With all the talk of a resurgence of a 1970s-style vicious cycle of record energy prices, frozen credit markets and increasing unemployment, one would think that the nation’s political leadership would be carefully studying the solutions that rescued the country from our last bout of stagflation. Instead, some are actually proposing a return to the very policies that cut off credit to millions of middle-class Americans a generation ago.
In the late 1970s, consumer credit and home mortgages all but disappeared because the cost of credit in the global capital markets rose above the artificial ceilings on lending rates imposed by state usury laws. Small business owners found themselves unable to finance purchases of equipment. First-time homebuyers found themselves frozen out of the housing market. Consumers’ access to short-term credit dropped precipitously, with disastrous consequences for the retail sector.
The strangulation of the economy by usury laws ended only when the U.S. Supreme Court, the Federal Reserve Board and Congress all endorsed the somewhat arcane idea of “pre-emption” to override parochial state interest-rate ceilings for the common benefit of the national economy. Yet Senator Richard Durbin, D-Ill., has now proposed reintroducing usury limits to the world of consumer lending in a bill entitled the Protecting Consumers from Unreasonable Credit Rates Act. The motivation for such a bill is understandable and even admirable in these challenging economic times, but history shows that the result for consumers may well be less credit, not cheaper credit. As a senior vice president of Citibank told the New York Times in 1980, “We’re not making personal loans. We can’t afford to make them at these rates.”
The Supreme Court led the drive away from usury limits in 1978, ruling in the famous Marquette National Bank case that a national bank located in one state may “export” that state’s maximum interest rate to loan transactions with consumers in other states with more restrictive usury laws. After Marquette, most major credit card issuers moved their operations to states such as Delaware or South Dakota, which have no legal usury limit, and the number of Americans with access to the convenience of credit cards increased exponentially. In one of history’s more interesting examples of bipartisanship, the principal architects of Marquette were Justice William J. Brennan Jr., the author of the decision and one of the most liberal justices of the modern era, and conservative icon Robert Bork, the lawyer who argued the winning side.
In 1980, when the prime lending rate reached 20% (it currently stands at 5%), it became clear that even stronger medicine was needed to protect consumers’ access to credit. Then-Federal Reserve Chairman Paul Volcker (a Democrat), with bipartisan support, championed the passage of the Depository Institutions Deregulation and Monetary Control Act (DIDMCA), which pre-empted state usury limitations on many home mortgage loans. Volcker recognized that, when “the whole level of market rates moves above a state’s usury ceiling, that state is going to be in trouble.” In words that ring especially true today, President Jimmy Carter emphasized in signing DIDMCA that pre-empting state usury limitations would “ensure [a] steadier flow of credit for productive uses, especially housing.”
Usury laws limit credit supply
Why, then, would anyone want to reintroduce usury limits, especially at a time when consumer credit is already scarce? The reasons are rooted in an understandable desire to protect consumers. The popular imagination bristles at the idea of payday lenders charging a 500% annual percentage rate to low-income borrowers. (Many people are unaware that most payday-loan customers never experience such rates because they repay their loans quickly and pay only a fee covering the lender’s fixed costs, or that, as a recent study by economists Paige Skiba and Jeremy Tobacman found, high default rates keep payday-lender profits low.) The idea that subprime mortgage customers paid higher interest rates than prime borrowers also strikes some people as troubling. (Press accounts often omit the idea that these higher rates are designed to compensate lenders for bearing the higher default risk associated with subprime loans.) In this environment, it is no wonder that politicians seeking to protect consumers would like to control the cost of credit if they can.
But if history teaches anything, it is that price controls — usury laws included — create shortages. Big-city rent control laws, ironically enough, resulted in fewer and more expensive apartments. Nixon-era price controls on oil resulted in nationwide fuel shortages. And usury laws reduce the credit supply to people who need credit the most. Since we once again face the economic problems of the 1970s, our leaders should re-examine the solutions discovered by the leaders of that era. Usury laws are part of the problem, not part of the solution. We don’t want them back.
Brian P. Brooks is the managing partner of the Washington office of O’Melveny & Myers. Elizabeth Lemond McKeen is a counsel to the Newport Beach, Calif., office.