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Volokh Conspiracy

Comments on Department of Defense proposal to expand Military Lending Act


In September, the Department of Defense proposed new regulations to expand the reach of the Military Lending Act to cover several consumer credit products that previously were outside the scope of the regulation (Ballard Spahr has an excellent discussion of the proposed rule here and its dramatic assumption). The text of the rule is here.

The Consumer Financial Protection Bureau (CFPB) filed a comment letter supporting the new rule (here) and released a new study that it claims supports the new rule (here). The Bureau of Consumer Protection and Bureau of Economics at the Federal Trade Commission filed a comment in support of the rule (here) (which apparently was authorized by four commissioners and so I'll call it the FTC comment) and Commissioner Josh Wright filed a comment letter opposing the rule (here) (Wright comment).

Reading the DoD rulemaking, and then reading the CFPB comment letter and FTC comment is a disheartening experience. Reading it is like a time machine-it is as if hundreds of years of the history of economics and regulation simply was thrown out the window. We discuss this history extensively in "Consumer Credit and the American Economy" chapter 11, dealing especially with usury regulations, which have been the subject of extensive study over many years. As Milton Friedman summarized the economic consensus regarding the negative effects of usury regulations in Newsweek in 1970:

During the nearly two centuries since Bentham's pamphlet was published, his arguments have been widely accepted by economists and as widely neglected by politicians. I know of no economist of any standing from that time to this who has favored a legal limit on the rate of interest that borrowers could pay or lenders receive-though there must have been some. I know of no country that does not limit by law the rates of interest-and I doubt that there are any. As Bentham wrote, "in great political questions, wide indeed is the distance between conviction and practice."

Yet here we are, with the federal agencies that are supposedly experts in consumer credit economics and its regulation endorsing the expansion of usury regulations to consumer lending products used by members of the military. And in the case of the FTC comment skating very close to endorsing usury ceilings generally.

The DoD rulemaking, the CFPB comment, and the FTC comment all rest on the same tired myth that propped up the political case for usury for centuries-that one can suppress the forces of supply and demand by writing laws. Just as generations of central-planning predecessors, the agencies all believe that they can write regulations that will eventually subject all types of consumer credit to a comprehensive consumer lending code that will control all possible products that consumers (in this case military members) might want. But this is precisely what centuries of experience shows cannot be done.

Consumer credit is often analogized to squeezing a balloon-you can squeeze on one part (say, the interest rate) but the amount of air in the balloon stays the same, so it pops up in some other part (say the down payment, maturity, or default terms). And so what economists universally have found is that you cannot change the total price of consumer credit-you can simply shift the costs around and to the extent that you can't, then the consumer ends up not being able to get credit at all (rationing). At least from legal lenders, that is.

So all of these comments point to the "problem" that because the original set of rules only covered some products (such as payday loans) borrowers and lenders have increased their use of other, non-covered products (such as installment loans) or redesigned existing products to evade the regulation (such as converting payday loans into longer-term loans). This is also the central finding of the CFPB's report-namely that because of regulation, military members are unable to use certain high-cost consumer credit products. So instead they use other (unregulated) products more than other consumers.

Well, duh. This is exactly what has been known about usury regulations for centuries (as we document in the book). First, when you regulate some terms of a loan, other terms of the loan adjust to reach an equilibrium price. For example, when credit card interest rates were capped by usury ceilings in the 1970s and 1980s, issuers imposed annual fees to make up the difference. Second, borrowers and lenders will work together to redesign products to meet the letter of the law. Chapter 11 of our book discusses the astonishing array of peculiar products that existed in earlier periods of U.S. history, from "Morris Plan" banks to "salary buyers" and retailers operating under the "time-price doctrine."

Usury regulations, therefore, have always been a dog chasing its tail-as fast as regulators try to suppress the forces of supply and demand, borrowers and lenders redesign products to fit within the interstices of the law. In the end, however, products become more complicated and less transparent, leading to higher costs and less competition-and hurting the consumers they supposedly were intended to help.

A second effect is product substitution. So, for example, where credit cards were unavailable because of usury restrictions, consumers were instead forced to use pawn shops or retail store credit. The latter offered a particularly useful way of evading usury restrictions because by bundling the credit offer with the goods the retailer could bury their losses on the credit terms by marking up the goods themselves for goods such as appliances, which traditionally have been purchased on credit.

The experience with the MLA illustrates this experience as the "loopholes" in the original MLA rulemaking spawned the supposed need for the new, broader rule. Does anyone really think that this rule will now cover all of the potential ways in which borrowers and lenders can reconfigure loan terms to evade the rule? Does anyone think that borrowers will be made better off by more convoluted products designed to evade usury rules-which exist only because consumer demand exists? So long as the consumer demand continues to exist, consumers and lenders are going to try to meet the market demand.

More important, the regulation does not cover overdraft protection, which is a close substitute for payday lending and other short-term loan products. As Commissioner Wright notes (echoing a point I have made as well), the Wall Street Journal has reported on the apparent growth in usage of overdraft protection by military members since the MLA was originally enacted. Indeed, I have occasionally observed that the new MLA regulations could be renamed "the overdraft protection stimulus act" because it leaves overdraft protection as one of the few remaining options available to service members.

Of course, it isn't possible to always still meet all consumer demand-which is where loan-sharking traditionally has entered the picture. Wright's excellent comment quotes a passage from famed economist Paul Samuelson that I have quoted here previously:

The concern for the consumer and for the less affluent is well taken. But often it has been expressed in a form that has done the consumer more harm than good. For fifty years the Russell Sage Foundation and others have demonstrated that setting too low ceilings on small loan interest rates will result in drying up legitimate funds to the poor who need it most and will send them into the hands of the illegal loan sharks. History is replete with cases where loan sharks have lobbied in legislatures for unrealistic minimum [sic] rates, knowing that such meaningless ceilings would permit them to charge much higher rates.

It is also revealing that all of the agency comments refer to "lenders" evading the law, when of course it is both borrowers and lenders who are cooperating to avoid the reach of the law, just evidencing their confusion on this topic. Still, CFPB Director Richard Cordray's remarks seem a bit over-the-top given the subject matter:

"The current rules under the Military Lending Act are akin to sending a soldier into battle with a flak jacket but no helmet. To give our troops full-cover protection, the rules need to be expanded," said CFPB Director Richard Cordray. "The Department of Defense's proposed revisions will go a long way toward better shielding our military from high-cost credit products."

It is depressing that after all these years the supposed government "experts" are making all the same mistakes that have been made by generations of politicians before them. Indeed, there are some passages (particularly in the FTC comment) that go beyond the narrow confines of the MLA and hint at support for usury restrictions generally. Looks like our book is going to be more relevant than I thought. Commissioner Wright's dissent is a good overview of the economics and history of usury laws.

Politicians can pass all the laws they want, and regulators can write all the rules they want, but they can't repeal the law of supply and demand or the law of unintended consequences.

Update: A reader calls my attention to an apparent error that I had never noticed before-Samuelson refers to "unrealistic minimum rates" when read in context he obviously means "unrealistic maximum rates" I double-checked the source and the error appears in the original text. So I've added [sic] to the quote to acknowledge what appears to be a clear typo.