other censorship devices are meant to serve national security interests (in theory).  We've limited the right to smoke in the interest of protecting those who are involuntarily exposed.  It's illegal to drive a motorized vehicle without a driver's license.  While typically of libertarian mind when it comes to paternalistic policy solutions I recognize that certain standards and rules are necessary when a person's actions might affect others involuntarily.  Along this line of thought I believe that every American who wishes to borrow money in any form should first be required to take a class, pass a written exam, and obtain a license to borrow.  Borrowing without full understanding of the mathematical implications, positive and negative, is detrimental for individuals, households, and our society at large.  More so than than any credit card pamphlet or consumer protection agency this law would help further the critically important cause of disclosure, and bring to light various deeply-rooted practices in our society that skew the distribution of wealth. We must force ourselves to learn more about the mechanics of money in order to make better informed financial and political decisions for ourselves, our families, and our society.
Related articles:
* The New Republic / Cass Sunstein: Show me the Money - Behavior Economics and Consumer Protection (added 28oct12)
* Daily Beast / Newsweek /
Sharon Begley: The New Science Behind Your Spending Addiction
* The National Bureau of Economic Research /
Livshits, MacGee, Tertilt: Costly Contracts and Consumer Credit
* New Yorker /
James Surowiecki: Delayed Gratification
* Project Syndicate / Kenneth Rogoff: Coronary Capitalism
* The Guardian / Jeremy Leggett: Prosperity without Growth