Consumer Credit and the American Economy
Not long ago, many businesses competed to extend credit to consumers through unsecured lending, auto loans, home mortgage loans or installment sales. Sadly, true competition is no longer.
In today’s consumer lending environment, businesses are nothing other than agencies of federal and, to some degree, state governments acting under the veneer of a private business. They have an unholy alliance with government.
The industry promised, “We will do your political bidding. We will give you political cover, so you can carry out the social policies you wish. In exchange, Mr. Government, you will make sure we never lose any money.”
That pact has been honored by both parties to the detriment of us — naive consumers.
Todd Zywicki helps us understand how we got here, where we go from here, and how to spot it when it happens.
One sentence summary:
Why Everything Elizabeth Warren Told You About Consumer Credit is Wrong
Key Concepts
Consumer Credit
In this context, the term household investments on credit does not refer to financial investment in such assets as stocks, bonds, or mutual fund shares. Rather, it means making expenditures for high-value goods or services (such as automobiles, appliances, home repairs and furnishings, education, and significant hobby items such as boats and motorcycles) that provide their benefits over a period of time and whose cash purchase does not usually fit comfortably into monthly budgets. (Kindle Locations 504–507)
Supply and Demand
The price of credit (interest) is a function of supply and demand just like everything else.
Consumer credit has exploded since WWII, as demand for durable goods, homes and college tuition, have become available to more people. Since these are long-term investments, they often require loans to bridge the gap between present and future earnings.
On the supply side, automakers innovated new kinds of consumer finance to help their customers afford their products
The Myth of Predatory Lending
Most lending meets a valid economic need and is not predatory in nature. Lending to people who can’t reasonably expect to pay it back is a bad business model.
In the rare cases where credit is extended to high-risk borrowers, it is a last resort. Regulation tends to simply take away this option.
“Activists, journalists, and regulators used the term predatory lending to describe abusive loans, although there is even less agreement on a strict definition of this term than for subprime lending.”
There is no precise definition of predatory lending. Fraudulent practices are already illegal.
The Permanent Income Hypothesis
Credit allows for “consumption smoothing” in a world where demands are often “lumpy” or uneven over time.
“Credit markets arise to change the lumpiness of the patterns, particularly of the outflows for purchasing housing and durable goods, and to bring household capital investment transactions forward in time to the present instead of far off in the future.”
Milton Friedman’s Permanent Income Hypothesis says that individuals seek to maximize their lifetime utility by basing consumption not on present income but expected future income.
The Myth of Growing Indebtedness
Headlines everywhere report on the insane levels of debt, and low levels of savings among Americans.
This fear is resolved when you remember that every debt also entails a corresponding asset that someone else is holding. The old adage that we “owe it to ourselves” largely applies.
The authors point out that debt in and of itself does not cause economic dislocations.
Are Borrowers Rational?
Consumers using very small consumer finance loans generally evaluated their purchase decision positively. When asked to evaluate whether the loan was worth it or not, 84.8 percent of customers said that the loan was worth it. (Kindle Locations 9289–9296)
Most people who borrow at seemingly unreasonable interest rates are early in the income-earning years, or have children (i.e., urgent near-term demands). Thus, they discount the future, when their expenses will be lower and income will be higher.
Young people taking on college loans are sometimes acting irrationally when they study subjects with little practical benefit.
However, the student loan crisis is largely fueled by interventions in the free market — not a lack of regulation or consumer protection.
Book Highlights
The Three Primary Economic Benefits of Consumer Credit
First, consumer credit makes engaging in household investment undertakings easier and more timely for many families. In this context, the term household investments on credit does not refer to financial investment in such assets as stocks, bonds, or mutual fund shares. Rather, it means making expenditures for high-value goods or services (such as automobiles, appliances, home repairs and furnishings, education, and significant hobby items such as boats and motorcycles) that provide their benefits over a period of time and whose cash purchase does not usually fit comfortably into monthly budgets….Specifically, rather than postponing the purchase of household investment goods and services and the consumption benefits they provide until funds are available from savings (a difficult task for many families, especially in the earlier stages of their earning years), consumers can use credit to purchase the investment goods and services first and pay for them while using them.
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A second economic benefit of consumer credit is its substantial contribution to the growth of durable goods industries, where new technologies, mass production, and economies of scale historically have produced employment growth and new wealth. It is simply hard to imagine development of the suburbs or the automobile and appliance industries in this country and worldwide in the twentieth century, or, for that matter, the higher education system as it now exists, without the simultaneous rise of consumer credit to facilitate sale of the output.”
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[Third], consumer credit provides an important outlet for employing financial resources available from net surplus components of the economy (savers), notably from consumers themselves. In fact, if not in common perception, the consumer sector of the American economy taken as a whole actually has always been a net lender in financial markets, not a net borrower.”
