Friday, December 19, 2008

The Black Market for Credit

The current credit crisis seems to me like a perfect illustration of what happens when the governmnet tries to establish price ceilings for goods in high demand and low supply. One of the effects is scarcity: if banks are supposed to lend at effectively zero, they will refuse unless forced to by the government. That's no different from farmers refusing to sell their grain at government mandated prices below the free market price. 

But - does this mean there is no credit available? I don't think so - if I went to the local Money Mart, I could get credit on the spot. At a price. Not the fictional interest rate set by the government, but the interest rate agreed to by free actors in a free market. Granted, many people who use payday loans are high-risk folks who take drugs, gamble, and are otherwise indulging in that most expensive of hobbies - stupidity. So one should not be surprised that these folsk are charged pretty stiff interest rates.

But, it is no longer only druggies and gamblers who use these services, but increasingly
middle class folks as well. And to make matters even more interesting, the effective cost of borrowing from banks seems to be going through the roof as well.

It's easy to decry the payday loan folks as loan sharks, and
to seek some kind of political solution. But this misses the basic problem that the price of credit is far above the official interest rate. High average interest rates mean at least two things. The first, and most obvious, is that there is a growing number of people who are unlikely to pay back the money they are lent. Interest rates are compensation for risk, and the higher the risk, the greater the interest rates. More and more people likely to declare bankruptcy is clearly not an indicator of a stable economy. 

The second is less obvious - and I may be wrong about this - but rapidly rising interest rates can also mean that lenders feel the need to protect themselves against inflation. Charging the official interest rate would not be profitable even if the debtor was completely solvent and guaranteed his job for many years to come. Lenders not only have to secure themselves against the risk of individual debtors going bankrupt, but also against the effects of inflation.

So, maybe the interest rates charged by payday loan operators - when averaged out over the entire economy - are also an indicator of inflation? Maybe even a better indicator of inflation than many others? I haven't given much thought to how one could calculate this, but maybe somebody smarter than I - and with access to good data - could.

One thing, however, is clear: there is no difficulty to get credit - if you are willing to pay the market interest rate. The reason banks are not lending is that they are not willing to lend at the 'official rate'. Go to your local bank and offer them 30 percent interest, and I'm sure you'll get a loan (provided you have collateral). After all, if your local payday loan operator will be more than happy to lend you money for the right price - why wouldn't banks with their much greater resources want a piece of the action as well?

If you want a loan, you can have one - just be willing to pay the market price.

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