This idea of “excessive” interest is not necessarily easy to put into operation, and its application in practice requires some ethical discernment. This is not to say that it is unimportant, but government regulation can be a sledgehammer that misses a nut. Let’s think of this from both the lender’s and borrower’s points of view.
Consider a payday loan. Such loans are typically small and are repaid over a short period of time. When their interest rates are “annualised” – calculated as if the loan were rolled over on the same terms, month after month, for a whole year – incredible rates of interest are quoted. However, it is, in fact, easy to reach a large figure for the interest rate without any substantial profit being made, simply because of the nature of the transaction.
For example, imagine a loan of £100 for two weeks, which involved an administration cost of only £5 and where this was the only cost passed on to the customer (with no allowance for interest, profit, or risk of non-repayment). The annual effective rate of interest on such a loan would be more than 250 per cent. Comparing the cost of a short-term loan with longer-term alternatives is like comparing the cost of renting a hotel room at a nightly rate for 365 nights with renting a house for a year.
You might be thinking “the fact that the lender is not making a particularly large profit from the transaction is not much comfort for the borrower – it could still lead the borrower into a spiral of debt with devastating consequences.” But this is not as clear as it seems. An individual who has a very low, predictable income and uses a payday loan to meet regular expenses is likely to run into trouble. On the other hand, if somebody whose winter electricity bill is due five days before he is to be paid takes out a payday loan and repays it within the month, he avoids either a bad credit record or the hassle (and possibly additional cost) of a bank overdraft. Students may also take out payday loans, perhaps because of the need to buy a large consumer item (such as a laptop), just before their student loan payment is made by the government. Before the market was regulated in the UK, the average payday loan borrower had a similar level of education than the average of the population and was more likely to be working.
Whether lending at high cost is exploitative, or sends the borrower into a spiral of decline, very much depends on the particular circumstances of the lender and the borrower.
What would happen if we were to regulate interest rates? We know the answer to this question, because many jurisdictions do regulate payday lending. Regulation of payday loans tends to make complete financial breakdown and subsequent difficulty obtaining housing and employment worse; leads to the use of illegal lenders, who tend to have rather brutal methods of enforcement; leads to greater reliance on family members; and leads to the use of more expensive forms of credit. (Evidence from various studies can be found in the IEA’s Flaws and Ceilings, edited by Coyne and Coyne, pp. 139-146.)