The Free Thinker

Interest, Usury, and Mortgages

I believe the prohibition of interest has been a common feature of the moral rules of several civilizations. Interest was condemned by Aristotle and generally by the ethical systems of the ancient world. It was treated as a sin by the medieval Catholic Church and subject to bans and punishments. And Islam also forbids interest today, a rule that Muslims, unlike modern Christians, still regard as binding, which has driven the emergence of "Islamic banking."

Contemporary economists, by contrast, habitually regard both legal prohibitions and moral strictures against interest as pure superstition. They regard interest, on the contrary, as both necessary to the functioning of the economy, and as morally innocuous. All the prohibitions of interest by philosophers and ecclesiastics for so many centuries they regard as based on the simple fallacy that regards it as "unfair" to get more money tomorrow for money lent today because of the inequality of the sums of money involved. But of course, money-today is not the same commodity as money-tomorrow: for one thing, prices may have changed; but even if they haven't, there is a set of opportunities between today and tomorrow to which money-today gives you access and money-tomorrow doesn't. For people to exchange money-today for money-tomorrow is perfectly sensible and rational on both sides, like trading haircuts for nails or bread for cars or any other ordinary, voluntary, mutually beneficial exchange, and there's no reason that the price should be $1:$1.

Who is right? Mostly the economists. Interest is certainly necessary; it is often innocuous and useful; prohibiting loan interest is a very bad idea; and the motive for past prohibitions has usually been simple fallacies combined with the aristocratic class prejudice and philosopherly impracticality. However, there is one valid argument on the other side. Laboratory experiments have shown that people often exhibit hyperbolic discounting behavior, a fancy term meaning that they place a higher relative value on present enjoyment than is consistent with their desires when they are taking the long view. It seems to be human nature to be somewhat impulsive and to behave in ways prejudicial to one's long-run well-being, to the extent that people sometimes invest in costly self-control mechanisms. (Example: If I remember right, it has been shown statistically that people buy gym memberships even though it would be cheaper to pay per visit; the argument is that they foresee this, but are trying to bind themselves to exercise regimens by lowering the marginal cost of visiting the gym.)

If (some) people are impulsive, other people can exploit this weakness, giving them money now for prices in future money that their long-run selves would not agree to. How to do welfare analysis when people have time-inconsistent preferences presents difficulties, but plausible intertemporal utility functions would support the folk economics idea that loan sharks harm their customers. It might be useful to define usury as lending at interest that exploits people's impulsive short-sightedness, and interest as lending at interest to rational borrowers who have good reasons to place especially high value on money-today. Of course, an external observer couldn't always tell, and you might never be completely certain, whether any given transaction was a case of usury or interest. Even the lender and the borrower might not know. Indeed they might know least of all: they would have the best information, but maybe also incentives for self-deceit.

I think the Christian attitude should favor interest, thus defined, and oppose usury. It should be regarded as a sin to lend money at interest if the lender has strong reasons to think that the borrower is being impulsively short-sighted and will regret the loan later. It might also be good for the law to prohibit usury. This is paternalistic, but perhaps not coercively so, The law could (maybe it does, I'm not sure) simply say, "We define such-and-such contracts as usurious and therefore invalid, and we will not enforce them. If a usurious lender wants to simply trust his borrowers to repay, we won't interfere, other than to make it clear to borrowers that they are entirely at liberty to walk away from such illegal debts; of course, a lender who tries to recover his money by any but purely social and moral pressure will be treated as any other extortionist."

But of course, the problem is how to prohibit usury without prohibiting interest. That can't be done perfectly. The moral usury/interest distinction will not correlate perfectly with any particular interest rate or form of contract. A loan at 0% interest might be motivated by instant gratification, while a prudent entrepreneur may occasionally have sound business reasons to borrow even at very high interest. Some entrepreneurial ventures might be recklessly self-indulgent, while other loans purely for present consumption (think of a payday loan to provide a wedding reception for one's daughter) might be quite consistent with making the best use of one's resources in the long run. The ideal might be a combination of law and moral suasion. Usury laws should prohibit the most abusive forms of lending, even at the expense of occasionally curtailing entrepreneurship; but they should allow a wide range of lending practices and rates, even though this will leave the door open to a good deal of substantive usury and exploitation. Meanwhile, churches and civil society organizations should use exhortation and stigma to shape norms so that moneyed persons will use moral discernment to try to lend only in a manner that benefits their borrowers.

A system of "morally sound" financial practices as described above would likely have prevented much of the crisis. Of course, we have some of it already: usury laws are on the books. Yet all in all our society is the opposite of the medieval Catholics: the state not only does not prohibit lending at interest, but subsidizes it. Student loans are one instance of this, and perhaps the policy of putting young people in so much debt gets less criticism than it deserves. But the most egregious example is the mortgage-interest tax deduction, which creates strong incentives for much of the population to become deeply indebted. It's clear now, in the wage of the largely mortgage-driven crisis of 2008, that much of the home mortgage industry was usurious in the sense described above, yet this industry was, and still is, being subsidized by the tax code. Surely this is perverse and should be abolished. We shouldn't go back to medieval prohibitions of usury, but perhaps something in between?

Densification

This passage from Jane Jacobs' Dark Age Ahead looks very astute right now:

In 2015, those born in 1950, the crest of the baby boom, will become a flood of aspirants to retirement...  Many, perhaps most, are counting on their largest significant assets, their houses and lots, for retirement nest eggs, or perhaps to provide education funds-- or, more realistically, credentialing funds-- for grandchildren.

Perhaps money will keep growing on houses, indefinitely.  That will take some contriving.  In March 2003, a former Federal Reserve governor, Lyle Gramley, was quoted by The New York Times as saying that Alan Greenspan... had means for pushing thirty-year mortgage rates as low as 2.5 percent and keeping them there, and the Times pointed out, accurately, that this policy would continue to stoke "a storm of home buying and refinancing, promoting consumers to convert the rising equity in value of their homes to cash...  But this easy easy money has done nothing to rejuvenate business spending, and a growing number of economists suspect that war jitters are not the only reason."

In other words, the house price bubble can possibly be deliberately maintained for years to come.  But even as Gramley was being quoted, in both the United States and Canada vacancy rates were rising in condominiums, and apartment and house prices and rents were falling in London-- not enough to solve the shortage of affordable housing for the poor, but signaling that supply and demand are slowly converging.  In any case, sooner or later the bubble must burst, as inevitably all speculative bubbles do when their surfaces are not supported by commensurate increases in economic production. (Dark Age Ahead, Jane Jacobs, 147-9)

Having predicted the housing bubble bursting, Jacobs goes on to suggest a market reaction and a solution:

When the housing bubble bursts, whether before or during the coming demographic bulge in retirements, the force driving densification of suburbs could become irresistible in some places, overriding zoning and other regulations as owners of suburban houses and land discover that these can no longer supply cash passively but must somehow earn it instead...

Some resourceful owners will convert their rec rooms to low-cost rental suites, and others may notice that their lots can accommodate one or two small buildings at their rear, which they can either rent or move into themselves, reducing their chores and other upkeep.  This will free up their former home and its garages for another family, a bed-and-breakfast, a hair salon, a funeral home, or offices for voluntary institutions or for some of the lawyers who will be needed to handle all the new contracts people are signing...

From the viewpoint of society, it will be preferable for owners themselves to put their lots to more intensive use because their ingenuities will not necessarily require demolition of still serviceable buildings, as developers' ambitions are prone to do, and will almost certainly introduce wider ranges of uses, as well as charm.

This is exactly what I think needs to happen to suburbia.  In the last couple of decades our society has taken a somewhat wrong turn, in the direction of increasing sprawl.  This was partly a result of a monetary policy error-- the Fed focused on consumer prices and ignored house price inflation-- and partly a result of political subsidies to sprawl such as the mortgage-interest tax deduction and the formerly implicit government guarantees and Fannie Mae and Freddie Mac.  The result of all this is space being used in inefficient ways, people living in bigger houses than they need, and traffic jams, as sprawl involves too thin a population density to be accessible to public transport.  Actually, public roads are another form of subsidy to sprawl.  If roads had to be self-financing through congestion charges and higher gas taxes-- that is to say, if not only the cost of building and maintaining and policing roads, but also the rental value of the underlying land, were not publicly subsidized-- it would be costlier to live outside of public transit accessibility of one's workplace and there would be less sprawl.

The government-subsidized housing glut in suburbia is not inherently wasteful, however.  It could easily be made useful by (a) modest rebuilding efforts such as Jacobs describes to facilitate densification, and (b) letting in a lot more immigrants to live in all our extra houses and apartments.  This would do much to solve the problem of financing the retirement of the baby boomers, because it would restore real estate values, not through another bubble, but by repurposing buildings so that they could create sufficient economic value to justify the high prices.  This would require something of a social as well as a policy revolution, however, one for which the American people seem not to be prepared.  Recently, for example, they rejected the tough, honest talk of George W. Bush and opted for Obama's escapism.

"Watch out world, Americans are saving again"

In one of the biggest and most misunderstood changes in modern economic history, citizens of the largest economy in the world are suddenly doing something they haven't done in years: They're saving money. It is having myriad consequences, including a tsunami of money in one part of the world, and an air pocket in demand in other parts of the world, especially China.

Americans are suddenly spending less than they earn. While that might not sound heretical or surprising - how long can you go on spending more money than you earn? - it is an epochal moment for the free-spending United States. After saving an average of more than 7 per cent of disposable income until almost 1990, the United States went into a savings tailspin. Savings rates fell, in fits and starts, from 8 per cent, through 6 per cent in the early 1990s, to 2 per cent around 2000, to the ignominy of a negative savings rate by mid-2005.

Now, however, that is changing rapidly. November economic data showed U.S. savings spiked to 2.8 per cent of disposable income, up from zero at the beginning of 2008. Is it that Americans have suddenly figured out that saving is a good thing, or are they taking some sort of moral stand against profligate spending?

Be serious. Americans remain the wild-eyed spenders of the world, and that was never likely to change without external pressure. They have, however, been forced into this, with their equity investments and real estate investments all sliding into nothingness, and with the economy in a deep recession. They must repair their broken personal balance sheets, and so, as painful as it might be, they are saving money.

Great. Good for Americans, right? Savings über alles! Well yes, but there is much more to it than that. For starters, the U.S. savings rate won't stop at 2.8 per cent. My guess is it will rapidly rise to 4 per cent by the end of the year, and will likely hit 7 per cent by late 2010.

But in the end, fixating on those numbers misses everything that matters because that money has to come from somewhere. Your savings, in some sense, represent my lost income.

Not if my savings go into a bank, which lends them out to an entrepreneur, who starts a new business and hires you.  But will that happen?

It should be said that the supposed low savings rate was always a little bit misleading.  Why save when your net worth is rising anyway because of rising home and/or stock prices?  Low official savings rates were the flip side of the asset bubble.  People want their net worth to rise over time.  Now that rising asset prices aren't raising their net worth for them, they're saving instead. 

It's too bad, though, that we piled up so much debt to the Chinese to build houses we didn't need.  Don't forget that a lot of the blame for that belongs to Freddie Mac and Fannie Mae, and the mortgage-interest tax deduction, and the misguided policies that tried to drive homeownership rates artificially high.