Economics, consumer loans and gangsters

01.01.07 Publication:

There is a common proverb in English that says that “the road to Hell is paved with good intentions”. The meaning of this saying is that many policies or actions may be done with the best and most noble justifications or intentions, but they still lead to disastrous consequences. In fact, they lead to consequences that are the opposite of what was hoped for. So the implication of the proverb is that noble intentions or justifications are not enough. An action must also be practical. It must work.

                This proverb came to my mind when I heard about the Japanese government’s proposals to place new controls on consumer lending companies in Japan. The Financial Services Agency, together with the LDP, has proposed that a new limit should be imposed on the interest rate that consumer-finance companies can charge to borrowers, imposing the same maximum interest rate on them as is required for ordinary commercial banks. The idea is to protect ordinary Japanese, especially the poor, against being charged very high rates for their borrowing. At a time when concern about inequality in Japanese society has become widespread, such a measure is understandable. This policy is being proposed with a noble intention.

            It is still a mistake. It will lead to the opposite result from what is intended. One person who would have understood why is Milton Friedman, the famous American economist who died in November at the age of 94, and who is widely regarded as having been the greatest and most influential economist in the whole world during the second half of the 20th century. Mr Friedman became famous for his work on central banks and monetary policy. But the first subject on which Mr Friedman caused controversy was the topic of rent controls on condominium apartments in New York City.

            In an article in 1946, co-written with another economist who, like Mr Friedman, would later win the Nobel prize in economics, George Stigler, Mr Friedman argued that the effect of rent controls was to hurt the poor, not to help them. It meant that fewer apartments were available to them than would otherwise be the case. Those who already had an apartment with a controlled rent gained a big benefit, of course; but owners were discouraged by the rental limit from making new apartments available. The supply of accommodation to the poor became lower.

            He was correct: the poor in New York do not generally benefit from rent controls. Faced with a shortage of available accommodation, they have to look elsewhere, in the outer suburbs, for places to live. Exactly the same argument applies to consumer lending in Japan. The new, reduced maximum interest rate on consumer loans will make life harder for poor Japanese, not easier. It will mean that fewer loans are available for them. The result will be that for many poor Japanese the new choice will be an even tougher one than before: they will either have to borrow nothing, or they will have to borrow from an illegal, unregulated lender, a “loan shark” as they are popularly known. Such illegal lenders are usually connected to gangsters.

            The reason is obvious, when you think about it. If price limits were to be imposed on other products, such as a bus ticket or a bottle of beer, then suppliers would obviously provide fewer of them, especially in areas or to customers where the costs are higher and profits lower. Unless the government stepped in to provide subsidies for these services, the supply of them would fall. It is basic economics, what Americans call “economics 101”, referring to their basic college courses. But, as Mr Friedman and Mr Stigler found with their article on rent control, many politicians and commentators do not accept or understand the lessons of basic economics, especially when they think they are trying to achieve socially desirable ends.

            That is exactly the problem with consumer lending in Japan. The government wants to help the poor, to improve society. But its policy will make it harder for the poorest to obtain loans. Some people might argue that that is a good thing: they want the government to intervene to stop poor people from behaving in ways that are bad for them, such as borrowing too much money. I, like Milton Friedman, would argue that citizens, whether rich or poor, should be free to make their own choices. But that is a different debate, about freedom. Let us stick to economics.

            The reason why the supply of consumer lending will fall, driving some borrowers into the arms of illegal loan sharks, is that the business of making loans to poor people is not a profitable one. That is why ordinary commercial banks, who are subject already to a low maximum loan interest rate, do not do much of it. The default and bankruptcy rate for the poorer borrowers is too high.

            Admittedly, the FSA’s policy does include one sensible idea. Currently, consumer-finance companies are not all required to share information about borrowers on a credit database. So people can borrow money from several different lenders (there are about 14,000 such companies in Japan) at the same time, and each of the lenders will not know about the other borrowings and so cannot make a proper evaluation of the borrowers’ ability to repay them. The FSA wants to make membership of the credit database compulsory. Unlike its maximum lending rate, this part of the policy will have a good effect of improving the working of the market, by making information more reliable and easier to obtain.

            But, overall, the new policy will be damaging. It will hurt the poor, but will also as a result hurt the overall Japanese economy. Currently, the big worry about the economic recovery concerns household consumption, which has been weak. Corporate profits, investment and exports have been strong, but so far consumer spending has not grown strongly enough to support economic growth. Wage growth has been slow, and many people who have been reducing their savings are now trying to rebuild them, and so are not spending all the extra income they are earning. This new policy against the consumer-finance companies will make things worse. By limiting borrowing, it will make it harder for poor households to buy things. Consumption will be depressed.

            The only people who will be helped will be the gangsters. The road to Hell, remember, is paved with good intentions.