Fed Economist’s Study Shows Harm Of Government-Spread Misinformation On Small Loans

The “Twitter Files” have made some shocking revelations about government entities muscling social media companies to de-platform people in the name of preventing so-called misinformation. My colleague Jessica Melugin, Director of the Competitive Enterprise Institute’s Center for Technology and Innovation, decried “the use of government coercion to pressure these companies to make politically-motivated decisions they might not otherwise have made.” And as many observers have noted, much of what the bureaucrats called “misinformation” is actually legitimate debate about the science surrounding Covid-19 and other issues.

Ironically, when it comes to spreading genuine misinformation (a phrase that’s kind of an oxymoron) with harmful effects, one of the biggest culprits is the government itself. One big example of this is federal government policies that for decades have mandated that financial firms exaggerate the interest rates that most borrowers actually pay on short-term, small-dollar loans. These inflated interest figures have dominated policy debates around consumer credit, leading to interest-rate caps that a new study co-authored by a Federal Reserve economist confirms have hurt lower-income borrowers who have few alternatives to obtain credit.

Under the Truth in Lending Act of 1968, providers of just about every loan and cash advance — even ones with a duration as short as two weeks — must disclose the interest rate as if the consumer were paying interest for an entire year. This is called the “annual percentage rate,” or APR as abbreviated. As my colleague Matthew Adams and I have written in a recent paper for the Competitive Enterprise Institute, this so-called annual percentage rate leads many cash-strapped consumers to misunderstand available options. Worse, by distorting the policy debate, the APR leads politicians at the federal and state level to propose banning these options.

To illustrate the absurdity of applying the APR to short-term lending, let’s look at a basic loan with a duration of two weeks. (These types of loans have become known as “payday loans” due to their length matching those of many employees’ pay periods.) As Adams and I explain in the CEI paper: “If a borrower takes out a $200 loan with a $30 finance charge for two weeks, the interest rate totals 15 percent. Yet, when that figure is annualized by multiplying it by the 26 two-week periods in a year, the APR becomes 390 percent, even though nothing about the loan’s features has changed.”

Applying the APR to short-term loans, the great economist Thomas Sowell has pointed out, is as ridiculous as multiplying the rate of a $100-per-night hotel room by the number of days in a year. “Using this kind of reasoning—or lack of reasoning—you could … say a hotel room rents for $36,000 a year,” Sowell writes, “[but] few people stay in a hotel room all year.”

Thus, through the “magic” of government-mandated misinformation a 15 percent interest charge becomes an almost-400 percent interest rate. But this rate is as mythical as unicorn, as virtually no borrower has been documented as actually extending a two-week loan to a year and actually paying it. As Adams and I write, “Data suggest most borrowers pay back the initial amount borrowed within six weeks, so it is highly unlikely that most borrowers would end up paying anywhere near the purported APR of the loan.”

Yet the specter of loans with a 300 to 400 percent interest rate – even though it is far in excess of what most borrowers pay – is wielded as justification for interest rate caps in several states. In Illinois, a coalition of social justice advocacy groups cited triple-digit APRs in campaigning for a bill that capped interest rates on small loans at 36 percent per year. When the so-called Predatory Loan Prevention Act became law in March 2021, the groups cheered it as “a significant milestone for economic equity in Illinois.”

A new study co-authored by a top economist at the Federal Reserve, however, finds that the law’s effects have been anything but equitable. Released through the Social Science Research Network, a prominent repository for academic papers in economics and social sciences, the paper finds that lower-income and disadvantaged borrowers have taken a massive hit due to the law. “Their overall financial well-being had declined,” the study reports. The study was conducted by Gregory Elliehausen, principal economist in the Consumer Finance Section of the Federal Reserve; Thomas Miller, professor of finance and Jack R. Lee Chair of Financial Institutions at Mississippi State University; and J. Brandon Bolen, Assistant Professor of Economics at Mississippi College.

These scholars find in their paper that the Illinois law decreased the number of short-term loans unsecured by collateral to at-risk borrowers by 40 percent. Utilizing survey data from Illinois borrowers whose lenders had stopped making loans due to the law, the scholars find that 49 percent of borrowers with incomes below $50,000 reported that their financial well-being had decreased, and only 11 percent of all borrowers said that it had increased. 79 percent of borrowers said they wished they had the option to return to their previous lender.

The scholars conclude in their study that “the Illinois interest-rate cap of 36 percent significantly decreased the availability of small-dollar credit … and worsened the financial well-being of many consumers.” In his recent Forbes column, author and FreedomWorks Vice President John Tamny makes the valid point that the scholars demonstrate the folly of price controls. “It’s a reminder that price controls work, though not in the way that their proponents want them to,” he writes.

Tamny is certainly right about the consequences of prices controls, and that is why many prominent economists oppose them. Yet it is the massive exaggeration of small loans interest late mandated by federal law that impassions much of the public and lawmakers to disregard logic on this issue. That’s why this study makes a powerful case that Congress should investigate not just government attempts to suppress views on social media by deeming such speech as “misinformation,” but the government’s spreading of misinformation itself.