The Magazine

Credit Is Given

Indebtedness (and its discontents) is as old as human nature.

Mar 5, 2012, Vol. 17, No. 24 • By JAY WEISER
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Doomsayers have denounced consumer debt for decades. But today, for the first time since the 1930s, consumer chickens have come home to roost, with a debt crisis in the housing markets and a looming student loan debt disaster. Debtor Nation digs through a century of trade publications and government documents to offer an

Photo of shoppers with filled shopping carts

Black Friday, 2011

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institutional history of the business-government interaction that created our current, massively over-leveraged consumer debt system.

Unfortunately, Louis Hyman’s moralizing gives him excessive faith that, after a century of perverse consequences, government regulation will magically develop the ability to steer credit appropriately. He starts with a distortion that reflects his limited understanding of finance: Before the 20th century, he says, consumer debt was unprofitable. In fact, it was profitable, but bundled. Strapped consumers—whether Victorian factory laborers or today’s white-collar workforce—have always sought loans to cover the gap between cash on hand and their need for goods. Going back to ancient times (according to David Graeber’s Debt: The First 5,000 Years), most consumer lending was store credit, recorded in account ledgers, but without an explicit interest charge. (Newt Gingrich’s no-interest Tiffany charge account is a survival of this earlier practice.) The retailer’s profit was the cost of goods plus the implied cost of credit, less bad debt chargeoffs. The key 20th-century change was unbundling: Rapidly falling information costs created a consumer lending market separate from store credit—which fueled a massive consumer economy while creating new systemic risks.

Hyman notes that stand-alone consumer lenders existed before the 20th century, but following popular usage, demonizes them as “loan sharks.” His evidence on the late-19th-century Minneapolis pawnbroker John Mackey—a key figure in the transition to 20th-century consumer credit as the founder of Household Finance Company—indicates that the market, rather than rapacity, was at work. Mackey faced high information and processing costs for pre-computer-era small loans; his financially stressed clientele had a high default rate; and low usury law ceilings made it illegal for him to collect market interest rates, thus encouraging a higher default rate. Therefore, despite charging usurious interest rates of up to 300 percent a year, Mackey’s annual profits in various lending offices ranged from 3.3 to 16.6 percent a year—a modest return for a high-risk business. When usury limits loosened after World War I, small consumer loan rates dropped to around 45 percent a year, but Hyman observes that lender annual returns remained similar, suggesting that the usury laws caused the astronomical rates.

Like early-20th-century reformers, Hyman sentimentalizes borrowers as needing cash only for noble purposes: tiding over a spell of unemployment or buying shoes for a child, rather than funding reckless spending or compulsive gambling. His later evidence suggests otherwise. After accounting for defaults, inner-city consumer durable retailers in Washington, D.C., for example, made only modest profits on their draconian installment sale contracts even before their deadbeat clientele, rioting after Martin Luther King’s murder, torched their records and looted their stores. (Washington’s 14th Street is only recovering four decades later.) And in a preview of today’s Federal Housing Administration meltdown, the Johnson/Nixon-era FHA Section 235 mortgage guarantee program for low-income borrowers with minimal down payments—an early “ownership society” effort—soon collapsed in fraud. Hyman, wearing his ideological blinders, blames “realtors, builders, home inspectors, and mortgage bankers [who] colluded in unsavory ways to defraud trusting first-time buyers.” He thus downplays the tradeoffs inherent in consumer debt: Wide availability creates risks of adverse selection (people eager for high-rate or low-down-payment loans are more likely to have trouble paying them) and moral hazard (greater borrower protections equal greater temptation to stop paying the debt), but tight regulation effectively rations credit by cutting off high-rate, high-risk credit for some people who could manage it.