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Sean Gabb of the Libertarian Alliance in the UK has produced an excellent essay dismantling the British government’s announced plans to cap the interest rates on personal loans. “Loan sharking” strikes many people as a rather contemptible activity, and hence something the government ought to prohibit. Actions have consequences, however, and putting a cap on interest rates means that people who desperately need loans but are very bad credit risks—the people whom lenders must charge higher than average rates—simply won’t be able to get loans.
As with the minimum wage, such seemingly kind-hearted government regulations price the neediest people out of the market altogether.
Gabb’s essay expertly critiques the proposed law through an analysis of the principles behind it and a concise education about how loans really work:
The reason I can borrow at about five per cent is because I have a known record of paying my debts. And, if I cannot pay them in future, I have assets that can be seized after the appropriate legal action. The reason other people are charged much higher rates is because they have a poor credit history. Or, if they have no history, they fall into one of the categories of people who cannot easily be made to pay their debts. These categories include the young, those without assets, habitual defaulters, those who are able to move about the world or to disappear without trace, and the generally feckless.
Loanable funds are perfectly mobile. A lender can do business with people like me, or with young men without assets who have already been made bankrupt at least once. He will expect to walk away from either class of deal with the same overall return. If lenders can make more overall from this second group, they will compete with each other for business, until the rate of return has fallen to the same as can be earned on loans to the first group. Therefore, someone who is charged 1,000 per cent on a loan is not necessarily being exploited. He is being charged a premium that takes into account his perceived risk of default.
Therefore also, any cap on interest rates to those at high perceived risk of default will result in a drying up of loanable funds. As said, these funds are mobile. They will move out of markets where overall returns are lower than elsewhere. If some people cannot be charged 1,000 per cent on loans, they will not be able to borrow at all.
Or they will be able to borrow – but not from people in suits who try to collect unpaid debts through letters sent in brown envelopes and through the courts. When these people vacate a market, because of legal caps on rates of return, their place will be taken by real loan sharks – the kind of people who collect debts by threats of violence, and who, because of the risk of punishment, and the limitation of competition, will charge more than the lenders they have replaced.
For this reason, limiting interest rates will not help the poor. Indeed, even without the criminality of the loans markets that emerge in the shadow of interest limitations, this kind of law is bad. A loan is an act between consenting adults. It is of exactly the same nature as any other financial or other transaction. Any restriction in one area on freedom of association will, by example, encourage restrictions in others. It will encourage further state socialism or moral authoritarianism.
It’s well worth reading in its entirety.