Monday, January 30, 2012

Consumer financial protection, 1840

I recently read again a very nice paper by Toby Moskowitz and Effi Benmelech, "The Political Economy of Financial Regulation" which studies 19th century usury laws. Usury laws limit interest rates that can be charged for loans, supposedly to protect borrowers.

It doesn't always work out that way.

Even a well-intentioned usury law has the unintended consequence that poorer, smaller, less well connected people find it harder to get credit.  And it benefits richer, well-connected incumbents, by keeping down the rates they pay, and by stifling upstarts' competition for their businesses. Toby and Effi present a powerful case that this is what happened in 19th century America.

I like this paper also for a deeper methodological reason. Cause and effect are devilishly hard to distinguish in economics. We have many fewer good instruments or "natural experiments" than we would like. Toby and Effi build a strong case for cause and effect with patient and exhaustive circumstantial evidence. I can't cover all that in a blog post, but it's good to look for it in the paper.

Here are just a few of the fun facts.
  • Tighter usury laws led to less credit. People didn't easily get around them.
  • Tighter usury laws led to slower growth. A one percentage point lower rate ceiling translates in to 4-6% less economic growth over the next decade. 
  • Usury laws only affect the growth of small firms. Big firms do fine. 
Unlike many analyses, Toby and Effi spend a lot of effort understanding why the right hand variable moves. Why do states put in usury laws?
  • Usury laws relax in financial crises, when all interest rates spke and even well-connected borrowers are starting to be affected. 
  • Usury laws are stronger in states where voting is restricted to wealthy people. It's also stronger in states with other restrictions on competition such as restricted incorporation laws
  • Usury laws are relaxed when there are more newspapers, and when those newspapers are more active an challenging politics and corruption. 
In sum, "Our evidence suggests that incumbents with political power prefer stringent usury laws because they impede competition from potential new entrants who are credit rationed."

Now let's think about our massive financial regulation and consumer financial "protection." Let's guess who will end up benefiting...