Normally Ms. Saunders is a sensible, if slightly left-ish, author, but in the case of her most recent article, she simply drops the ball. Giving in to populist arguments and economic misunderstanding such beliefs engender, she ends up arguing for practices that nominally help borrowers, but really only favor the irresponsible at the expense of the responsible. Worse still, she indulges in an arrogance usually shown by liberals rather than conservatives, thinking she knows better than borrowers what they should do, and thinking the state should enforce her opinion through law, that is the threat of force.

We will leave until later her mistaken impression that new bankruptcy laws favor only banks and lenders, and instead deal first with her other obsession, the need to cap interest rates and fees.

Repeatedly, Ms. Saunders argues that congress should have "helped borrowers" by capping the rates lenders can charge, as well as the fees they can assess. Admittedly she intermingles this with a number of facts and figures about the merits of savings, and statistics that she claim show thos ewho take on "too much" debt end up failing economically. (Of course, the counter argument that perhaps their incipient economic failure is why they had to resort to taking on debt is never raised.) Still, it is clear that her main point is the one with which she closes:

Now, having helped the banks [by changing the bankruptcy laws], Washington should do something about rapacious bad-faith lending before there is a cascade effect across the economy.

By which she means they should have supported a bill capping interest rates and prohibiting excessive fees.

I often criticize those who overuse that Santayana quote about history, but in this case it is so apropos. The populists continue to trot out the myth of predatory lending, of "unearned income", of "dead money" versus productive labor, and their favorite, the concept that there is some "fair" interest rate above which we should not rise. Have these people never studied history? Among the many factors that kept European progress at a standstill during the middle ages was the church's prohibition on lending for interest. It was hardly the only cause, or even the most prominent, but is it coincidence that the cities which allowed something like modern banking, mostly merchant cities in Italy, both became immensely wealthy and were the centers of the Renaissance? Or that other states only began to enter the modern economy when they threw off the prohibitions against interest? Lending for interest is essential for any sort of real growth. Without lending there is very little growth, and without interest there is no lending.

Let me start off simply. You have an apple. You don't need it. I want an apple, but have nothing to exchange. So I ask you to give me the apple and I will give you one tomorrow. Now, maybe if you are exceptionally kind you will give it to me. But then you recall that I didn't give you back that coat I borrowed last spring, and are a bit reluctant. Or, even if you trust me completely, you wonder if you might not want that apple sometime between now and the time I give it back, so you are reluctant to give it away. In either case, to overcome that reluctance, I offer a bit of incentive, let's say, I will give you an apple and a few grapes tomorrow in exchange for an apple now. But John wants the apple too. So he offers an apple and two handfuls of grapes. And I have to decide whether I want the apple badly enough to offer even more...

Well, that is the basis of interest, and why it is essential to a modern economy. There have been endless arguments among economists about what the specific causes of "time preference" are, and in what ratios they apply¹, but to reduce the complicated argument to a very simple summary, to one degree or another, we prefer to have something today rather than tomorrow for two reason. Because what we have in hand is immediately usable, while something we must wait for is not, and because the future is always uncertain and we may never see something we do not have in our hand. And that is why we charge interest, because the borrower may not repay, so we want some money for accepting that risk, and because we could be using that money for other things during the time we are giving it to someone else, so we want some payment for forgoing those other uses.

The final factor is more on point to this discussion, and that is competition for resources. Money is just like any other commodity, were it free there would be an unlimited demand, and that is what an interest free world would mean. If there were no interest, I could borrow any amount of money I wanted, and then when it came due, borrow more to pay that off. I would never need to stop doing this and so could live for free on someone else's money. And of course everyone would be doing the same, meaning that at an interest rate of 0% all available money would be immediately consumed, which would also cause our plans to collapse,a s we would all default on our first loans, unable to borrow any more.

Since there is a limited supply of money to be borrowed, the lender can charge a premium, which is set by the bidding of the buyers². Of course, this is not an actual auction. Like so much in the free market, the prices are set through "the market", but the outcome is the same. Whether we hold a formal auction with people promising varying interest rates for the money available, or the lenders adjust rates as the market changes, the result is the same³, the market rate is set at a price, that is interest rate, which will provide all the money demanded by those who are willing to pay that rate.

So, how to deal with the various rates depending on credit, income and so on? Well, there are two ways we can view this. We could either view all money as having one basic interest rate, that obtained by borrowers with A credit and full income documentation, and that the remaining rates represent premiums paid by other borrowers to account for their increased risk of default. Or we can view each credit category as a different commodity with the various interest rates representing the price of that particular product. As many lenders specialize in one category of credit, or have varying pools of cash available for each credit category, the second may come closest to representing the truth of the market⁴.

As I am sure many are already starting to stare glassy-eyed and wonder what other blogs they could be reading, let me start to tie all of this to my original topic, Ms. Saunders' call for caps on interest rates.

The call for caps on interest rates is based on an assumption, that the rate of interest is arbitrarily set by the lender. However, as I showed above, the rate is not an arbitrary number, it is set by the market. So, what happens if the interest rate is capped? Well, first of all, the amount of money available for lending drops. Someone who may have offered their money at a return above the cap may no longer offer their money. Second, many lenders will simply stop offering loans to people with exceptionally bad credit. Without the inducement of high returns, they will simply offer that money to less risky borrowers. And the few who do choose to continue lending to high risk customers at the maximum allowed rate will see every dime borrowed, as a price cap always results in shortage of the commodity, and money is no different.

So, instead of protecting those at high risk, by capping the interest rate we have pretty much guarantees that most of those with bad credit will be unable to find money to borrow. Worse still, those few who do continue to lend to high risk borrowers at this lower rate do not make enough interest to both make up for losses and continue to pay investors at the old rate, which presumably was the rate the market required to induce them to lend money to poor credit risks. Thus they see their investors pull out to move the money to more appealing investments and eventually there remains no money left for high risk borrowers.

To make this very clear, and as simple as possible, by capping interest you do not protect borrowers, you make it impossible for a certain category of borrowers to find any loans at all.

Of course, perhaps that is Ms. Saunders' goal. Among her complaints are "those who rely on payday loans". So, maybe she thinks those who need a loan on future income and those who borrow despite bad credit simply would be better off were they not granted a loan.

My response to that is: who does she think she is? It was the same objection I made when Maryland banned payday loans. They argued that payday loans were "exploitative" and bad. But my argument was that if a borrower, knowing the terms, thinks he wants a loan, who are we to say he is wrong? Maybe he knows his needs better than we do. Why do we have the right to put the judgment of the state in the place of his own judgment? Why do we have the right to say "You think you need a loan, but we say you can't get it, as the lender might be exploiting you."

That is the arrogance of all populism, the assumption that most people are incompetent and, but for the intervention of good wise people like us, these poor fools would never survive. I just cannot embrace that sort of arrogant attitude. My fellow citizens are adults. Some may be dumber than I am, some smarter, it doesn't matter. They are competent adults, they can make their own choices. They probably will make mistakes, but that cannot be my concern. It is worse to treat an adult like a child and prevent him from choosing than it is to allow him to make mistakes. I would much rather a "heartless" free society existed than even the most caring dictatorship. But it appears these populist measures call for the opposite, and want to prevent people from doing anything that might possibly bring them harm.

But I have written about this before at great length⁵. So, let us move on to the other half of my essay, the reason that lenient bankruptcy laws are a bad idea for both lenders AND borrowers; how, despite Ms. Saunders' claim, they do not favor borrowers, but end up hurting responsible borrowers to the benefit of only the irresponsible.

There are essentially three approaches to bankruptcy.

The first is to have no laws at all, allowing creditors to sue for collection with no judicial intervention at all. This works out poorly for both sides as it effectively means that the first creditors to get to court are paid in full, while the remainder get nothing until the borrower has accumulated more assets. Once he has, there begins another legal race to collect from him by the remaining creditors and so on. It basically creates a mess for everyone involved.

The opposite extreme is a system which not only allows for management of the repayment through a receivership, but also allows some forgiveness for the debtor, up to a full forgiveness of all debts. This system is usually promoted as being favorable to borrowers, though, as I shall show later, this is not entirely true.

Finally, there is the position between the two, where the debtor enters receivership and schedules are set up to repay his debts while leaving him sufficient money for his necessities, but which does not allow for any debt forgiveness, and only allows him to leave receivership once every debt has been repaid in full. While this is seen as being "pro-creditor" I will argue that it is really in the best interest of everyone, or almost everyone.

So, why do I say that debt forgiveness is actually bad for debtors? Because lenders are not fools. If the law allows for lenders to be forgiven debts by entering receivership, then those who make loans will take this into account and increase the interest charged on loans to cover the anticipated losses from debt forgiveness. In addition, to the degree the law allows, they will simply refuse to lend to those whose profile suggests a likelihood of declaring bankruptcy.

So, though it is claimed that lenient laws favor debtors, in reality they do not. They favor debtors who default, that is true, but for everyone else they actually increase the costs of borrowing, as well as making funds unavailable entirely for those fitting the profile of a likely defaulter. As there are far more responsible borrowers than defaulters, the lenient bankruptcy laws end up doing much more harm than good for borrowers as a group. Were we to adopt laws which instead allowed for a receivership, but required full repayment, it would still provide protection for borrowers, but would not make lenders increase rates⁶  to cover losses from debt forgiveness.

And thus we can see that Ms. Saunders is wrong on both counts. Far form being "pro-lender" more stringent bankruptcy provisions actually are in the interest of everyone except those who expect to default. And on the other hand, capping rates⁷ does not favor borrowers, but simply makes loans unavailable to borrowers with bad credit, as the lenders cannot charge rates which their risk requires.

But that is usually the case with such populist measures, while they sound good on paper, provided we don't look too closely, int he end they do much more harm than good, often to the very people they are supposed to benefit.

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1. Eugen von Boehm-Bawerk wrote a huge work on this topic. It is probably the most detailed analysis of the time preference I have read yet. For our purposes, we do not need anything approaching such a detailed analysis. It is sufficient to know that unavailability and uncertainty are enough to explain interest. That is not precisely what was said in Boehm-Bawerk's essay, but it will do for our purposes.

2. As I state in the essay, the free market does not usually use formal auctions to set prices, but the outcome is the same. The mechanism of prices work as if there were an auction, in general. Admittedly, sometimes prices are not adjusted quickly enough and we end up with shortages, but such shortages themselves drive up prices, resulting in the eventual setting of the correct price.

3. This is somewhat obscured by the fact that the Federal Reserve meddles with rates by increasing and decreasing money supply. So take this description as that of an optimal system.

4. We must then include the lenders themselves as competitors in the market, as money can be borrowed from one category to be used for loans in another, which will change the price charged in that market. However, this is no different than many commodities which can be used both for production and consumption. Lumber prices are set by both producers such as home builders and consumers such as homeowners. This is nothing unique.

5. I chose not to litter this essay with links. So here is a list of essays which relate to various topics:
    On arrogance and Liberalism: Arrogance, The Essence of Liberalism, Arrogance and Gun Control, A Very Simple Truth, Man's Nature and Government,Copyright as Politics
    On protecting people from themselves: Our View of Our Fellow Citizens, Those Other People, Seeing People As Stupid,The Virtue of Humility
    On populism: Beware Populist Deception, Saving Us From Lower Prices, and almost any essay on bad economic policy
    Limits of Economic Regulation: The Limits of Technocracy, Predictability, Why Government Fails, The Shortcomings of Pragmatism, Protectionism

6. Because receivership does postpone payment there may be some slight increase in premium just to cover the delay, but it would still be much less than that caused by forgiveness. Second, if we adopt a full repayment bankruptcy, but do not allow for the accrual of interest while in receivership, that will also be reflected ina  slightly higher interest rate, but, again, it will be less than that caused by debt forgiveness.

7. I skipped over the topic of fees as the argument is identical to those for interest rates. If lenders cannot charge a late payment fee adequate to reimburse them for the inconvenience, then the money will go elsewhere. While some may call those fees "abusive", they are likely the only reason that money is available. In addition, if a borrower thinks such fees are too high, he is free to borrow elsewhere. If he borrows from someone charging excessive fees, he has only himself to blame. I would much rather require people to suffer the consequences of their own lack of foresight than I would surrender the freedom to contract whatever I desire.

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DISCLOSURE

While young and unemployed I was in default of my student loans and also during periods of unemployment found myself unable to pay bills at various times. I also did have experiences with a bad lender, as one of my student loan holders (not the company which gave the original loan) argued that by dropping out I was subject to immediate collection, in direct contradiction of the terms of the loan. As I was broke and unable to afford a lawyer, I was forced to let it default rather than fight it out in court. However, none of my personal experiences change the laws of economics. Despite the appeal of populist rhetoric, and despite the fact that lenders often engage in practices some would call abusive, the fact remains that laws which favor default or skew the market in favor of either party tend to produce worse effects than a market in which the government does not play favorites.

In short, my disclosure is pointless, as my own experiences "should" make me favor defaulters and borrowers. But my personal experiences have no bearing on the laws of economics, so my opinion would be the same whatever had happened to me.