Should There Be a Limit on Interest Rates?
This is an interesting question, and something that I have been asking myself while I have been reading a book on the history of debt. Historically, entire families ended up destitute or in servitude over small debts that snowballed with compound interest, sometimes across generations.
This is one extreme, and something that as a modern society we want to avoid. We would rather not have entire families, or even communities, be burdened with crushing debt, and so it makes sense to put legislation in place to prevent that.
But, are there any intended consequences to doing so? Well…yes.
Any organisation that lends money to individuals faces competition from other lenders. The more competition there is and the more capital there is available, the lower the interests rates are likely to be. This is why illegal lone sharks can charge such large interest rates, because the lender is likely in a position where they have no other option because of their situation.
But, the loan shark is also taking a far larger risk than any financial institution. Even with the threats of breaking legs, they will often not get the money they lend out back, and so they have to charge high interest rates to cover this risk.
Forgetting loan sharks, the issue with capping interest rates is that it reduces the ability of lenders to price in the risk of the loan, which would inevitably reduce the amount of capital available for borrowers.
This is not necessarily a bad thing, but it does impact the poorest and least well off the most, as they are the ones who are likely to pay the highest interest rates, albeit on smaller loan sizes. It is incredible, when you think about it, that Cambodian farmers pay some of the highest interest rates in the world, and they are some of the least likely to be able to afford it!
But, should the government step in and legislate the choice of a poor person to take out a high-interest loan? There is an argument here that low levels of education can make it difficult for the borrowers to fully understand what may happen with compound interest.
This is is made even more difficult when you look at very small loans, such as payday loans, otherwise known as salary advances. These have a bad reputation, as they are typically used to by individuals that are living pay check to pay check and experience some type of emergency before their next pay check. The interest rates are very high, but this is also because the administrative cost of giving out a loan is approximately the same, regardless if you loan out $100 or $10,000, and so it will inevitably be a higher percentage of a smaller loan.
There are some further interesting areas to cover here. One question is whether there should be a cap on the total amount that should be paid back. If I loan you $100 with any interest rate, what is the maximum that you should pay me back? Is it fine if you never pay off the principal amount and pay interest forever? Or should the interest payments not exceed a certain percentage of the original amount of the loan?
Historically, when there have been sweeping loan resets, often due to the threat of mass revolt.
In ancient Mesopotamia, there were regular debt forgiveness programs known as “clean slates” where all debts were cancelled and credit records were wiped clean. These clean-slate policies were implemented by rulers to prevent the accumulation of debt and ensure social stability. The rulers would periodically announce the cancellation of all outstanding debts, including those owed to the palace, temples, and wealthy individuals. This would prevent small farmers and debtors from being forced into debt bondage or losing their land to creditors. The clean slate policies also helped to redistribute wealth and maintain social harmony.
The Bible also mentions the practice of debt forgiveness, such as the Jubilee Year in Leviticus, where all debts were cancelled, and slaves were set free every 50 years. The Jubilee Year was a way to ensure that wealth and land were not concentrated in the hands of a few individuals and that the poor were not permanently trapped in debt. The Jubilee Year also helped to maintain social stability and prevent rebellion by ensuring that all members of society had a chance to start anew.
In ancient Greece, the concept of “Seisachtheia” was introduced in the 6th century BC, which abolished debt slavery and cancelled all outstanding debts. This policy was introduced by the Athenian statesman Solon, who recognized that the growing gap between the rich and poor was a significant source of social unrest. Seisachtheia helped to reduce the number of debtors who were forced into slavery and also helped to redistribute wealth and power among the citizens. The policy also helped to ensure that small farmers were not forced to give up their land to creditors and that there was enough food to feed the population.
Loans with interest greater than the principal often get wiped clear in these historical instances. This could mean special consideration is given to those who pay more in interest than they originally borrowed.
So, perhaps this is where the moral line should be drawn: interest payments should never be greater than the principal amount.
