Usury Laws Revisited


Many goods have been subject to price ceilings at one time or another in the United States, but there is one good in particular that has been price-regulated, almost without exception, from colonial times to the present day—money.

In a free market, that is, where people's choices to buy and sell goods are unobstructed by government(s), the price at which a good is bought and sold reflects a balancing of the respective decisions of buyers and sellers of the good. If it were offered at a higher price, some potential buyers would hold back or some potential sellers would rush into the market, resulting in a surplus of the good—excess supply. If offered at a lower price, the activities of buyers and sellers would be just the opposite, resulting in a shortage of the good—excess demand. The price arrived at in the market, balancing potential buyers' and sellers' decisions, is the equilibrium price, understandably so called.

It thus comes as no surprise that the effective imposition of a lower-than-equilibrium price ceiling results in unsatisfied demand for the good or service the price of which is regulated. But it is often overlooked that the ceiling's impact will vary, depending on whether the item is generally sold for cash or on credit.

For example, assume that two goods are available on a given day. Steel is being sold, only for cash, at $100 per ton, and money is being lent at 10 percent per year. Now suppose the government places ceilings of $90 per ton on the price of steel and 9 percent per year on the interest rate. Supply and demand are now in disequilibrium in both markets, as there are now more willing steel buyers and money borrowers, and probably fewer steel sellers and moneylenders, at the ceiling rates. But here the similarity ends.

Assuming that steel is not sold only to established customers, friends, etc., there is no way steel producers can differentiate among would-be buyers; all have cash in hand, and steel will most likely be allocated on a first-come-first-served basis. But not so with loans. The fact that money is borrowed on credit introduces an element of risk: what is the probability that the borrower will be able to pay off the loan? Since some people are better credit risks than others, lenders will reduce their loans selectively by rationing on the basis of risk. Some borrowers who would have qualified for 10-percent loans will now be excluded from the (9-percent) market. Thus, whereas price ceilings on most goods affect all purchasers about equally, loan-rate ceilings directly injure marginal borrowers whose creditworthiness would otherwise have been sufficient.

None of this is revolutionary. In fact, it is downright obvious. Yet the need to examine the effects of interest-rate ceilings is great; as of mid-1974, only one state, Massachusetts, had no bank usury laws on its statute books. And the specter of the "loan shark" remains vivid in the popular history of the late 19th and early 20th centuries. Cartoons of bloated capitalist moneylenders preying on poor working people still dot American-history books, fueling the widely held myth that this was an era of mass depredation and suffering.

For a case study of the effects of government intervention into the loan market, the experience in New York between about 1860 and 1920 is particularly valuable. Almost every issue we face today existed then. Although the particular circumstances have changed, the principles remain the same.


Throughout much of the 19th century, especially in urban areas, pawnbrokers were a major source of personal loans. In 1828, for example, 149,000 pledges were reported by pawnbrokers in New York City alone (Rolf Nugent, Consumer Credit and Banking [New York: Russell Sage Foundation, 1939], p. 58). Despite the fact that pawnbrokers were unable to satisfy the rising demand for loans, especially by borrowers unable to offer personal goods as collateral, commercial banks were unwilling to enter the market on any but the most meager scale. Why? The maximum interest rate allowed by New York law at the time was six percent per year. Because this return was insufficient to cover costs, banks' so-called accommodation loans were universally unprofitable and thus justifiably unpopular with bankers. Although some loans were occasionally extended to well-to-do customers of long standing, such occurrences were quite rare.

Of course, because of the magnitude of economic growth throughout the century, banks found that their available funds could be employed readily and profitably at legal rates by the many expanding industrial and agricultural enterprises. But it is often assumed that this ease of placement mitigated the effects of the usury laws, a conclusion which is totally unjustified. Had banks been free to charge any rate on personal loans which was mutually acceptable to themselves and their customers, it is reasonable to assume that some portion of the funds extended to commercial enterprises, would have been loaned instead to individuals. Rate ceilings redistributed some funds away from their most profitable employment, thereby reducing total economic efficiency and utility and—perhaps most tragically—driving individuals whose needs could not be accommodated into the hands of the illegal small lenders, or loan sharks.

The loan sharks had two basic types of lending arrangements. Some loans were secured by wage assignments (liens on the borrower's future income). These ranged from $5 to $50 and carried an interest charge of from 10 to 40 percent per month. Other loans were secured by liens on household furniture (chattel mortgages) and ranged from $10 to $300. Because they were larger and less risky, rates generally varied from 5 to 20 percent per month. (Nugent, "The Loan Shark Problem," Law and Contemporary Problems, Winter 1941, p. 5.) (Other things being equal, larger loans generally carry a smaller interest rate because, as a percentage of the loan, fixed costs of lending vary inversely with loan size.)


These interest rates were extremely high. Why did the loan sharks charge so much? They were able to because of the urgency with which the funds were sought; they had to because of the risk of both social condemnation and legal prosecution. In the absence of usury laws, the risk of ostracism is minimal; of prosecution, nonexistent. Hence, the would-be lower rate of legitimate creditors in the laws' absence.

Free from legal competition, the loan sharks adopted other practices to increase their revenues. For example, short maturities, to increase the frequency of refinancing and encourage delinquency charges, were common. No interest refunds were allowed for prepayment, and collection practices brought to bear on recalcitrant debtors were sometimes harsh.

By about 1880 the ubiquity of small lenders in New York and other states became the subject of considerable legislative inquiry. Two general "solutions" to the problem were undertaken: (a) stricter laws or more vigorous enforcement of existing laws against the practices of the small lenders and (b) encouragement of competition by relaxing or revising laws that had served as de facto barriers to entry. But were either of these approaches really effective?

In attempting to eliminate loan sharks by legal, rather than economic, means, legislators generally avoided fixing new and lower rate ceilings on all loans. Instead, noting that small loans were almost universally secured by either wage assignments or chattel mortgages, many states prohibited or regulated the use of one or both of these types of collateral (David J. Gallert, et al., Small Loan Legislation [New York: Russell Sage Foundation, 1932], p. 18). But the futility of this approach soon became obvious. A brief example of the law (and court interpretations) relating to wage assignments should illustrate the point.

The legal right to assign a claim for wages or income already earned at the time of the assignment had never been questioned. But with the increasing use of wage assignments as collateral for small loans, the courts were asked to rule upon the legality of the assignment of future wages. With few exceptions, it was held that this type of arrangement was valid in the presence of an existing employment contract. However, the assignment of future wages not "guaranteed" by existing employment was disallowed. (Gallert, pp. 181-84.)


The inequity of the ruling is obvious. The future earning power of any person is unquestionably an economic asset and thus provides a type of collateral. The fact that one is not working naturally makes the value of that asset more uncertain—but this additional risk is a factor which can be taken into account by a creditor and his client, with a concomitant adjustment in the rate of interest charged for the loan. The courts' refusal to allow such transactions was thus a clear violation of the rights of both parties to enter into voluntary agreements. Not only did existing rate ceilings effectively prohibit both the employed and the unemployed from contracting for small loans at relatively low rates, but now those whose need for credit was greatest were barred from the use of perhaps their most important asset as security on a loan of any type.

With the advent of this ruling, loan sharks often entered into transactions known as wage purchases, whereby the lender "bought" a given amount of wages to be earned by the borrower. The purchase price was, of course, considerably less than the dollar value of the wages purchased. It was claimed that this was a sale, not a loan, and therefore not subject to the usury laws. In fact, most courts held that this was a loan agreement. Nevertheless, the practice continued; for risky borrowers whose needs could be met no other way, this type of loan was preferable to no credit at all.

The record of the various legal attempts to deal with the small lenders is extremely poor. A minor change in the details of a transaction was often sufficient to place it outside the purview of the law. Furthermore, to enforce laws violated by loan sharks, authorities generally had to rely on the complaints of their customers, and for a number of reasons—fear of retribution, ignorance of the law, and, primarily, an overriding need for the continued availability of loan funds in the future—small lenders remained relatively immune from prosecution. And, in all likelihood, had prosecution been widespread, the increased risks would not have done much but raise charges on illegal loans even higher.


Legislators came to realize that further regulations would not ease the problem. They might even aggravate it. A different approach was gradually adopted, whereby new competitors were encouraged by liberalization of the usury ceiling to engage in cash lending. Although pre-1920 New York cash lenders also included credit unions and industrial banks, this discussion will only cover two types of institutions: remedial loan associations and licensed lenders (personal finance companies).

The first and most prominent remedial loan association in New York was the Provident Loan Society. It was incorporated in 1894 as a semiphilanthropic lender—although contributors of funds risked the loss of their principal, their maximum return on investment was strictly limited, with profits above a given rate automatically resulting in a decrease in charges to borrowers. The legislature's first step toward liberalization was a halting one; it allowed Provident to charge up to 12 percent per year. Located in New York City, Provident was relatively successful. Loan volume grew continuously, yet average loan size was kept low in order to "compete with the loan sharks" (Nugent, Provident Loan Society of New York [New York: Russell Sage Foundation, 1932], p. 9). Additional legislation in 1895 permitted the incorporation of other remedial lenders, but only a few came into existence and the loan sharks still held onto a very sizable share of the small loan market.

The founding of the Russell Sage Foundation in 1907 was of particular importance to the future of cash lending. Its studies of the small loan industry during the next two years and the data which it gathered on the actual costs of lending encouraged a search for intelligent alternatives to the current situation in the industry. With strong support from the foundation, the New York legislature enacted a law in 1913 that permitted individuals and corporations to engage in personal lending upon receipt of a state license. (Receipt of the license was a mere formality; the state was not empowered to refuse to issue it.) Rate ceilings were hiked to 24-36 percent per year, depending on loan size, which was limited to $200.


This law, with provisions similar to those of the later Uniform Small Loan Law, marked the beginning of the regulated small loan business (licensed lending) in New York. The following year, in reaction to adverse publicity surrounding the liberal rate ceilings of the 1913 law, the maximum charge on any loan under $200 was reduced to 24 percent per year. Also, the Superintendent of Small Loans was empowered to refuse to issue lending licenses.

Perhaps due in part to this downward revision in the rate schedule—rate ceilings were generally higher in other states—the rate of growth of New York licensed lenders' loan volume between 1914 and 1930 was considerably lower than that of their non-New York counterparts. It was not until 1932, when the legislature revised the ceiling upward to 30-36 percent per year and increased the maximum loan size to $300, that New York licensed lending really took off.

With the completion of urban and suburban electrification in the first decades of this century, there came a tremendous expansion in the production of durable consumer goods. The concurrent growth of installment lending, boosted by liberalization of interest-rate ceilings, brought substantial benefits to consumers and borrowers in that it was no longer necessary to accumulate the entire purchase price of a good before having the use of it. Relative to earlier years, liberalization was an unmitigated success.

Why, then, did liberalization not proceed further? Why were rate ceilings not set even higher—or abolished altogether? Most western European countries had removed all usury laws in the mid-19th century. Why did the state demand the power to issue licenses to lenders on a discretionary basis? Why were loan size-limits retained? Answers to these questions are of particular relevance today, since present arguments against further liberalization are generally based upon the same theories of competition and price determination which held sway decades ago.


The motives of the reformers were quite laudable; most realized that the traditional six-percent usury rate was the cornerstone of a blackmarket for loans that for years had been decidedly injurious to the interests of borrowers. Indeed, the loan sharks owed their very existence to these laws. But the flaw in the reformist chain of reasoning was this: they voiced little opposition to rate ceilings as such but vociferously opposed laws which established the maximum rate at an "unreasonable" level. The implicit assumption, of course, was that they felt themselves capable of determining a reasonable rate.

Why the unwillingness to allow rates to be determined solely in the marketplace by borrowers and lenders? Most reformers and legislators believed that unlimited legal competition would necessarily be destructive. The market would become chaotic. Rates charged to borrowers would skyrocket. But these fears could hardly be justified. On a theoretical level, a universal outcome of competition is that the rates of return on capital in all industries, adjusted for risk, tend toward equality. Massive profits in one area induce the entry of new firms, increasing the supply of the product and thus lowering its price. This consideration is particularly apt in this case, since only a relatively small capital investment is needed to enter the loan industry. Furthermore, from historical viewpoint, even rudimentary knowledge of the economic history of postbellum America would have indicated that unregulated competition invariably resulted in a significant reduction in the prices of goods and services.

Last, but not least, it should have been clear that the abuses in the loan market that new legislation was designed to correct had themselves been caused by earlier legislators' desires to make sure that interest rates never reached "unreasonable" or "unconscionable" levels. It should not be difficult to grasp that a transaction occurs only if a gain is expected from the trade by both parties (and the expected gain is greater than from any other trade). So a loan will be made only if both lender and borrower expect to benefit from it. The term "unconscionable," or its equivalent, is meaningless.

Little thought seems to have been given to the relationship between loan availability and state licensing. Unless a state declines to wield its power to refuse licenses to those who request them—a most unlikely occurrence—the result is predictable: a reduction in the number of market participants and a decline in competition, manifested in lower supply and higher prices, due to the establishment of a legal monopoly of suppliers.

The fact that rate ceilings, albeit liberalized, continued to exist ensured that very small loans (which, as previously noted, required very high interest charges to cover costs) would continue to be made primarily by loan sharks. From 1915 to 1930, for example, the average loan size of unlicensed lenders, almost exclusively loan sharks, in the U.S. fell slightly, from $38 to $32, while that of licensed lenders rose from $55 to $145 (Louis N. Robinson and Rolf Nugent, Regulation of the Small Loan Business [New York: Russell Sage Foundation, 1935], p. 175). In fact, in 1928 New York State Attorney General Ottinger estimated that illegal interest paid in the state totalled $25,000,000 annually (New York Times, Feb. 17, 1928, p. 23).


What, with all this, was the fate of the Provident Loan Society? In the name of philanthropy, Provident had agreed prior to its incorporation that the return to its investors would always be strictly limited. Its primary source of funds was wealthy New York businessmen (including Schiff, Vanderbilt, and Morgan) who could easily afford a small return on a relatively insignificant share of their wealth and who would, additionally, receive a large amount of favorable publicity for their actions, so this policy was quite acceptable to them.

But the ceiling on earnings meant that only those who could afford a low return on their funds could invest in the organization. Consequently, Provident's ability to expand its operations was always quite limited—and potential benefits to New York borrowers were never realized. That Provident was a victim of its own social philosophy can be seen from the following statement in its own publication:

Many of those who are closely connected with the Society share the view with a number of disinterested students that personal loans—even the small loans which must be transacted at a loss—constitute a social obligation as well as an opportunity for the banking and lending community. No lender, it is felt, can discharge his social responsibility if he merely skims the cream off the loan demand to which he caters. [The Provident Loan Society of New York (New York: William F. Fell, 1944), p. 35, emphasis added.]

Provident clearly accepted a false alternative: a firm can either serve the public or attempt to maximize its returns. On the contrary, the evidence indicates that the former purpose cannot be served if the latter cannot be. As proof, consider the following. In 1930, when less than 50 high-rate, profit-seeking licensed lenders operated in New York, with outstanding loans of less than $3,000,000, Provident held outstanding loans of $28,447,548. One decade later, after a 1932 increase in rate ceilings, when 313 licensed lenders had outstandings of $72,269,240, Provident held only $23,568,964.


What can be learned from the early New York experience? The same rate problems that existed 50 years ago continue to exist. Ceilings on lending charges abound. Many borrowers are unable to obtain credit from normal sources because legal and profitable lending have been rendered mutually exclusive. A recent report of the National Commission on Consumer Finance cited research showing that, for a typical finance company to extend a $100, one-year loan to a borrower of average creditworthiness, an effective rate of about 92 percent per year must be charged merely to break even! Of course, break-even rates fall precipitously as loan size increases, but even on a $300 loan a rate of 40 percent per year is required. (Consumer Credit in the United States [Washington, D.C.: Government Printing Office, 1972], pp. 141-45.) Since most state laws prohibit such high rates, personal loans of this size are generally unavailable to risky borrowers, who frequently have no access to other sources of personal loans, like bank credit cards. The only alternative? The neighborhood loan shark, whose rates are likely to be much higher. He must be compensated for the risk he is taking in offering the loan—potential legal expenses, payoffs to local law enforcement agencies, possible loss of income if arrested and convicted.

But the most important implications arise from the issue of government intervention. When any agency of government intervenes in any way in the economy, it is always with the express purpose of altering the terms of trade—either to make something happen which would not otherwise have occurred or to prevent some action which would otherwise have taken place. The specific outcome of any particular type of intervention is uncertain; the government action may or may not change anything. For example, if rate ceilings were set at 1,000 percent per year, loan availability would not be affected at all. But intervention would not be undertaken if it were not expected that some change would, in fact, occur.

Economic indictments of intervention can proceed on two levels: against the harmful effects of a given action or, equally important, against the setting of a precedent (that the government has the right to intervene in such and such a way) that, if applied to other concrete situations, would also be harmful. In either case, the inflicting of harm derives from the fact that individuals' choices have been overruled by force.

But the most crucial arguments against government intervention are not directly economic. Questions of force, voluntary action, etc.—in other words, of rights—are political, and at heart philosophical, issues. Discussions of market freedom and government intervention should be dealt with in more than solely economic terms. The fundamental question is not so much: what is the effect of a rate ceiling on the supply of loans? Or even: what are the effects of price controls? Rather: what are the implications for individuals' rights if government commands the power to override voluntary choices?

This is not to say that economists must always link economic analysis with philosophy; investigations of usury laws, general price ceilings, and the like are necessary and desirable. Of course, occasional success in dismantling or preventing government intervention can undoubtedly be achieved merely by reference to the economic consequences of that intervention. But, in the long run, narrowly economic analysis cannot succeed in establishing a free society.

That economic theory ties in with philosophy was once well understood; it is not an accident that economics was once known as political economy. But for most of the past century, with few exceptions, the link between politics and economics has been recognized only by statists. The present predicament of the world should serve as abundant evidence of the validity of their insight. It is a lesson that libertarians cannot afford to ignore.

David Rogers received his B.A. in economics from the University of Michigan and his Ph.D. from Columbia University in American economic history. He is presently an economist with B.F. Goodrich in Akron, Ohio. He is the author of Consumer Banking in New York, in which parts of the present discussion appear.