Three important reasons the government shouldn’t impose a cap on payday loans

In (another) abrupt u-turn, it now seems likely that the government will accept the substance of the Labour peer Lord Mitchell’s amendment to the Financial Services Bill, which calls for a cap on the interest rates charged by payday loan companies such as Wonga and Provident.

Finally, the day has come when you will be able to read your statutorily regulated newspaper, drink your minimally-priced lager, and pay for both of these with a payday loan the price of which is set by the government. Oh, and whilst doing all of this you’ll be kept warm by an energy tariff which an energy company has been forced by law to offer you. I caricature, but you don’t have to be Old Holborn to feel uneasy.

It is very difficult to defend payday loans. They are symptomatic of the sort of financial desperation that we all hope never to experience. But there are three important reasons why the government should resist a cap.

The first is that a cap lacks a convincing intellectual grounding. Its supporters want a cap because they believe that the cost of credit is unacceptably high given that it is being used to purchase life’s essentials. But if we accept that the cost of something should be capped because it is “too high”, then it is not clear why we are capping interest rates rather than the prices of essential goods themselves, such as food and petrol.

The answer is that we just don’t like the idea of payday loans – they evoke images of grubby, predatory loan sharks. In contrast, those of us cocooned in the comforts of suburban London seem far more comfortable with a 150% tax on every litre of petrol purchased by the “vulnerable poor”. Go figure.

The second reason to resist a cap is that it would not address the real reasons that people turn to payday loans. The most basic reason – that life’s essentials are too expensive – I have already mentioned. The flipside of that coin is that incomes are too low, and there is much that the government could do to help here. The target of a £10,000 tax free allowance is a start, but we should be moving much more quickly towards that goal. Too often though, it seems that two market distortions – in this case, income tax and interest rate caps – are seen to make a right. It is the same with income tax credits: take with one hand, give with the other.

The need for payday loans also arises from the absence of alternative sources of credit, such as overdrafts and credit cards, which require the borrower to hold a bank account. Those who cannot obtain bank accounts are effectively locked out of traditional credit markets. This is a problem which requires real policymaking effort to solve – and so a cap on payday loan interest rates is viewed as an attractive, effortless solution.

And that brings me to the third reason: an interest rate cap is just too easy. It is a populist reaction to a well-run campaign. Real political leadership would be refusing to endorse a cap, and committing instead to a comprehensive policy programme which addresses the real problems which cause people to take out payday loans.

But instead, intervening in a free market is seen as a quick, easy and harmless fix. Unfortunately, this is unlikely to be the case. When governments set a price cap, prices tend to gravitate towards that cap, as we saw with tuition fees. Some payday loans will probably become more expensive.

And there is a real danger that by setting a maximum interest rate, all loans at or below that interest rate become “respectable”, taking the urgency out of the need to deal with the underlying problems.

When governments set prices, unintended consequences follow, and payday loans will be no different. Financial desperation deserves to be taken seriously. A cap on interest rates is lazy, and represents a neglect of the political leadership which this issue requires.

Matthew Powell tweets @matthewpowell89

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21 Responses to Three important reasons the government shouldn’t impose a cap on payday loans

  1. New blogpost: @matthewpowell89 outlines 3 important reasons the govt shouldn’t impose a payday loans cap http://t.co/GXmxPLpd #fb

  2. RT @PlatformTen: New blogpost: @matthewpowell89 outlines 3 important reasons the govt shouldn’t impose a payday loans cap http://t.co/GXmxPLpd #fb

  3. RT @PlatformTen: New blogpost: @matthewpowell89 outlines 3 important reasons the govt shouldn’t impose a payday loans cap http://t.co/GXmxPLpd #fb

  4. New blogpost: Three important reasons the government shouldn’t impose a cap on payday loans http://t.co/7gMIkmoO

  5. RT @PlatformTen: New blogpost: @matthewpowell89 outlines 3 important reasons the govt shouldn’t impose a payday loans cap http://t.co/GXmxPLpd #fb

  6. MUST READ from @matthewpowell89: “capping pay-day loans won’t work, and won’t cut the cost of living”. http://t.co/zFGChQPn via @PlatformTen

  7. MUST READ from @matthewpowell89: “capping pay-day loans won’t work, and won’t cut the cost of living”. http://t.co/om7OEVEx via @PlatformTen

  8. MUST READ from @matthewpowell89: “capping pay-day loans won’t work, and won’t cut the cost of living”. http://t.co/4a9cGDq1 via @PlatformTen

  9. This is really smart: Three important reasons the government shouldn’t impose a cap on payday loans | Platform 10 http://t.co/nk9d0SBG

  10. Three important reasons the government shouldn’t impose a cap on payday loans | Platform 10 http://t.co/LDBFVg0o

  11. Ethan says:

    I disagree. Typical APR of 2,791% is bloody larceny.

    I think in addition to being forced to quote an APR they should also be forced to spell out a typical scenario…eg Borrow £100 from us and immediately you owe us nearly three grand and some large gentlemen will be round to break your legs next month when you cannot pay.

    There is a need to keep these people honest.

  12. pwuk says:

    unauthorised bank overdraft fees? More expensive and much more opaque

  13. Curmudgeon says:

    In the words of H. L. Mencken,

    “The trouble with fighting for human freedom is that one spends most of one’s time defending scoundrels. For it is against scoundrels that oppressive laws are first aimed, and oppression must be stopped at the beginning if it is to be stopped at all.”

  14. Ethan says:

    pwuk says:
    Tuesday December 4th 2012 at 10:37 am
    unauthorised bank overdraft fees? More expensive and much more opaque

    No LloydsTSB is quite clear and far far cheaper than the usurious btards who cheerfully quote 2,791% (from the spivvy payday loansharks TV ads).

    19.94% APR plus a fee of £31 a month.

    Besides how hard is it to NOT spend money you don’t have. I find not spending money I don’t have very easy. A pity that HMG doesn’t live within it’s means then we’d all have been better off.

  15. Scary Biscuits says:

    A libertarian is not an anarchist. The former believes in minimal government, not no government.

    There has been a long history (way before we had the mass of regulators we do today) of regulating human vice, particularly as the rich and powerful would often prey on the poor.

    Usury falls into this category. And usury is what payday loans are.

    I agree that a cap is too easy. In fact, it is probably welcomed by the industry as a cap will be seen as official recognition of their business model. No doubt they’ll soon be saying ‘interest rate approved by the FSA’ in the marketing material much as the less reputable pawn shops do today.

    The real solution is to ban them altogether. Payday loans do not help the poor with ‘essentials’; they just make paying for them even more difficult next month.

    There is not too little credit at this level but too much. There is a shortage of people trying to live within their means and saving for their future. The availability of credit and other forms of escapism and dissipation, such as the National Lottery don’t help.

    Credit is best reserved for people who have a definite plan for changing their life and paying it back (such as going on a training course or starting a business). Giving credit to people who just want to get to next month, starves more deserving people of credit, and fuels the have-it-all-now culture.

  16. Dave B says:

    Some USA states have tried caps/bans on payday loans:

    “Georgia banned payday loans in May 2004 while North Carolina banned them in December 2005. These two events provide the authors with an opportunity to empirically investigate several effects of the removal of payday loans on household behavior. Morgan and Strain find that relative to households in other states, households in Georgia bounced more checks, complained more frequently to the Federal Trade Commission about lenders and debt collectors, and were more likely to file for bankruptcy under Chapter 7 after the ban of payday loans . . . The results for North Carolina, which the authors regard as preliminary, given the shorter period in which payday loans have been banned, are similar to those for Georgia. ”

    http://www.theatlantic.com/business/archive/2009/11/on-poverty-interest-rates-and-payday-loans/30431/

  17. As the FS Bill passes, a thoughtful contrarian view on why we shouldn’t cap payday loan rates from @matthewpowell89 http://t.co/vwj7t4JL

  18. Misterned says:

    I agree that capping pay-day loans is far too simplistic. The problem is one of lending money and expecting to be repaid all that money, PLUS more money that was never ever created. Usury is evil and was outlawed on pain of death for many centuries for good reason.

    The fractional reserve banking of fiat currencies is a system which is created at the outset to allow the money creators/lenders/Userers to flood a market with cheap credit, creating an artificial surplus of money, creating economic confidence, which encourages more and more people to borrow more and more money. Then when the time is right, the creators of all this easy credit stop lending. Then there is not enough money going into circulation to fund all the required repayments on all the loans, which creates a recession, which allows the bankers to take over the real and tangible wealth offered up as collateral.

    It is a ridiculously simple scheme which has been repeated over and over again down the centuries. It ALWAYS ends the same way. Massive inflation and currency collapse and mass starvation, the enslavement of the host population into levels of un-payable debt.

    We need a system of money which frees, enhances, empowers and serves mankind, not one which enslaves us.

    Outlaw lending at interest altogether, unless the interest is created and given into circulation when a loan is created. That way, there will always be enough money in circulation to repay the debt.

    Currently, only the principle is created and lent into circulation. The interest on credit is NOT and can only be created and LOANED into circulation by the creation of yet more interest bearing loans. This is wrong and should be outlawed, for it is legalised theft.

  19. Scary Biscuits says:

    I don’t have a problem with frational reserve banking. The problem only arises when it is backed by the state: that is, the banker gambles with taxpayers’ money. Heads he wins, tails the taxpayer loses.

    The principle behind fractional reserve banking is similar to a design principle of the network you read this blog post on. It assumes that not everybody needs bandwidth at the same time so the total supply pipe can be a faction of the sum of the end users’ bandwidth. To provide capacity so that everybody could use maximum bandwidth at the same time would be grossly wasteful. Occassionally the system falls over but that is much better than bearing the cost of over-capacity. It is the same with money supply: if you have enough on hand to cover all expected liabilities you are probably wasting it, constraining economic growth.

    You say fractional reserve banking has ‘always’ led to problems. This is only so if you regard banks going bust as a problem. I don’t. I regard it as part of a healthy capitalist system. It is only a problem when politicians say something must be done!

    Money should be denationalised. Banks that issue cash should be free to define the terms on which they do and customers should be free to choose between alternative models. Neither should expect or receive a government guarantee. That way the market, comprised of free agents, rather than you or I telling people what to do, can decide whether fractional reserve, full reserve or some other model is best.

  20. RT @Sarah_Buckley: As the FS Bill passes, a thoughtful contrarian view on why we shouldn’t cap payday loan rates from @matthewpowell89 http://t.co/vwj7t4JL

  21. Your three reasons are utter cobblers Matthew:
    (i) the prices are excessive because the business model is to throw money out of the door with inadequate checks on whether people can afford to pay. Lots don’t so default rates are really high, and that means those that do pay back are paying for lender irresponsibility. Prices are also high because normal competitive pressure doesn’t exist in the market – people are desperate for cash and take it at any price, leaving them prone to exploitation.
    (ii) People do need access to small sum credit at affordable prices but the market seems incapable of delivering this. Instead of banks and financial markets channelling millions into the expansion of payday lending they need to be encouraged to put it into the expansion of affordable products, including credit unions. The returns won’t be as high, but they will still be profitable. Ultimately, its about banks being given social as well as shareholder responsibilities.
    (iii) Of course prices ‘gravitate’ towards the cap. They were above this in the market and are now reduced to it. That’s not a problem provided the cap allows for a reasonable return, based on lenders having proper affordability checks in place. Where this has been done (e.g. Florida) there are fewer defaults and the costs to the lenders is reduced, allowing them to operate under the cap.
    Your arguments are purely theoretical (as usual for pro market lobbyists). Empirically, free markets rarely deliver good outcomes for poor people and interventions such as caps are found to be effective and practical.

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