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E-MailJonathan R. Macey is Sam Harris Professor of Corporate Law, Corporate Finance and Securities Law at Yale Law School. This post is based on his recent paper, forthcoming in the Texas Law Review.
In a recent paper, I point out that access to credit sometimes provides a provide a path out of poverty and even a gateway to real prosperity for those who use the funds to start a business, but when credit is granted improvidently it can lead to financial ruin for the borrower up to and including homelessness and food insecurity. In light of the extreme range of consequences from the granting of consumer credit, it is peculiar that the various extant regulatory approaches to consumer lending do not distinguish between these two wildly disparate effects of the lending process. Rather current approaches to regulation focus almost exclusively on disclosure of certain features of the loan and the annual percentage rate (“APR”) associated with the loan.
A better regulatory approach would be to utilize the analytic framework developed in this paper, which utilizes the effects of borrowing on the balance sheet of the household taking on consumer debt. The key to this framework is based on the fact that it is easy to determine how the proceeds from a particular loan will be allocated, because borrowers must generally inform lenders about how the proceeds of a loan will be deployed. With this basic, non-technical, yet critical item of information, it is possible to determine whether, ex ante (which in this context means at the moment the loan is made), the immediate effects of the loan on the borrower’s balance sheet.
This is because, at the moment a loan is granted and borrowed funds are deployed, it is inevitable that the borrowing will have only one of three possible effects on a consumer’s balance sheet. Specifically, every loan necessarily will be either wealth enhancing, or wealth neutral or wealth destroying for the borrower. In other words, the analytic framework developed here recognizes that various kinds of personal loans impact borrowers in vastly different ways and that a balance sheet perspective can be used to estimate that impact. Specifically, there is a difference in the balance sheet impact of a loan based on whether the loan proceeds are being used: (a) to make an investment (where the borrower hopes to create wealth by earning a spread between the cost of the borrowing and the returns on the investment); (b) to fund capital expenditures, (where the borrower borrows to purchase an capital asset such as a home or a cars such that the proceeds of the loan have a neutral effect on the consumer’s balance sheet because the borrowed funds are used to acquire an asset that is worth at least as much to the borrower as the cost of the funds); or (c) to fund current consumption (medical care, food, etc.).
From a balance sheet perspective, this third type of lending is distinct. Such loans, by funding the acquisition of things that are consumed immediately, reduce wealth and are correlated with significant physical and mental health problems. In contrast, loans used to acquire capital assets (i.e. houses) and to make investments are positively correlated with such socioeconomic indicators. Of course, people who borrow to fund current consumption are not borrowing for fun, and they are not borrowing because they like descending more deeply into poverty. Rather, rational consumers borrower to fund current consumption because they have no choice. In particular, poor people borrow to fund current consumption because they are hungry, because they need to fix their cars in order to go to work, because they need to buy medicine for their children.
As a matter of basic social justice however, borrowing for current consumption should be funded by wealth transfers effectuated through a negative income tax, or other forms of means-based wealth transfers such as welfare. In other words, the taxonomy of household balance sheets developed in this paper provides a basis for determining the proper limits on consumer debt. Debt is appropriate to fund investment and the purchase of durable assets like houses, cars, and boats. Similarly, investments in education, which can have a positive impact on consumers’ balance sheet by increasing the value of their human capital and thereby raising the present value of their expected stream of future income.
It should be the role of the state and not the role of the consumer lending market to fund current consumption in order to avoid people having to remove themselves involuntarily from the work-force, or in order to pay for food required for subsistence or to pay for necessary medication. In other words, the household balance sheet helps to define the proper role for the welfare state and to distinguish that role from the proper role of private credit markets in the economy. At a minimum, the welfare state should be responsible for helping people who are facing uncertainty about how to feed, clothe or house themselves safely.
Credit markets can handle wealth creation and capital goods purchases. Money, after all, is fungible. The rich and the relatively well-off should not be allowed to get government subsidies to borrow to fund current consumption in order to free up other, fungible cash to use to make more investments. Likewise, borrowing should not be subsidized when loan proceeds are used to enable households to increase the leverage of their investment portfolios.
Payday loans are the paradigmatic example of the use of credit to fund current consumption. Loans to fund current consumption reduce the wealth of the borrower because they create a liability on the “personal balance sheet” of the borrower, without creating any corresponding asset. The general category of loans to fund current consumption includes both loans used to fund unforeseen contingencies like emergency medical care or emergency car repairs, and those used to make routine purchases. Consistent with the stated justification for creating emergency lending facilities, subsidized emergency lending facilities should be made accessible to individuals facing emergency liquidity needs, either directly through the Federal Reserve’s lending facilities, or through government subsidized loans from private lenders.
Similarly, loans that are taken out for current consumption but used simply to smooth out variations in patterns of consumption over one’s life cycle need not be subsidized. But, lenders who make non-emergency loans for purposes such as education or housing that are so significant that they can transform the borrower’s balance sheet should be required to treated borrowers with the same fairness and respect routinely provided to investors in securities. Compliance with such duties would require not only much greater disclosure than is currently required, it also would impose a duty of suitability on lenders. The enhanced anti-fraud protections for people taking out loans that transform their household balance sheets would require lenders to provide borrowers with the loan most appropriate for their needs. These heightened duties should be extended to any borrower who takes out a loan that increases the debt on a borrower’s balance sheet by more than 25 percent.
The complete paper is available for download here.
