Usury Laws: Are They Justified?
Shiva Thiagajaran '05
Restrictions on the rate of interest are probably the oldest and most ubiquitous forms of economic regulations. Among the oldest known references to usury are found in the Vedic texts of ancient India (2000-1400 BC) and the legal codes of the Babylonians. The practice was condemned in several books of the Bible, and it was banned under the Lex Genucia reforms in Republican Rome of 340 BC (Visser and McIntosh, 1998).
Over the course of history, however, usury would become a more relative term. Steps towards redefining usury as charging a rate of interest that was too high, rather than simply charging any interest at all, include those taken by Julius Caesar, who set the maximum rate at 12% (Visser and McIntosh, 1998), and in India by the Laws of Manu, circa 100 AD, which stipulated that "interest beyond the legal rate, being against the law, cannot be recovered" (Jain, 1929: 10). In Europe, the increase in economic activity and the expansion of personal freedom that came with the Renaissance and advent of Protestantism forced modifications of laws governing money lending (Bowsher, 1974). Interest came to be seen as justified, but the belief continued that borrowers should be protected by excessive interest charges.
While usury laws were phased out in much of Europe in the latter half of the nineteenth century, they persist to this day in many countries of the world. Japan and Korea, for example, have severely restricted interest rates (Glaeser and Scheinkman, 1994). In many Islamic countries, it is illegal to charge interest, or riba, unless it is tied to profits. Usury laws are prevalent in the United States as well, where most states have laws setting limits on interest rates.
In this paper, I attempt to answer the question of whether interest rate regulations of this sort are justified. I will present the arguments cited in favor of such regulation, and also those that make the case for abolishing it. In the ensuing discussion, I hope to show that usury laws are inconsistent with a liberal economic regime and are misguided attempts to protect the small borrower or to stimulate investment; often, they achieve the opposite of their objectives. Finally, I propose some steps that may be taken, including the repeal of all usury laws, to increase the efficiency and fairness of the credit markets.
The Philosophical Angle
Arguments for Usury Laws
Those opposed to the charging of any interest whatsoever invoked moral arguments to justify their stands. Aristotle and Plato viewed money lending as a morally questionable act, and believed that the pursuit of commercial interests as an undesirable distraction from man's purpose of serving the state (Glaeser and Scheinkman, 1995). Christian and Muslim thinkers viewed interest as unearned income. Unlike agriculture or trade, money lending was not seen as a value-creating process, nor was it seen as an enterprise requiring labor, expense or risk. "To live without labor was denounced as unnatural, and so Dante put usurers in the same circle of hell as the inhabitants of Sodom and other practisers of unnatural vice" (Birnie, 1958: 4).
The stand that interest is unjustified is now rightly discredited. By lending his or her money, the lender substitutes present spending power for spending power in the future, and this must be compensated. If the borrower were to put the money to productive use and earn a profit as a result of having taken out the loan, the lender should be entitled to some of it. Furthermore, every loan has some degree of risk associated with it, and for the lender to break even on a basket of loans he or she must be paid, in addition to the loaned principle, an additional percentage equal to the percentage rate of failure of his or her loans. To this percentage rate must also be added the rate of inflation. Interest, therefore, is justified, and so any argument in support of usury laws in order to be taken seriously should argue not for an abolition of interest altogether, but for a maximum permissible interest rate.
The most often cited argument against interest rate restrictions is the libertarian argument of Bentham, Mill and the like. Underlying this argument is the strong belief in the virtues of contractual freedom. This view holds that the parties of the transaction alone should set the terms of the transaction. If a borrower is willing to pay a high interest rate for a loan that she believes is for her benefit, any law that prevents the pareto improvement from taking place (by making it illegal for the lender to lend her the money at that interest rate) is inefficient and illiberal. Bentham (quoted in Coco and de Meza, 2000: 3) sums up the argument as follows:
My neighbours, being at liberty, have happened to concur among themselves in dealing at a certain rate of interest. I, who have money to lend, and Titus, who wants to borrow it of me, would be glad, the one of us to accept, the other to give, an interest somewhat higher than theirs: Why is the liberty they exercise to be made a pretence for depriving me and Titus of ours?
Mill was of the opinion that usury laws were an undesirable "interference of government grounded on erroneous theories," and that their existence was due to irrational beliefs (Coco and de Meza, 2000: 3). Such government interference is more than just philosophically questionable. It also has the effect of excluding those high risk borrowers such as the temporarily poor, who would not be able to borrow at a low rate, from the credit market, thereby denying them access to the funds needed to tide themselves over for the duration of their temporary poverty. For the liberal economic environment prevailing today to extend to the credit market, lenders should be able to charge any rate of interest that borrowers who are aware of the consequences of their actions would be willing to pay.
Protection of Borrowers
Arguments Supporting Usury Legislation
Historically, usury laws have been employed to protect the small borrower and to curb the monopoly power of the creditor. In developing countries like India, usury laws are seen as a way of improving the financial situation of the small agriculturalist. Government officials are often of the view that the farmer, who must borrow to purchase seed, fertilizer and other inputs, and who sells his produce to the same individual, the middleman, is exploited in each transaction. The power of the middleman is attributed to his control over credit. Since the farmer cannot function without borrowing, the argument goes, the moneylender can charge an exorbitant interest rate, thereby making a large profit at the expense of the impoverished farmer. To repay his loans, the farmer must sell his crop immediately after the harvest, the least favorable time, and thus sees most if not all of his labor evaporate in debt payments (Long, 1968). Moreover, as the final purchaser of the farmer's produce and therefore as the farmer's only customer, the moneylender wields additional exploitative power. It thus appears that a solution to this unfortunate state of affairs would be to limit the rate of interest that the lender can charge and thereby prevent the exercise of monopoly power. This notion, and the fact that farmers often hold much political power, is a strong force holding usury laws in place in developing countries.
Usury laws as safeguards against loan sharking extend to developed countries as well. The premise is that most lenders are knowledgeable about the conditions in the credit market in which they operate, while many borrowers are "unsophisticated and naïve" (Bowsher, 1974). In several cases, the borrower may be unaware of the rate of interest he or she is paying, and rarely ever studies conditions or shops around for better terms. Given this, loans made to unsophisticated borrowers at rates higher than those existing in the market for similar types of loans are a distortion of competitive forces and lead to above-normal profits to lenders.
Why These Arguments Fail
Advocates of usury laws would argue that usury laws exist to protect the naïve borrowers who are not aware of the consequences of their actions. Gullible credit applicants would ostensibly enter into oppressive contracts without such laws. But why single out the credit market for such laws protecting against oppressive contracts? Are not individuals as likely to be gullible in their dealings in other markets? It would be more efficient to provide education and counseling of borrowers rather than imposing rigid laws on the entire market (Bowsher, 1974). The Federal Truth in Lending Act is a step in this direction. It requires creditors to disclose the terms and cost of credit they extend to consumers (Senate Committee on Economic Development, 2000). Armed with such information in a competitive credit environment, borrowers should be able to make informed decisions regarding loans, and so usury laws that are meant to protect them from making uninformed decisions cease to be useful.
In developing countries, however, especially in rural areas, the credit markets are generally not very competitive. The case for usury laws as instruments to protect farmers from monopolistic moneylenders is then easier to make. In India, for example, one of the reasons cited for the high prevailing rate of interest for agricultural loans is the low density of moneylenders. But Long (1968) argues that the figures are misleading, and that apparent monopolies are in actuality more competitive once we consider creditors who do not view themselves as moneylenders, as well as loans obtained from outside the village.
In the case of agricultural credit markets, it is likely that the high interest rates on loans are not as much a result of credit monopoly as on factors specific to the market. Most loans, for instance, are unsecured, and involve relatively small sums of money. Administrative costs are thus correspondingly higher. More important, though, is the increased risk of default. Most moneylenders lend to farmers in their own geographic region, and so the crops of the majority of their debtors can fall prey to the same natural disaster (Long, 1968). Portfolio diversification is therefore difficult, and hence they are forced by their circumstances to bear additional risk. This risk must be compensated by higher interest rates.
While such rates are difficult for the farmers, they are necessary to ensure that the moneylender continues to lend. Laws restricting interest rates could have the effect of making the money lending enterprise less than worthwhile, thereby harming the farmers who depend on it. The problems involved in agricultural loans, therefore, cannot be eliminated by setting a maximum interest rate. They can only be solved by fostering a competitive and integrated money market, perhaps by encouraging microfinance and by liberalizing the banking and insurance sectors, and by encouraging better agricultural practices that allow for diversification, such as the use of irrigation, pesticides, and crop rotation.
High rates of interest are not exclusive to developing countries. Consumer finance loans in the United States, such as Subchapter F and 'Pay Day' loans, command high rates of interest as well (Senate Committee on Economic Development, 2000). The reasons are similar. The loans are small, unsecured, and of short duration, and so the associated administrative costs are high. Borrowers are also usually high-risk individuals who borrow to finance consumption expenditure during periods of temporary poverty.
Usury laws that fix ceilings below the rates required to make such loans would thus be undesirable, as they would prevent these mutually beneficial transactions from occurring. Such a situation fosters illegitimate loan "sharks" with exorbitant interest charges and violations of the Truth in Lending Act. The costs of operating outside the law are high in order to compensate the creditors from the risk of government prosecution (Blitz and Long, 1965), and these costs are passed on to the borrowers. Interest rates can thus be several times the level that would have existed in the absence of ceilings. Interest rate ceilings can actually hurt the small borrower.
That usury laws often weigh heaviest on the most risky credit seekers is further corroborated by a study conducted by Miller (1973). He analyzed consumer loans from credit card companies in Washington state. Consumer advocates felt that the prevailing rate of 18% was too high for poor people, and successfully lobbied for a referendum in 1968 that reduced the maximum rate to 12%. At that rate, however, credit demanded exceeded the amount supplied. Not surprisingly, it was the people with the weakest credit worthiness, like welfare mothers, students, the elderly, and people with records of unstable employment, who were denied credit. On the other hand, those with the most wealth, the best jobs, and the highest probability of repaying the loans, were the ones who benefited from the reduced rate.
It is helpful to turn back to India - specifically, colonial India of the nineteenth century - to shed more light on the effects of usury laws on an underdeveloped economy. India in this period was a land of stark inequalities of wealth and income, and so serves as an instructive example for discussing whether usury laws are, as proponents claim, useful in preventing the inequitable distribution of wealth associated with lending and borrowing by different sections of society.
Systematic legislation on usury laws was introduced in India in 1793 by the British (Natarajan, 1939). By 1826, the East India Company had started issuing bonds in the open market, and probably with the view of raising more money, embarked on a study to assess the effects of the interest rate regulations and to consider the possibility of further reductions in the ceiling. The majority of district collectors were of the opinion that the usury laws had not worked. For example, the collector of Cuddappah, a Mr. Harris, believed that the rate of interest was better left to the forces of supply and demand, since "the natural price of money will make its way through a country with little obstruction, in defiance of the legislatures of the most powerful Government" (quoted in Natarajan, 1939: 188). He went further and suggested that the interest rate be allowed to rise (Ibid.):
When there is little money in a country, the natural high rate of interest so far from being evil to the people is their salvation. It prevents the waste of money and directs it in outlets where it is most wanted and most useful. It creates domestic economy and industry. So [people] will live as sparingly as they can with comfort for two strong reasons, viz., to avoid the necessity of borrowing and to obtain the advantages of lending.
The reports of civil servants like Harris reveal the state of rural finance during the period, and suggest that usury laws did not have the intended effect on the populace.
One of the reasons for why this was true is the ease with which usury laws can be circumvented. In Coimbatore district, when money was lent at rates higher than 12%, the difference was entered into the principle and the interest was made payable on both; in Madura district, it was the practice for the moneylender and the borrower to agree on a rate of 1.5% per month separate from the bond (Natarajan, 1939). The practice of evading the law seems to have been common in many districts. Mr. Gardiner, the collector of Vizagapatam, said: "I consider it very desirable to lower the rate of interest if possible; but feel satisfied that any enactment for that purpose would be evaded...This practice exists among the natives and would be carried to a much greater extent, I apprehend, if the legal rate of interest was lowered" (quoted in Natarajan, 1939: 190).
This practice of evasion is a powerful argument against usury laws, and can be seen everywhere where there are restrictions on interest rates. In the United States, one imaginative way in which usury laws are evaded is through 15-day sale/leaseback contracts, in which the borrower 'sells' a personal item, such as a television set, to the lender, who then leases it back to the borrower. Usury laws, therefore, while not only being violated (and therefore useless), also encourage "falsehood, injustice and treachery in defendants; falsehood and subordination of false evidence in plaintiff and perjury in witness" (Bentham, quoted in Natarajan, 1939: 187).
The failure of usury laws to protect the small borrower is a crushing blow to advocates of interest rate restrictions. With the rise of consumer lending in the United States, they responded by recognizing that higher rates should be allowed on small loans (Bowsher, 1974). In this way, usury laws could be better justified if different maximum rates were applied to different types of loans (for example, classified by rural or urban, by size, by geographical area etc.). However, this would require considerable analytical and administrative sophistication. Blitz and Long (1965) suggest that instead of attempting to regulate with such a complex usury legislation, it may be simpler and more efficient to do away with usury laws and instead work toward making markets more competitive.
The Economics of Usury Legislation
Justifying Usury Legislation
Surprisingly, one of the proponents of usury laws was Adam Smith, who evidently did not believe that the reach of the invisible hand should extend to the credit market. Smith believed that high interest rates had an adverse selection effect on the quality of loans. In The Wealth of Nations he stated that if it were possible to charge high interest rates, "the greater part of the money which was to be lent, would be lent to prodigals and projectors, who alone would be willing to give this high interest" (1937 : 339). If, on the other hand, the legal rate of interest were fixed at a little above the market rate, "sober people [would be] universally preferred, as borrowers, to prodigals and projectors" (Smith, 1937 : 340).
Another argument comes from Keynes' General Theory. Keynes believed that throughout history, the propensity to save was stronger than the inducement to invest, and that this "weakness of the inducement to invest has been at all times the key to the economic problem" (1936: 348). He believed that a ceiling on interest rates would increase investment, thereby leading to an expansion in output through the multiplier. In his opinion, "a wise Government is concerned to curb [interest rates] by statute and custom and even by invoking the sanctions of moral law" (Keynes, 1936: 351). Usury laws would counter the tendency towards inadequate investment by lowering the "hurdle rate" sought by investors, as long as funds were available (Coco and de Meza, 2000). In Keynes' model, a reduction in interest rates would cause borrowers to want to borrow more, but would reduce the amount lenders would want to lend. Lenders would therefore devote more money to capital rather than to debt, and borrowers' increased demand for cash balances would translate into increased consumption. By reducing the propensity to save in relation to the inducement to invest, usury laws would help fuel growth by leading to an expansion in spending. According to Keynes, therefore, interest rates, being an essentially monetary phenomenon with potentially vast real effects, could and should be manipulated to increase investment (Coco and de Meza, 2000).
Adam Smith's support of usury laws, while surprising, is hardly justified. As mentioned earlier, he believed that if it were possible to charge high rates of interest, money would be lent to "prodigals and projectors," who, unlike the "sober people," would be willing to pay for it. This does not have to be the case. Lenders would recognize this adverse selection effect and act to curb the interest rate below market clearing level in order to safeguard their own interests. Smith's prodigals, who borrow for consumption spending, would be granted credit at lower interest rates if they were able to offer collateral. More importantly, as Bentham pointed out, it is the projectors, or the innovators, rather than traders engaged in established activities, who are responsible for economic progress (Coco and de Meza, 2000). Innovation carries high risk, and can only be funded at high rates of interest, and so limiting the allowed interest rate with the aim of preventing innovators from borrowing would stall the engine that drove economic growth.
By contrast, well-established businesses, and for that matter wealthy individuals, are able to borrow at considerably lower interest rates. Ceilings on interest rates prevent higher risk borrowers, such as small innovative firms, from competing for funds, and so a larger proportion of available credit flows to the lower risk applicants. The anticompetitive effects of interest rate restrictions are consequently spread from credit markets to goods and services markets (Bowsher, 1974).
It is also possible to point out possible flaws in Keynes' argument in support of usury. A decrease in lending does not necessarily imply, as Keynes suggests, a corresponding increase in investment. Keynes' model implicitly assumes that former debtors borrowed cash and held it in the form of substantial additional cash balances, and that potential creditors for whom lending is made unattractive would invest as much in physical capital as would their debtors if there were no interest rate ceiling (Blitz and Long, 1965). These assumptions seem implausible; Blitz and Long's analysis suggests that usury laws have the effect of actually decreasing investment. Even if they do stimulate investment, arbitrarily low interest rates discourage savings, thus placing an upward pressure on interest rates. Rates can then only be maintained at an artificially low level by some form of non-price rationing or by the creation of money and credit at an accelerating pace, actions which reduce efficiency or contribute to inflation, respectively (Bowsher, 1974).
The adverse economic effects of usury laws are well-illustrated by real-life examples. In his report to the Federal Reserve Bank of St. Louis, Bowsher discusses some such examples from the Eighth District. For example, commercial banks in the district tended to lend in the unrestricted Federal funds market rather than locally under "oppressive" interest rate ceilings - net Federal funds lending was $368 million in 1973-74, when the Federal funds rate was 10.3%, as opposed to $283 million in 1972-73 at a rate of 7.3%. Interest rate ceilings were 8% in Illinois and Missouri, and 8.5% in Kentucky, and so loans to individuals and firms in those states were rendered uncompetitive by rising interest rates elsewhere.
We thus see that one consequence of usury laws is that lenders in states with low usury ceilings will be tempted to move funds out to states with more liberal laws. As a result, businesses and individuals in states with higher usury ceilings find it easier to obtain funds, and can therefore be more competitive. This competitiveness comes at the expense of those in states with low ceilings, where economic activity suffers. To counter this, states like Missouri allow large corporations, which are assumed to be capable of protecting their interests when dealing with lenders, to take out loans at any interest rate (Bowsher, 1974). Not surprisingly, these large corporations have a huge advantage in attracting funds over more 'protected' firms and individuals.
In this paper I have discussed the various philosophical, political and economic arguments that have been, and currently are, used to justify usury laws. These include an irrational distaste for commerce, a view of interest as unearned income, protection of the small borrower from unscrupulous loan sharks or moneylenders, and ostensible economic benefits. I also presented several arguments in favor of abolishing usury laws.
Ceilings on interest rates that lenders are allowed to charge are inconsistent with today's liberal, or liberalizing, economic and political landscape. They cause loss of individual economic freedom and prevent mutually beneficial transactions among informed adults. Interference in the credit markets creates economic distortions. Illiberal restrictions on borrowing often hurt the very people they are expected to help, by limiting their ability to borrow, by making it unprofitable to lend to them, and by driving them into the clutches of illegal loan sharks. Usury laws also slow economic development. Low ceilings channel funds away from innovation and reduce the ability of the region to compete with more liberal ones. Moreover, interest rate restrictions deny savers, especially those who do not have access to more lucrative investment avenues like uncontrolled capital markets, competitive returns on their savings; consequently, saving is discouraged and the economy suffers.
Usury laws are obsolete relics of ancient and medieval thought, and exist today because of a lack of political will and a lack of confidence in market forces. They are based on false assumptions, operate perversely, and are economically inefficient. There are several other measures that governments can adopt to achieve the sought-after ends. One is to promote policies that foster competition in the credit market, thus strengthening market forces. In the developing world especially, these would include liberalizing the banking sector and increasing monetary integration. In agricultural countries, it will be more effective to attack the causes, rather than the symptoms, of high risk; this can be achieved by increasing the availability of insurance, perhaps through liberalization of the insurance sector, and by encouraging improved agricultural practices. Small borrowers in the developing and developed world alike will benefit from laws along the lines of the Federal Truth in Lending Act, which requires lenders to explicitly inform their customers of the terms and rates of their loans. Education of borrowers will also help in alleviating the problems of asymmetries in market power.
The introduction of alternative policies such as these will allow for the upholding of liberal economic values, protection of the borrower, and economic development, without the ill-effects associated with rigid interest rate restrictions. Governments should therefore implement such policies, and finally abolish usury laws.
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About writing, Shiva says: "I do all my research before beginning to write. I usually put together a stack of notes consisting of external material and my own thoughts and labor through it. Once I've formulated my thesis and have essentially the entire paper in my head, I sit down to write, and prefer to finish in maybe two or three long sittings. I don't write drafts - instead, I revise as I go along, so that when I'm done writing, I pretty much just print out my work and hand it in."