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| The Money Changer and His Wife, by Marinus van Reymerswaele |
Debt-financing is increasingly common. It used to be the case that people would occasionally need loans during the course of their lives, perhaps to buy a car or a house. These were exceptional cases, outside the normal conditions of life. In most instances, people would rely on savings to cover their consumer costs, or go without. This has now all changed. There is more complexity in the markets for private debt. People use loans to cover holidays, education, healthcare and other unforeseen costs. They have high interest credit cards and payday loans to help them get to the end of the month.
Is this a good thing? Debt-financing has a long and chequered past. For large swathes of European history, the lending of money for profit (usury) was illegal and morally condemned. There was, of course, a degree of hypocrisy about this, with usury often being tolerated in the shadows. More recently, debt has been viewed as a necessary and useful tool for a consumerist society. Economists often see debt contracts in a win-win light. They transfer money from people who don’t need it to people who do, allowing both to gain something valuable in the process. They enable people to ‘smooth out’ their consumption of goods and services over the course of their lifetimes by bringing forward in time some expenditure. They grease the wheels of economy and prevent it from slowing down too much during times of perceived crisis.
But there is undoubtedly something disquieting about the explosion of debt-financing, particularly the forms of debt financing that target the poor and less well off. The financial crisis of 2008 was precipitated by a crisis in the sub-prime mortgage market, i.e. in the market for home loans to those who were perceived as being at high risk of default. Banks profited off the backs of the poor through labyrinthine securitisation and repackaging of debt agreements. While some banks suffered in the aftermath, many grew larger and fatter as governments poured debt of their own into their rescues. It is the poor and less well off that seem to have suffered the most with increased income and wealth inequality, and rocketing property prices.
In her article ‘What could be wrong with a mortgage?’, Lisa Herzog tries to explain exactly why we should be disturbed by the market for private debt. Although she acknowledges the economist’s argument in favour of debt contracts — and thus thinks there is nothing intrinsically wrong with debt — she argues that there are specific features of the current market for private debt that make it ‘structurally unjust’. In short, she argues that debt has become more necessary and more difficult to handle for those from poor and less advantaged backgrounds. This exacerbates their already precarious and difficult position. This is not due to any conspiracy or fraud that is perpetrated against the poor (though that may be a feature in particular cases) but rather due to a confluence of factors beyond any one individual’s control.
Herzog’s argument breaks down into three sub-arguments which compound into the case for structural injustice. The overarching structure of the argument is illustrated below. I want to examine each element of it over the remainder of this post.
1. The Argument from the Lack of Informed Consent
One condition on the justice of debt contract (and, indeed, any contract) is that the borrower enters into it following a fully informed consent to its terms. This is a challenge because there is significant inequality of bargaining power in most debt contracts. Unless you are wealthy, banks and other financial institutions will be able to control the terms and conditions of your debt agreement with little interference. This means that when you are signing up to the contract you are signing up to their preferred model of the agreement.
This is already an inauspicious starting point, but if it is to be in anyway legitimate you must know what it is you are signing up to. In other words, you must understand what your future liabilities under the debt contract are going to be: how much are you obligated to repay and over what time period? What are the consequences for you if you do not meet your repayments? If you lack this information, or are unable to understand it if you receive it, then there is the potential for injustice. Herzog’s claim is that this is more likely to be true in the case of poor debtors than in the case of wealthier debtors. This places the poor debtors at a disadvantage.
She doesn’t set out the argument in formal terms, but if she did I imagine it might look something like this:
- (1) In order to be just, a debt contract must be entered into on the basis of informed consent, i.e. the borrower must know and understand the terms and conditions of the agreement.
- (2) Poor debtors are less likely to know and understand the terms and conditions of a debt agreement.
- (3) Therefore, debt contracts are more likely to be unjust in the case of poor debtors.
What this argument is highlighting is the need for financial literacy among debtors. The support for premise (2) comes from a set of studies suggesting that the demands of financial literacy are much harder for poor debtors to satisfy than those from well-off backgrounds. Herzog summarises the results of those studies in her article (if you click on each instance of the word ‘studies’ in the following quote you will be linked directly to the ones she cites):
Studies confirm, for example, that subprime borrowers were far less knowledgeable about types of mortgages and interest rates than prime borrowers… Studies LINK indicate that financial literacy is distributed according to clear socio-economic patterns: it is higher for men than for women, and positively correlated to education scores. As Lusardi and Mitchell emphasize, summarizing the empirical evidence: “Financial savvy varies by income and employment type, with lower-paid individuals doing less well and employees and the self-employed doing better than the unemployed”.
(Herzog 2016, 9)
This lack of financial literacy means that poor debtors tend to enter into debt contracts with less favourable terms and conditions and higher costs. Think, for example, of the 2-28 mortgages that many sub-prime borrowers agreed to in the lead-up to the 2008 crisis. These mortgages charged very low, teaser interest rates for the first two years before a much higher interest rate kicked in. This often meant that unless the borrower could sell their house at a higher price within two years, the mortgages would be untenable. It’s clear that some people entered into these agreements without fully appreciating their ramifications.
2. The Argument from Lack of Access to Regular forms of Credit
There are debt contracts and then there are debt contracts. If you are from a middle-class or upper-class background, you probably have a particular conception of what a debt contract is and how you go about securing one. It usually means going to a bank or building society and seeking a loan to pay for a house or a car (or some other large expenditure item). In other words, it entails going to a (hopefully) well-managed and well-regulated financial institution that will offer you reasonably favourable terms of credit (relatively low interest rates, with repayments to take place over a reasonable timeframe). The financial institution will not treat you with suspicion or derision; they will try to meet your needs on the best terms. If you run your own business or are involved in commercial financing, you may be familiar with other forms of credit, but again they will typically be sought from mainstream financial institutions on reasonably favourable terms.
If you are poor, you may be shut out from this world of debt. Banks may not even entertain the possibility of giving you a loan because you fail to meet their criteria (or some legally imposed criteria) for a preferred borrower. If you lack a regular place of residence, for example, you are automatically excluded from many types of credit. If you lack a bank account, the situation is even worse. This means you lack easy access to regular forms of credit and may have to seek it from less favourable and less-friendly sources, e.g. loan sharks and payday loan companies. We can express this argument in more formal terms, as follows:
- (4) In order to be just, the market for credit should be equally accessible to all, i.e. everyone should, in principle, have access to the same types of credit.
- (5) Those from poor backgrounds are likely to be shut out or denied access to certain forms of credit.
- (6) Therefore, the market for credit is not just.
Expressing the argument in these terms highlights a problem. Surely banks and other financial institutions are justified in denying some people access to credit? Wasn’t the financial crisis of 2008 caused by the over-extension of credit to people who were unable to meet the repayment conditions? Wouldn’t it make things much worse, for everyone, if everyone had equal access to credit?
Two points can be made in response to this. First, we need to specify what ‘equal access’ actually means in this context. It may not mean that people should be entitled to the same credit terms — some individualisation of the terms and conditions of agreement would be appropriate. A poor person could have equal access to different forms of credit without necessarily having the same terms and conditions of repayment. Second, a distinction should be drawn between a poor person who is insolvent, and therefore would not be capable of repaying a loan, and a poor person who is merely illiquid, and therefore faces some difficulties in meeting certain repayment schedules. The former would be a major credit risk but the latter need not be. The concern about equal access could then be recast as a concern that the kinds of exclusion criteria used by banks (e.g. information about address and personal background) do not adequately distinguish between the different forms of poverty. Herzog makes this point specifically in relation to the scoring technologies that banks use to deny people loans:
For example, scoring technologies often draw on data such as postcodes, which means that applicants from poorer areas are automatically rated as “riskier” than others. Individuals are thus evaluated not on the basis of what they have done or want to do, but rather on the basis of where they come from, without any attention to their specific situation.
(Herzog 2016, 11)
Scoring algorithms can thus be seen to erect invisible barriers to credit that unfairly target certain populations.
3. The Argument from Higher Costs
The lack of access to regular forms of credit has a knock-on effect for the poor: it means that when they do obtain credit they must obtain it from alternative sources, and usually at much higher cost. The classic example is the payday loan: a short-term loan, usually given in order to meet immediate financial needs, with a high interest rate. The name originates in the practice of giving people an advance on their paycheck, but now applies outside of that context. The person seeking the loan agrees to repay the amount on their next payday. Payday loans are typically unsecured and have highly unfavourable terms. Annual percentage rates (APRs) of more than a 1,000% are not unheard of. If you are in particularly dire straits, you may ‘rollover’ your payday loan, i.e. use a new loan to meet the repayment of an old one. This can lead to some exceptionally high costs of borrowing:
Extreme examples sometimes make headlines, such as the case of a man who allegedly paid $50,000 of interest on $2,500 of payday loans that he had to take out in order to cover medical bills for his wife and the subsequent loans he took out to pay back the first ones.
(Herzog 2016, 13)
If you suffer from occasional periods of illiquidity, you are more likely to require such a loan. Poor people are, for obvious reasons, more likely to suffer from such occasional periods of illiquidity. As Herzog notes, there is a double injustice in this. The standard economic argument for debt is that it enables people to smooth out their consumption over the course of their lifetime, i.e. borrow from their future incomes in order to pay for current consumption. But, of course, this comes at a cost of some sort: you have to pay slightly more in the long-term in order to benefit from the immediate use of the money. This places you at a disadvantage relative to someone who has the funds available to cover their expenditure needs. The problem is that poorer people are likely to require more of this ‘consumption smoothing’ due to their general lack of funds. Indeed, many times they will have to borrow to meet unforeseen expenses. So they are more regularly placed in a position of disadvantage relative to social peers. This is then made worse by the fact that they are charged an additional premium for their credit they do obtain.
You might argue the high cost of credit is justifiable — that it accurately reflects the additional risk involved in making loans to poorer people. But Herzog doubts this. She argues that some additional cost may be justified but that the exceptionally high cost of credit that we observe in ‘fringe banking’ (e.g. payday loans) is likely to represent some exploitation of the financial illiteracy of the people seeking those loans. As she puts it, the high interest rates charged are probably not ‘an undistorted market equilibrium [but] rather an expression of market power and one-sided dependence’ (Herzog 2016, 12).
4. Conclusion
The upshot of the three arguments is that poorer people are significantly disadvantaged by the current structure of our debt markets. The three arguments outlined above combine to make their position particularly bad: (i) they have less financial literacy, and so are less likely to understand what they are getting themselves into and more likely to be exploited by lenders; (ii) they are automatically shut out from the market for regular forms of credit; and (iii) because of (ii) they have to seek credit from less favourable, less salubrious corners of the market. This may well open them up to other mechanisms of injustice, such as social exclusion and stigma due to their debt problems.
Herzog closes her article by considering some potential legal and regulatory responses to the structural injustice of the debt market. I’m not going to discuss these solutions in any great depth. In general, she suggests that we should reconsider how we distribute financial risk in society. At the moment, debt contracts tend to place all the responsibility on the individual borrower if things go wrong, but we should consider redesigning them so as to redistribute some of the risk onto lenders and the broader society. Individual bankruptcy rules already do this to some extent, but more could be done. Contingent debt contracts are one solution she mentions: these would include automatic rescheduling of repayments or recalculations of interest rates if certain conditions obtain (e.g. automatic rescheduling of mortgage repayments if house prices fall). This happens, already, through individual renegotiation of debt contracts, but including it as a default rule could ease the burden on poorer debtors who face a significant inequality of bargaining power relative to the financial institutions with whom they are trying to renegotiate.
I’m certainly a fan of the idea of rethinking how we distribute financial risk, particularly given that we live in a world in which banks are often bailed out for their own reckless borrowing and lending. But I tend to think there is deeper issue here: our inflationary, debt-based, monetary system, given its current structure, is fuelling our need for for more and more debt. Governments pour money into banks; banks lend this money in a way that drives asset price booms (particularly in property), which in turn create a greater pressure for debt-financing by ordinary citizens. Until we do something to address those pressures, tinkering with the default rules in debt contracts is unlikely to be that helpful.
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