I was at a book event for Gary Rivlin’s Broke USA, which I’m reading and is fantastic so far, and I was talking with several other financial style writers (I got to meet Mark Gimein, of the walking away posts I quote a lot), and we were discussing payday lending.
My general opinion is that I am for payday lending in theory but against it in practice. A short-term unsecured loan to someone functionally off the real economy’s grid is going to be an unpleasant loan. What I don’t like is the “sweat box” model, the type of lending that is the equivalent of throwing a net onto someone already at risk and when they can cut their way out they are done. You see this with the requirement in many payday lenders to have to pay off the entire loan in order to end it; you see this with toy models we’ve built at this blog of things like fix pay with credit cards, where if you can charge usury rates, your goal is no longer to get paid off but to not get paid off right away. Not necessarily wanting to get paid off right away creates all kinds of incentive and informational problems.
My ideal solution is public option style “vanilla products”, with a relatively deregulated market floating around that. Require that a certain type of product that is non-explosive be sold by financial dealers, and then whatever else people want to sell go have fun. This is a model that works for auto insurance companies, by the way. The fact that it is clear how the auto insurance model works isn’t a state of nature or natural market outcome – the government is involved with that.
Because if you dig down into some microeconomic models with a little bit of behavior theory, you can see why this gets broken. I spend some time thinking about what it means for markets to have “informed” and “uninformed” participants. The neoclassical story is that the most informed drive the market into equilibrium that is best for all, and that the uniformed piggy-back, through consumer welfare, onto their information. Markets as information aggregators.
But maybe it doesn’t work that way all the time. Maybe it works so that the informed can subsidize themselves off the wealth of the uninformed, and that firms will actively look to exploit this. I want to draw everyone’s attention to a paper by Gabaix and Laibson, “Shrouded Attributes and Information Suppression in Competitive Markets” (MR has a copy of a layman’s overview). If you speak Micro, it’s just a fascinating paper about how markets clear with naive investors and fees (one of my favorite papers).
It’s a look at markets where there are low cost, high hidden fee firms, and how competition from medium cost, no fee firms will lose. What’s interesting about this is it is generalizable to a wide variety of favorable market conditions (zero-cost advertising, for instance). And luring sophisticated consumers away won’t work as they are cross-subsidized by the naive consumers paying fees. Another way of saying this is that it is very difficult to break this equilibrium once it is in place, and it’s especially difficult to break this if the person who is “uninformed” is really just “broke.” And I think the evidence is clear that this cross-subsidy, persistent bleeding equilibrium of banking is what our current consumer financial system has ended up in, and I don’t think we’ll break out of it anytime soon.
And I think Steve Waldman had it best back during the vanilla option debates:
Consumers know they are at a disadvantage when transacting with banks, and do not believe that reputational constraints or internal controls offer sufficient guarantee of fair-dealing. Status quo financial services should be a classic “lemons” problem, a no-trade equilibrium. Unfortunately, those models of no-trade equilibria don’t take into account that people sometimes really need the products they cannot intelligently buy, and so tolerate large rent extractions if they must in order to transact.
The price of assuring that one is not taken advantage of by financial service providers is not participating in the modern economy. You cannot have a job, because payments are by check or direct deposit. You cannot buy a home or a car, because for the vast majority, those purchases require financing. Try travelling with only cash for plane tickets, hotel rooms, and car rentals. People will “voluntarily” participate in markets rigged against them for the privilege of being normal. And we do, every day…
Rather than being anti-market, vanilla financial products would help correct very clear market failures that arise from imperfect information and high search costs. It is the status quo that is anti-market.
If people do stupid things with consumer products it is, in general, their problem. But to see people exploited on what is a pre-condition to full participation in the modern economy should make us believe they are exploited through and through. If it’s part of a liberal vision that people need to have their basic ability to participate in the economy in order to pursue wealth, contracts and happiness, and access to the financial space is part of this basic ability (and it is), it should be offensive that people can’t get a checking account without being bled dry.
That said, I’m not sure what the solution is. A government-public-option postal savings account mechanism strikes me as much better than trying to micro-manage these firms. I wonder if just letting Wal-Mart (NYSE:WMT) become a bank would solve this problem. Micro-managing is difficult if only because those on the other side are smart and, frankly, quite willing to exploit. They’ll always be one step ahead, so a pure regulation response is difficult to do. But this is what motivates my case here.