On March 23, 2021 Illinois legislators imposed an interest rate ceiling of 36 percent on all non-bank and non-credit union loans under $40,000. The stated intent was to reduce the burdensome cost of interest for borrowers with less than prime credit scores. But as one would expect, markets speak even when lawmakers strive to blunt their message. Economists Thomas Miller (Mississippi State), J. Brandon Bolen (Mississippi College), and Gregory Elliehausen (Board of Governors, Fed), studied the subsequent impact of the cap, only to find that most subprime borrowers happened on a growing inability “to borrow money when they needed it.”
It's a reminder that price controls work, though not in the way that their proponents want them to. With the imposition of the cap, it was no longer affordable to lend to certain borrowers. As opposed to better off, the highest-risk borrowers in Illinois found they could not borrow the money they needed and that “their overall financial well-being had declined” in the aftermath of a market intervention falsely billed as compassionate.
That the State of Illinois failed in its attempt to decree credit cheap wasn’t surprising. And it certainly wasn’t surprising to Bolen, Elliehausen and Miller. They sensed that the “Predatory Loan Prevention Act” would “create shortages” of the market good that is credit. It all raises a question about the Federal Reserve. Wouldn’t its attempts to reduce the cost of borrowing similarly be mugged by reality?
When the central bank decreases rates, such a move implies that market actors are limiting the supply of credit, only for central bankers to intervene with “ease,” or “easy money.” But can they? Simple logic says no.
A price control is a price control. No entity, including a central bank can alter this reality. Assuming the Fed leans against prevailing rates, markets will have their say as they always do. If the Fed can actually force low borrowing costs, it’s only reasonable to conclude that access to the “cheap money” will be severely limited in much the same way that Bolen et al found that the Illinois rate cap “limited credit access to high-risk borrowers.”
More specifically, what’s true for Illinois is realistically true outside of Illinois. In March of 2021 when Illinois imposed its cap, the Fed funds rate was near zero. Stop and think about this. Amid what was billed as “easy money” care of the Fed, more than a third of Illinoisan consumers couldn’t even borrow at 36 percent.
To which some will point out that the rate cap was for non-bank and non-credit union lenders. That’s no doubt true, but it’s a reminder of why there’s so much small dollar lending taking place outside of the traditional banking system as is. There is simply because banks aren’t in the business of losing money. Their loans must perform. And traditional banks and small dollar lenders alike must adhere to the same compliance and underwriting costs that make the 36 percent rate unworkable.
So, while the Fed has for much of the 21st century targeted low borrowing rates through the banks that it projects its influence through, the paradoxical truth is that the low rates of interest on deposits and borrowing have been an indicator of “tight” credit. Which really isn’t even paradoxical.
We know based on common sense along with what Bolen et al discovered that artificial prices born of market intervention result in shortages. Call it basic economics. After which, anyone with a bank savings account has noticed extraordinarily low interest paid on deposits over the years. What this tells us is that as opposed to easy lending practices, banks have studiously avoided risk altogether. If this weren’t true, rates paid on deposits would be much higher to reflect bigger risks taken with the funds in their care. At present, low rates of interest tell us that as opposed to “easy,” banks are generally only lending to the proverbial borrower who doesn’t need the money.
Where it arguably becomes even more interesting is with technology companies of the Silicon Valley variety. So risky are the startups that populate the technology space that lending isn’t even a factor when it comes to financing the would-be businesses of the future. Since so many of them will go bankrupt in rather spectacular fashion, there’s no realistic interest rate at which to lend to them. The finance is all equity. Put more bluntly, Silicon Valley wouldn’t be Silicon Valley if loans were the only source of business finance.
Bringing it back to the Federal Reserve, the “easy money” born of “zero” Fed rates has always been a bit mythical. Markets always speak, and for that we should be glad.
