Debt in a Free Economy

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Debt in a Free Economy
by D.J. Webb
Published on the LA Blog on the 7th July 2013

Debt and debt collection are rising up the political agenda, and I think the issue is of central importance to understanding the British economy today. The banks have gained a centrality in life that they did not always have. It used to be possible to get paid in cash and handle most of your affairs in cash. Nowadays, financial products dominate the whole of the rest of the economy, and the burden of debt on UK consumers plays a large role in limiting any takeoff in private consumption spending that could produce a sustainable recovery. It is as if we only exist to service the banks.

The financialisation of the economy

Mortgages are the main form of debt in the UK, but they are now supplemented by huge student loans, which amount to a second mortgage. Add on credit card debts, payday loans, overdrafts and the like, and you have a highly dysfunctional economy, one where mass default on debt threatens to bring down the banks and cause a renewed sharp downturn.

How did we get here? Well, libertarians and/or their Thatcherite step-cousins have often seemed to support the financialisation of the economy—the running of the entire economy in the interests of financial services parasites—in the form of “encouraging home ownership” and “rolling back the state”. Home ownership is good (although the obsession with freehold property a delibitating factor in the economy), but by failing to draw a distinction between genuine productive activity and passive capital gains from site value increases as a consequence of social activity, libertarians have often seemed to argue that any increases in property prices are simply the free market, rather than a result of the hypertrophy of financial services.

John Stuart Mill believed in a land tax that could have restrained runaway land price inflation and limited asset price inflation that has pumped up the value of natural resources in the form of land, which is limited and is not the product of human labour. For this reason, I can only see as malignant a claimed form of libertarianism that sees average property prices in the UK (around £240,000) nine times the average salary (£26,000) as a natural result of a free market in property.

The arguments against unrestrained land price inflation are for another article. Focusing here on the problem of personal debt, individuals find themselves facing a huge lifelong burden if they are to buy somewhere to live. Renting is an insecure alternative owing to the effective unavailability of contracts longer than six months. In the UK, you cannot simply hand the keys back, as you will be pursued for any outstanding balance (probably including inflated repossession fees) for 12 years.

Property ownership is, of course, not a problem for libertarians. But personal debt at skyhigh levels is. Most people, once they have serviced the state (income tax, national insurance, council tax, the TV licence, and various forms of indirect taxation) and their mortgage have a surprisingly small proportion of their original salary left to spend on anything else. Of course, there are many people who have paid off their mortgages entirely, and maybe those people present some kind of hope for the British economy over the longer term, but for the young, who are the future of the economy, the situation is that the state plus property are likely to account for 60% or 70% of their salary.

The student loans problem is only just emerging as a significant issue, owing to the sudden surge in the size of the loans required to complete university. Once again, libertarians appear to have argued for the financialisation of higher education by calling for more market forces and less state spending in the tertiary education sector. Viewed in the round, the banks have merged with the state—a process made plain in the UK by the nationalisation of virtually the entire banking sector—and so I am not too sure that downsizing the state, but pumping up the size of the financial services industry was the right way to go about things here. Student loans are another millstone around the necks of the up-and-coming generation that will limit spending on everything else going forward.

Could libertarians have called for a rolling back of the state in a way that did not necessarily imply the explosion of financial services? Clearly, a form of higher education that you have to pay for upfront will require those without the money to take out loans. But the entire structure of the economy today is not consonant with libertarian principles. It was never the intention of J S Mill that the state should take 50% of GDP in taxation, and that after servicing such huge taxation demands people should then, on top of this, pay for their higher education via loans.

If the state spent just 10% of GDP and there was nothing in the way of taxation of personal incomes, people would probably have higher savings and a greater proportion of students and their families would have been able to pay for higher education with those savings. The entire structure of personal finances would be different in a genuinely free economy. Instead what we have arrived at is state hypertrophy supplemented by financial services hypertrophy—justified, bizarrely, as some form of “rolling back of the state”.

I should state in passing here that libertarians need to give careful consideration to proposals for a slimming of the state that would result in an enormous expansion of financial services. Proposals for health insurance to replace state spending on healthcare strike me as possibly just another scam for the financial services industry. Health insurance seems the only alternative to the state, but the way it is implemented seems crucial to achieving a positive impact on the economy.

Personal debt products

Mortgages and student loans are, in fact, low-interest-rate debt. A more astonishing aspect of personal finances in the UK is personal debt products such as credit cards and payday loans. The interest rates on credit cards range up to (or can exceed) 30% a year, with a range of fatuous charges applied to boost the amount owed in certain circumstances. The recent advent of the payday loan sector has brought loans with an annual percentage rate (APR) of nearly 6,000% to the UK.

My immediate instinct as a libertarian is to ask why people should need these products. Clearly many people are facing difficulty in basic day-to-day managing in what is, on paper, a wealthy society. Libertarians used to believe that a free market for labour would, in the end, allow wages to reach a natural level: one that was high enough to allow for the bringing up of a family and for participation in social life in a normal way. Working-class wages need to allow for at least the renting of a property, the payment of gas and electricity bills, the raising of two or three children, the running of a car to get to work, food and clothing of a non-luxurious type, the purchase of basic furniture, and some entertainment activities.

It is clear that low-end wages do not allow for this at all. In fact, in London, at least, even professional salaries can see people struggle to pay for the basics, depending on the mortgages/rents to be serviced. Something unusual is going on. Firstly, the state has implemented long-term policies to boost land prices, increasing all mortgages and rents and making basic life more of a struggle than it was decades ago when land prices were cheaper in relation to incomes. Secondly, the merry-go-round has been enabled to continue via in-work benefits. As low-end salaries are not enough to fund any sort of life, those with children have been able to get Family Tax Credits and other benefits, ratcheting up the tax rates on everyone else while effectively subsidising landlords, the banks and employers of cheap labour. Thirdly, immigration has been used to distort economic signals and keep low-end labour cheap despite its huge disparity with living costs.

It is not surprise therefore that many working-class people need to access additional finance. With gas and electricity bills often over £100 a month—another mortgage in itself—payday loans can keep the lights on, although payday loans are designed to spiral rapidly out of any connection with the original amount owed. I think most libertarians would agree that a genuinely free economy would see people able to live a normal life based on unskilled labour. This presupposes an end to mass immigration and an end to the various schemes designed to prop up land values at the expense of labour and capital. For this reason, a view of personal debt that supposes moral flaws in the debtor would appear to me to be a naive and inaccurate understanding of the problem of debt today. The real problem is the skewing of the entire economy to the funding of the state, to financial services and to the interests of landlords and others who hope to passively benefit from property. These three things are in fact interlinked in the form of personal debt.

Moral hazard?

I think this is where libertarianism parts company with conservatism. Conservatives strongly believe that people should just pay their debts—they have a moral duty to do so—and it is just hard luck if they have contracted too many debts. From the point of view of libertarians, however, debt is a risk contract, like any other in the free economy. The banks hope to make money by lending, but the interest charged clearly reflects the fact that the extension of credit necessarily involves risk. A certain percentage of people will not be able to pay back their loans, and the more likely this is, the higher the interest rate demanded, as payday loans show.

From this point of view, while there is moral hazard in allowing people to evade their debts—after all, people should take responsibility for themselves—there is also a moral hazard in any attempt to ensure that the banks always get their money back. The banks can only make so much money on debt because they might not be able to collect all the sums owed. So the state should not step in with excessively aggressive methods of grinding down debtors to pay sums that logically should be written off. The risk is two-way, and so is the moral hazard.

Take for example the distinction between secured and non-secured loans. A non-secured loan has a higher interest rate, because the difficulty of collection is much higher. A secured loan is secured on a property, and can, in the end, be recouped by repossessing the property, depending on the vagaries of the trajectory of house prices, which are themselves manipulated by the banks. And yet we read that judges often allow “charging orders” to be placed on properties for non-secured debts of as little as £500, thus turning a non-secured loan into a secured one. This makes a mockery of the original contract, which provided for a high interest rate precisely because the debt was unsecured. Given the difficulty of selling houses in the current market in most parts of the country, a £500 charging order that the bank later uses to try to force the immediate sale of the house could result in losses to the householder of many tens of thousands of pounds, especially if the house has to be sold at auction.

There ought to be some kind of limit as to the types of actions that the state will make to enable collection of private debts—and placing charging orders on properties for small unsecured loans does not fall within this logical limit. One could argue that charging orders on second properties, or properties that are not main residences ought to be possible, and that charging orders on very high-value houses should also be possible, as no one absolutely has to live in a £1m house if he has debts. But someone living in an ordinary terraced or semi-detached house really ought not to see magistrates convert non-secured debts into debts secured on his residence. From the libertarian point of view, what is objectionable about this is that it overturns the original contract.

However, as stated above, whatever the terms of an original contract, a loan is a risk-based financial product, and nothing the state does should be designed to ensure that credit is always a one-way bet for the banks. Default on secured loans should lead to loss of the property—but not pursuit for 12 years for any balance deemed to be owing. This forms part of the related, but separate, libertarian argument against state policies designed to boost land values. By making all property loans non-recourse, as in the US, debt deleveraging is achieved more rapidly in a slump, thus allowing the economy and the property market to begin to grow after rapidly hitting rock bottom.

It is the collection of unsecured loans, including credit card debts and payday loans, that is the most controversial aspect in the UK, owing to the high interest rates, the panoply of fatuous charges levied, and aggressive debt-collection techniques. I have previously outlined a view of libertarianism that allows for some regulation—by statute, and not by regulatory body, to be enforced in the courts—to avoid a situation where the disparity of power between the individual and financial services companies allows for aggressive enforcement of debt peonage under the rubric of “the free market”. I am not in favour of constant such legislation, but I do favour some. The alternative would be to turn libertarians into a group of cheerleaders for the parasitical financial services companies.

There is a Code of Business Sourcebook (COBS) that governs contracts with banks, requiring, in vague language, that banks treat their customers fairly and handle conflicts of interests between themselves and customers fairly. The COBS retrospectively forms part of all contracts with financial services companies and can be enforced in the courts, although the judges’ perceptions of what “treating customers fairly” means may be difficult to discern in advance of court action. At best, COBS would give an activist judge a tool with which to strike down an “unfair” contract, but in practice most judges see their remit as participating in aggressive debt collection.

I don’t favour the COBS, because of its loose language, but would be happy to place a more tightly worded legal limit on interest rates—there need to be higher interest rates on risky loans, but a 6,000% APR strikes me as absurdly out of connection with any possible definition of a lawful contract. In order to allow space for interest-rate pricing of loans, I would see an APR within 100 percentage points of the Bank of England base rate as more than adequate for anything other than loan sharkery. Many financial services contracts also come with detailed terms and conditions including clauses that provide for unilateral variation of terms and conditions by the banks even after a debt has been built up. I cannot understanding how this can be a lawful contract either. Allowing loan companies “continuing payment authority” to empty bank accounts at will—arrangements that can’t be cancelled—even where the amount owed is in dispute also seems to me to be, at best, theft. Apparently, the government is moving to force banks to allow customers to cancel continuing payment authorities. (The likely result is that savvy customers manage to cancel them, but uneducated, inept or mentally ill customers will not.)

Enforcing loan contracts

But apart from these specific points (stratospheric interest rates, unilateral variation of terms ex post facto, and continuing payment authorities), I do not see that courts should unpick contracts. However—and this is the key point—if you can’t afford to service a loan, you don’t owe it. Beyond a certain point, if the customer can’t pay, the bank has to accept that the risk they took on when extending the customer credit has materialised. They should write down the debt and move on to more profitable business. This is the free market. This is what the risk of extending credit entails. This is the reason why the lending business is profitable in the first place, as interest rates are charged to reflect the degree of risk.

Libertarians do not support the welfare state, but people who are unemployed or living on income support are clearly living on the minimum the state sees as appropriate. Welfare benefits are not designed to cover the servicing of usurious historic debts. Anyone who has no other income than welfare benefits by definition cannot pay a penny towards any debts. Apparently, the courts will order £1 a month payments by people on benefits, but I wouldn’t even support this much, as clearly the banks have been lending to the wrong people if they are chasing people living on social security. There should be no garnisheeing of benefits—and if the banks find that a problem, they should be more careful in their lending.

People in work are a better target for debt collectors, because they have incomes, and these incomes can be docked at source. The courts do order such arrangements, but I understand that magistrates will not allow so much to be docked that the debtor cannot afford basic living costs, although magistrates’ definitions of those may vary. As far as I understand it, once the matter goes to court, the decision is out of the hands of the financial services companies, and the judgements handed down by magistrates may not always be as munificent as the banks hope, which is precisely how it should be.

The problem with debt-collection practices seems to relate to two things: 1) the manner in which debt-collection agencies demand money well before the debt has gone to court; and 2) the enforcement of judicial decisions by bailiffs. Debt is a civil matter—it has nothing to do with the police—and so debt-collection agencies whose chosen tactic is to phone twenty times a day threatening arrest are clearly hoping to frighten the least savvy customers into making payments they can ill afford. This is just demanding money with menaces—which is a crime—and I would argue in a free society any such threats should lead to the immediate extinguishing of the debt. More than one phone call a week strikes me as harassment—which is also a crime, and not a civil matter—and failure to abide by a customer’s express wish to be contacted only in writing is also harassment. Customers at home rarely have phone-recording facilities, and so it seems to me to be appropriate for discussion of matters that have legal implications to be in writing only. Home visits by debt collectors who have no power of entry are also clear instances of harassment. While in a libertarian society, debts could be enforced by the courts, that is not the same thing as saying that harassment and demanding money with menaces should not be crimes in a free society. Ultimately, the spigot of debt needs to be turned off, and the labour market allowed to work property again, so that people do not need to take out these financial products. So legislation in a free society that makes it harder to collect debt is simply a way to achieve that objective.

Bailiffs are another interesting area of law. It has become standard for bailiffs to use force to gain entry to properties—by putting their foot in the door and forcing the door open. While this is not legal, magistrates are, bizarrely, unwilling to accept that this is what has happened unless video evidence is available. (We are entitled to ask how this meets magistrates’ duties to judge such cases on the balance of probabilities: the most charitable interpretation is that magistrates are too naive to realise that bailiffs regularly exceed their powers.) It seems to me to be fully within the scope of libertarianism to outlaw bailiff visits unless something unusual (pearls, gold bars, etc) are known to be in the home. Given that people with incomes see their incomes garnisheed at source as the preferred and easier method of debt collection, a restriction on these aggressive types of debt collection will only affect those loans extended to people without proper incomes—people who the banks should not be lending to in the first place.

A non-debt economy

Some libertarians seem so pro-corporate in their thinking that they have forgotten the original reason why they supported a free economy in the first place. A particularly nasty example is an article in The Spectator by Steve Davies of the Institute of Economic Affairs, entitled ‘Cracking down on payday lenders will hurt the poor’ (see here). I’m not at all sure that Dr Davies is concerned about the poor. Debt peonage is not really what a free society is all about. I envisage a libertarian society more along the lines of people being able to earn enough money, and keep it, to live their lives without subsiding parasites of various descriptions. Payday lenders are among those parasites, as is the state. There is little difference between the financial services companies and the state today (this is really what “too big to fail” means). Davies writes:

Now we have a summit and a lot of public statements from politicians to the effect that the activities of payday loan companies are uncompetitive and against the public interest. This kind of policy agenda is wrong on a number of grounds. It would firstly be wrong in itself, as it would prohibit a voluntary transaction between consenting adults that does not cause direct or immediate harm to anyone, and certainly not to third parties.

This analysis is wrongheaded, as direct and immediate harm is done to the borrowers, and the growth of such desperate forms of personal credit does cause harm to third parties. There is concern that such loans are a new ticking subprime debt bomb, and the mortgaging of the incomes of the poor to service loans that have grown 60-fold in a year does limit their private consumption spending, with an impact on all other providers of goods and services. Davies argues that payday loans are “almost always” paid off within two weeks, thus feigning ignorance of the fact that payday lenders finances depend on the continual rolling over of spiralling loans. He goes on to write:

Even more likely, the demand for these kinds of loans would remain but would now be met by truly unsavoury characters. If you want to help loan sharks and low life money lenders then restricting legitimate firms such as Wonga is the way to go.

Here, Davies appears to state that loan sharkery is “unsavoury”, but that payday loans are not loan sharkery... There is not a word in his article querying why people need to resort to such desperate loan products.

John Stuart Mill was against laws against usury. However, that is not to say that there should not be limits on the extent to which debt collection can be taken. While laws against usury are designed to protect only one party to a contract, state intervention to enforce onerous debts is an intervention that similarly attempts a one-sided protection of one party to a civil contract. J S Mill quoted examples in his Principles of Political Economy (see here) of usurious interest rates as high as 20% or 30%. However, we are in a totally different type of society, where interest rates range up to 6,000%, and the vigour of libertarians needs to be exerted, not to defend the right to extort very large sums from people who contract very small debts, but rather to reduce the size of the state such that people do not find the state the first charge on their income, forcing them to borrow at exorbitant rates of interest in order to purchase basic necessities. J S Mill did not live in a society where the whole of life had become dominated by the financial services industry, to the extent that the viability of capitalism itself has been threatened in recent years.

Even if it is not accepted that some controls are required—and I am not talking about preventing 30% interest rates, but 6,000%—the other suggestions I have made in this article may be sufficient to rein in the personal debt jamboree and thus allow a rebalancing of the economy towards proper production, investment and consumption.