Avoiding Payday Loans Makes the Poor Richer

Access to short-term, high-interest credit doesn't help people in a jam; it encourages reckless spending.

More harm than good.

Photographer: Gary Tramontina/Bloomberg

The U.S. hasn't traditionally gone in for a lot of paternalism. The idea of government nudging people to improve their own lives seems to violate the basic principle of individual self-determination. Economists, too, tend to be a pretty rigidly utilitarian bunch; as far as most of them are concerned, the greatest good lies in giving people what they want.

For this reason, there’s a deep suspicion of what's come to be known as behavioral economics, both inside the profession and in the wider American intelligentsia. The baseline assumption of much of economics is that people act in their own interest, and what constitutes someone’s “own interest” is often defined as what they try to do. That implies that no one needs government to help them do what’s best for themselves.

In general I’m on board with this philosophy, but it seems to have obvious limits. Making wise decisions requires information, effort and time. Some people, especially the poor and disadvantaged, have far less of all of these than the successful among us. In addition to being exhausted, harried and poorly informed, many disadvantaged people probably suffer from rationality deficits due to stress, illness, environmental toxicity, violence and drug use.

As a result, there are surely cases where poor people regularly make decisions that they later regret. One much-discussed example is payday lending, or short-term, high-interest borrowing. In most academic models, poor people would use payday lending only when it made economic sense -- for example, to offset a one-off monthly expense like a leaky pipe. Most economists wouldn’t write down a model where people consistently take out payday loans month after month out of pure short-sightedness. Even if many are skeptical of the value of payday lending, it’s very rare for such persistent irrational behavior to make it into the formal mathematics of a consumption model.

But models and the real world are two very different things. A recent research paper by economist Brian Baugh finds evidence that restricting payday lending can be good for the people who habitually use these services.

Baugh studies the impact of a 2013 initiative by the U.S. Department of Justice, somewhat dramatically labeled Operation Choke Point. The DOJ suddenly shut down a number of unlicensed online payday lenders. Baugh uses data from online financial account aggregators to identify consumers who used these lenders frequently.

His basic finding is that when payday lending is restricted, people who habitually borrow from these lenders see their consumption go up -- not just temporarily, but in the long term. Cutting off the flow of payday loans raises household consumption by an average of 3 percent.

Nor is the effect due to people’s inability to smooth out their purchases. An economic model might predict that any rise in consumption from no longer having access to credit would come at the cost of more uneven spending. But Baugh finds no change in consumption volatility for those who are cut off from payday lending. It seems clear that most of those who take out lots of payday loans aren’t doing it to meet one-off emergency needs.

So why are they doing it? A profile of heavy payday borrowers points to the answer. Baugh finds that payday borrowers earn 9 percent less on average than non-borrowers, but borrow considerably more. They bounce six times as many checks per month, and make three times as many ATM withdrawals at casinos. And they tend to gamble more immediately after receiving a payday loan. The evidence seems to indicate that payday borrowers are distinguished by short-sighted and even impulsive thinking. That implies that they take out payday loans not as a rational economic move, but because they have trouble controlling their impulse to buy more than they can afford.

As this hypothesis would predict, payday borrowers behave more responsibly when their flow of short-term high-interest loans dries up. They bounce 17 percent fewer checks per month, and they make fewer overdrafts. Taken together, this evidence suggests that the increase in consumption from restricted payday lending comes from more responsible behavior as well -- when given access to payday loans, heavy borrowers end up hurting themselves by reckless spending, leaving them poorer in the long run.

Baugh’s research suggests that the concern over predatory payday lending isn't overblown -- government really can help some people by nudging them away from financially harmful behavior. To many staunch antipaternalists, that’s not good enough -- they believe that the freedom to make one’s own mistakes takes precedence. That’s a moral argument, so it can’t be refuted with logic or evidence. But the fact that a lot of the people making this argument are rich and educated, and don’t have to deal with the mental stresses of lifelong poverty, makes the case less persuasive to me.

I still generally believe in individual self-determination, and I am suspicious of too much paternalism. But the case against government nudging has been overdone. I predict that in the coming years, we’ll find a number of areas where the state can help people make decisions that ultimately benefit them -- diet and exercise being two likely cases. Freedom is good, but sometimes a little push from society is good too.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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