Do Lower Legal Interest Rates Actually Reduce Borrowing Costs?

The problem with maximum interest rates is that they increase the marginal cost of borrowing

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Recently, a bipartisan bill was introduced into the U.S. House of Representatives that would restrict the interest rate on credit cards to a maximum rate of 10 percent. Economists are not big fans of price controls. As a result, it is no surprise that a number of economists have criticized this proposal. However, much of the focus of the criticism has been related to access to credit. I think that the focus on access to credit is somewhat misplaced. Instead, price theory would seem to suggest that the welfare effects would largely be driven by the extent to which such controls increase the (pecuniary and non-pecuniary ) cost of borrowing for the marginal buyer.

Price Controls, Willingness to Pay, and Adjustment on Other Margins

A maximum interest rate on credit cards is just a price ceiling (a legal maximum price). Often times, the standard introductory textbook will discuss price ceilings as follows. Suppose that a price ceiling is binding such that the legal maximum price is below the price that would typically prevail in the market. At that legal maximum price, the quantity demanded exceeds the quantity supplied. There is a shortage. Typically, the price would adjust to relieve the shortage. However, since the price cannot be legally increased, this shortage persists. The standard textbook might also list some other things that might happen, given the price ceiling, but this is typically as far as it goes.

Like any other market, one can think about the market for borrowing and lending. The supply of funds to be lent out is the typical upward-sloping supply curve. The higher the interest rate, the more funds lenders are willing to supply to borrowers. The demand for funds is the typical downward-sloping demand curve. As interest rates rise, the demand for funds to borrow declines. Thus, the standard logic of a price ceiling applies. A legal maximum interest rate below the market rate would increase the quantity of borrowing demanded and reduce the quantity of funds available to borrow. There would be a shortage of funds at the legally-imposed maximum interest rate. This provides a baseline for why criticisms of the proposed policy tend to focus on access to credit. Clearly, if there is an excess demand for credit, then credit must be rationed in some way other than the interest rate. This could be done by reducing credit limits on credit cards or by not allowing some people to have access to the credit card any longer.

However, excess demand isn’t actually the end of the story. The reference to the list of other things that can happen as a result of price ceilings that I mentioned above is actually where all of the interesting price theory is to be found. Let’s consider why that is.

When a price ceiling is implemented, the willingness to pay for the quantity supplied is higher than the previous market price. For the lending market, this implies that the marginal borrower is willing to pay a higher interest rate than the prior market rate. However, lenders cannot legally charge that amount. In order to try to capture some surplus, the lenders have an incentive to lower their marginal cost below the legal maximum interest rate. This could happen with existing lenders who eliminate costly provisions of “quality” associated with the credit card. For example, this might include the elimination of a credit card rewards program, reductions in the level of customer service provided, or even the introduction some costs on customers associated with chargebacks. It could also happen if new, lower-cost, but lower quality lenders enter the market.

A reduction in the “quality” of the lending products, however, would also have some effect on demand. For example, some borrowers who value the services provided by the credit card might reduce their demand for this type of credit.

The important lesson here is that lenders are likely to adjust on other margins. A reduction in the quality of service provided by the credit card company would reduce its marginal cost and thus tend to increase the quantity supplied of credit at the maximum interest rate. At the same time, these reductions in quality would result in some people reducing their demand for credit card services. This would tend to reduce the quantity demanded for borrowing at the maximum interest rate. The net effect of the adjustments I just described is that they reduce the degree to which there is excess demand at the maximum interest rate.

Thus, in terms of the costs associated with such price controls, access to credit would decline by less than the typical crude supply and demand analysis would suggest. Firms and customers adjust on other margins.

Access to Credit and Consumer Welfare

When thinking about credit, economists tend to think about lifecycle decision-making. Consumers tend to prefer to maintain a relatively constant standard of living. However, earnings over the lifecycle might not be consistent with this objective. Income varies in predictable ways by age, but there are also unexpected changes in income associated with good times (bonuses) and bad times (unemployment). Ideally, consumers can use saving and borrowing to smooth their consumption over time. For example, an unexpected period of unemployment might be a time to draw down one’s savings or to go into debt to maintain similar levels of consumption. The savings can then be replenished or the debt paid down when the consumer finds employment again. Saving and borrowing allows consumers to effectively transfer income from good times to bad times.

When we think about cutting off access to credit in this context, it seems almost obviously bad. Cutting off access to credit is just equivalent to imposing a borrowing constraint — and constraints make people worse off. However, the focus should always be on the relevant counterfactual and the marginal decision-maker.

As I noted above, there is some reason to believe that access to credit wouldn’t decline as much as a crude supply and demand analysis would suggest. Nonetheless, access would decline. But for whom does it decline?

The marginal borrowers who are likely to lose access to credit are the riskiest borrowers and the least credit worthy. Those who are less risky and have better credit histories will have access to alternative, cheaper forms of credit than credit cards.

All else equal, riskier borrowers are also more likely to file for bankruptcy. In fact, this is one reason that interest rates on credits cards are higher (even much higher) than alternative forms of credit. Credit card debt is unsecured debt. There is no posted collateral for the card issuer to claim in the event that the consumer defaults. As a result, the issuer charges higher rates of interest to compensate for these expected losses.

But bankruptcy is also the most relevant detail for addressing the counterfactual for the marginal borrower — at least as it pertains to access to credit. Bankruptcy provides a benefits to borrowers in the sense that it allows the borrower to discharge debt. However, bankruptcy also comes with a cost in the form of limited access to credit in the near future. In fact, this limited access goes beyond credit card debt. As a result, reducing access to credit today would impose a cost on risky borrowers in the sense that they might no longer be able to borrow the desired amount. Nonetheless, to the extent to which it reduces borrowing now, it also makes it less likely that the consumer would find himself (or herself) over-indebted in the future and thus less likely to file bankruptcy and face a future credit constraint.

Put differently, risky borrowers already face some probability of a more restrictive credit constraint in the future. Thus, what this sort of restrictive credit card policy might do is simply reallocate credit constraints across time. In some sense, the policy might impose a credit constraint now while making future — and likely more severe — credit constraints as a result of bankruptcy less likely. The welfare effects of such a change seem ambiguous since the costs are being reallocated across time and would depend on a variety on factors. For example, how much does the restriction now reduce the likelihood of bankruptcy in the future? How much more severe would future borrowing constraints be in comparison to that imposed by the credit card law? How much should future costs be discounted relative to present costs? If the reduction in the probability of bankruptcy is small and/or the future constraints aren’t all that more severe than the current constraint, then the policy would clearly be welfare-reducing for this group. Regardless, it is likely that the net effect on welfare is negative. Nonetheless, the potential for the intertemporal substitution of costs (or expected costs) suggests that this should not be the primary focus of the argument.

The Importance of the Marginal Willingness to Pay

None of this is meant to imply that restrictions on interest rates would be good. Rather, the point is that focusing on the access to credit is somewhat misplaced. So where should we focus?

The main focus of our analysis should be on the degree to which the marginal willingness to pay differs from the maximum legal interest rate. On this point, it is important to note that adjustments on other margins, such as quality, will tend to reduce the marginal willingness to pay. Thus, the focus should be on the distance between the marginal willingness to pay and the maximum interest rate after all adjustments on other margins have been made. This focus is important. One might be tempted to argue that this distance helps us to measure consumer surplus. However, this is misleading.

In a competitive market, the difference between the willingness to pay of consumers and actual costs is consumer surplus. In a market with a price ceiling, there is an additional layer of competition such that the total amount that we should expect people to pay (measured in interest costs) is equal to the willingness to pay of the marginal borrower for access to credit. To the extent to which these costs are paid to someone else in the economy, such as a payday lender, these are just a transfer. Borrowers are worse off, but the payday lenders are better off. However, to the extent to which these costs are paid in terms of time or in terms of expected future costs of dealing with a loanshark, these are not transfers. These are losses that accrue to no one.

Put differently, even though the standard analysis tends to focus on excess demand, which in this case is concerned with access to credit, the much larger costs come from the fact that there is greater competition for access to credit as a result of the fact that credit is limited and must be rationed with using interest rates. Once one fully considers the dynamic effects of changes in access to credit and the adjustments made on other margins, the direct welfare consequences of the reduction in the access to credit seem like they would actually be dwarfed by the costs of all of the resources that are wasted as people engage in a variety of forms of non-price competition.

In other words, the larger problem with the proposed law is that it doesn’t achieve the intended goal, which is to lower borrowing costs. Total borrowing costs (once on includes both pecuniary and non-pecuniary costs) are likely to rise for the marginal borrower who retains some access to credit due to wasteful non-price competition.