The Volokh Conspiracy

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"Consumer Credit and the American Economy," Part I: Consumer demand for credit


This posting begins brief discussion of some ideas and concepts from a new book by Thomas A. Durkin, Gregory Elliehausen, Michael E. Staten, and Todd J. Zywicki, Consumer Credit and the American Economy (Oxford University Press, August, 2014). The discussion here does not pretend to reproduce the depth or breadth of the discussion of these and other points in this work, or to report all the footnotes and sources there, but rather to provide a brief summary of some of the book's content. The following relates specifically to discussion in Chapters 1 and 3 of the book.

It seems that few collections of related goods or services have historically evoked as much angst and commentary, or produced as much intellectual baggage, as use of personal, non housing-related credit known today as consumer credit. Economists, behavioral scientists, historians, sociologists, teachers, lawyers, judges, journalists, and others through history have all offered their commentaries. Even theologians, and, naturally, politicians have weighed in on personal credit use since at least ancient Babylonian and Biblical times.

What is it about personal credit that has provoked so much commentary (and regulation)? It seems the answer is twofold: First, there is the view that credit use somehow involves an attempt to live beyond one's means, considered a moral evil in earlier centuries and potentially a cause of economic dislocations in more secular modern times. Second, certainly also an ancient concern but one given new life in the US since World War II, is the accompanying view that personal credit simply has grown without bound until the country today is awash in a flood of personal debt.

As it turns out, supporting evidence for both of these views is weak. During the scientific revolution, new thinking produced the end of widespread belief in geocentrism and other old ideas, even witchcraft, as explanations for observed natural phenomena. But it seems that mythology about personal credit use as a social phenomenon lives on. In every generation it is reinvented into new rationales for the need of additional government controls. Certainly in modern times the use of consumer credit is widespread. Evidence shows that three fifths to two thirds of families have such credit outstanding at any one time in recent decades and that most consumers use consumer credit at least sometime during their financial lifetime. But this does not prove convincingly that consumer credit users either are misguided and somehow trying to live beyond their capacities, or that resulting credit use is economically excessive. Let us look at the first of these myths in the first of these essays and the second in the essay to follow.

Consumers and Their Credit.

At its first level, the claim that credit permits living beyond one's means simply is visibly wrong on its face. For a consumer, borrowing resources now and paying them back later does not increase the total available for personal spending over his or her lifetime, unless the lender does not want to be paid back later. Lenders typically do want to be repaid, however, unless they are inherently charitable enterprises. Most lenders are not charities.

This means that lending and borrowing does not change the amount of the consumer's resources, but only the timing of their employment in personal spending. People borrow and then spend more today but repay and spend less later. To be sure, both borrowers and lenders can miscalculate what future prospects of a loan will be. Variability in future employment and income opportunities among borrowers promises that some loans are not repaid, a manifestation of the concept of risk. But risk does not change the amount of the resources involved, only the probabilities of which party ultimately ends up with them: the borrower retains them (or the benefits from them) if they are not repaid and, most commonly, the lender gets them back over time if they are.

The importance of the borrowing/lending process for consumers is not that it adds resources but that it can increase the total benefits of spending for borrowers by providing an opportunity to make relatively large expenditures now that provide benefits over time and produce a positive return over cost. Clearly many uses of credit imply such positive outcomes. Credit allows purchase of durable assets like vehicles, educations, and others out of the succession of current paychecks, rather than using current income only on current necessities plus the more mundane uses that are always available as alternatives (sometimes even referred to as "frittering away" the money).

Evidence shows that most consumer credit is used to acquire consumer-oriented assets that provide their return not in the moment when they are purchased or soon afterward, but rather over a longer period. For instance, cars and light trucks can provide access to better employment choices and the opportunity to live in a preferred location, providing valuable services to the purchasers for a lengthy period. Higher education provides more remunerative and satisfying employment opportunities possibly over decades. Likewise, home repairs and modernization protect and improve investments in housing assets, and household appliances and related durable goods including furniture, carpeting, and fixtures all provide services over a sometimes lengthy life but often do not lend themselves to fitting within a weekly or monthly budget. Some durable goods like vehicles and boats are even usefully available as collateral, and lenders can then lend upon them as secured credit at lower risk and production cost per dollar, saving the buyer money and enhancing the net return on the items purchased.

Most purchases otherwise made on credit could be accomplished by accumulating cash first and then buying the item later, but this often is not the time pattern consumers prefer. For many goods, accumulating cash first could mean doing without the item or paying for more expensive substitute services for a period that might amount to years, both of which are costly. People could walk to work, for example, or they could ride bicycles or take the subway and bus rather than making payments on car loans. They could forego the pleasures of easily visiting friends and family by car as part of the costs they would bear. They also could use laundromats, and scrimp on other appliances and furniture or acquire used equipment. They could put on sweaters and coats if the furnace failed while saving to replace it, or they could live with relatives. Many people do all of these things in lots of places, but with limited length of lifetimes that often involve children in relatively early years of a family's life cycle, waiting to make these investments is frequently not the preferred option in middle class societies if there is an alternative. The types of credit we observe in the marketplace in large part come about because they are the least costly ways of providing an acceptable alternative.

Thus, using credit to purchase productive assets does not imply living beyond one's means; rather it implies the opportunity to change the timing of purchases to a better one. The alternative is to save and accumulate cash in advance of a purchase, but this is not necessarily the best plan. Alternatives in the meantime (public transportation, furnished dwelling rental, foregoing higher education, etc.) can be expensive to those who take those paths, often requiring replacements or foregoing purchase for a long time. Replacement services like public transportation may even be unavailable in many areas, precluding preferred employment and living choices. Postponing some home repairs, like a needed new roof or a furnace purchase, while accumulating necessary cash in advance through monthly saving can even prove to be disastrous.

In effect, the motivation underlying borrowing by consumers is no different from it is for businesses contemplating new factories or shopping malls: a return on the assets financed. Although consumers may not specifically undertake the detailed risk-adjusted net present value calculus of the corporate financial analyst, consumers will consider the possibilities and will employ credit for purchases of automobiles, educations, home repairs, appliances, and large hobby items when their risk-adjusted rewards exceed their costs. The Federal Reserve Board's statistical efforts and analyses, including its periodic Surveys of Consumer Finances, show that most consumer credit is generated under the circumstances of financing the purchase of large purchases that provide their return over time.

To obtain this change in spending timing, borrowers pay interest, known in Truth in Lending requirements as a "finance charge." The finance charge serves as the needed inducement for the lender to defer its own current use of the resources elsewhere in some other way. The lending process amounts to the reverse of the timing change for the borrower, with the lender spending less now on its own uses in order to spend more later. But the possibility of a timing change and the accompanying exchange of a fee to bring it about has, literally, posed questions for millennia. As indicated, the implied behavior to be avoided by borrowers was for thousands of years the immorality of trying to live beyond one's means. Borrowing and lending should come about only in cases of true "needs." Attempting to restrict lending and borrowing to such situations leads immediately to the Biblical and medieval Church prohibition on the taking of interest (usury) as an affront to the religious requirement for charity in such situations.

More modern economic analysis in the twentieth century has expanded the concept of personal "needs." The work of economists Irving Fisher, Jack Hirschleifer, F. Thomas Juster and Robert P. Shay, and many others during the early to middle decades of the century formed the foundations of today's huge body of academic economic theory and empirical evidence on motivations for timing changes and associated risk of outcomes designated today as the microeconomics of finance. Fisher demonstrated that borrowing opportunities can enable an individual to undertake more productive investment and then borrow or lend to achieve more highly valued current and future consumption than would be possible without borrowing and lending opportunities. Hirschleifer extended this discussion to the case of imperfect capital markets where lending and borrowing take place at different interest rates. Juster and Shay extended it further to account for institutional characteristics of consumer credit markets including willingness of lenders to extend more credit only at higher finance charges and actual limits on borrowing posed by lenders. This work has been further extended by others.

As aficionados and practitioners of finance well know and understand, the economics and practice of return and risk analysis pioneered by these analysts can be complex and its mathematical academic language sometimes intimidating, but it is based upon a simple idea: Borrowers will borrow and lenders will lend when, for both parties, the risk-adjusted expected return from the change of spending timing exceeds its expected cost.

Twenty-first century minds have generally come to grips with these ideas, but it seems that vestiges of the ancient and medieval view remain in more modern dress. Psychological criticisms of the modern economic view of consumer credit use have also been around for a long time, but their latest imitation of the phoenix is a body of legal literature known as Behavioral Law and Economics (BLE). This is a loosely defined grouping of legal prescriptions based uncritically upon adopting into law some theoretical ideas from a relatively young branch of economics called Behavioral Economics. BLE focuses especially on a technologically newer manifestation of consumer credit use through credit cards.

More will be said about BLE later, but ultimately BLE suggests that there are limitations on the economic rationality of consumer borrowers that must be guarded against with regulation. The problem with BLE is that it conveniently ignores the well-developed ideas of traditional microeconomics without empirical evidence of the degree to which traditional economic theory needs adjustments to account for behavioral personal idiosyncrasies of individual consumer borrowers.

The special province of BLE involves credit card lending, an alleged special problem for consumers because of its ubiquity, easy availability, and immediacy. For BLE proponents, credit cards appear to be an entirely new area of lending in need of repair. It has become an area where they can argue that theoretical concepts based in psychology including "hyperbolic discounting," "mental accounting," "shrouding of fees," and "nudges" should translate into new regulatory spheres.

A more complete view of credit cards within consumer credit is that credit cards are an outgrowth of ongoing technological change of lending in a credit industry looking for ways to reduce costs. As empirical evidence suggests, they have mostly just replaced much of small ticket household financing formerly undertaken by local banks, finance companies, and retail stores and dealers, plus assuming an increasingly important role as payments devices that involve credit only statistically but not behaviorally. To be sure, some consumers may behave psychologically irrationally in their use of credit cards, but the important question is the extent and overall importance of such behaviors. BLE should provide better empirical evidence of frequency and quantity before recommending legal changes to a system used successfully by millions of patrons.

And so the ancient and medieval tradition of distaste for "immoral" use of personal credit continues into modern times. This does not mean, however, that old ideas should be replaced uncritically by newer sounding armchair empiricism that quickly translates into legal prescriptions. More thoughtfulness is in order.

Next time: examination of long-term growth in the use of consumer credit.