Everyone loves to hate crony capitalism. But crony consumerism, its evil twin, is just as dangerous, yet is barely known.
In the wake of the Great Society’s efforts to mandate equality for the poor and overcome a legacy of racial discrimination, activists demanded equal access to credit. With political support for a massive welfare state receding after Lyndon Johnson’s high tide, consumer-credit expansion seemed to offer an indirect, on-the-cheap way to reduce poverty: The poor would borrow money, which the government assumed they would pay back. In theory, the houses, higher education, and consumer durables they acquired would enable a middle-class life now while building wealth for the future, as the loans were gradually paid down.
It actually accomplished the opposite: While it lavished rewards on insiders who knew how to game the regulations (National Review Online recently reported that 18 percent of the top 0.1 percent of earners are in finance), the percentage of households with less than $10,000 net worth (in constant 2007 dollars) remained stuck near 30 percent from 1983 to 2007, even as the massive expansion of credit availability produced an equally massive expansion of indebtedness. (This analysis relies heavily on the work of Reuven Glick and Kevin J. Lansing, along with that of Edward N. Wolff.) Faced with the destructive consequences of easy borrowing for people with limited, irregular incomes and iffy money-management skills, the equal-credit ideology devolved into crony consumerism, which advocates cheap, ready credit for deadbeats while opposing lenders’ efforts to collect. The result has been half a century of successive bubbles.
Society had fueled the post–World War II boom with consumer Keynesianism, encouraging people to spend borrowed money on cars, houses, and home furnishings to pump up the economy and stave off another depression. This Krugmanesque paradise, however, could last only as long as a number of temporary (and, from today’s perspective, unacceptable or illegal) practices kept free markets from operating: de facto reservation of most good jobs for white males in single-earner families (according to an ethnic hierarchy allocating different levels of jobs to different Caucasian subgroups), cartelization of the labor market through widespread private-sector unionization and a high minimum wage (which kept minorities and women from undercutting white males on pay), and restriction of immigration and trade (which limited foreign competition).
These practices began coming to an end in the 1960s, thanks to Title VII of the 1964 Civil Rights Act (which banned employment discrimination), the Immigration and Nationality Act of 1965, and the full-fledged return of Western Europe and Japan to world markets. These changes undermined the economic standing of the white males who had benefited from the old ways, along with the Keynesian consumer model that was premised on their consumption.
But while African Americans, Latinos, and women were now legally equal, the effects of past discrimination impaired their ability to service debt, as did other characteristics unrelated to discrimination (e.g., relocation from lower-income rural regions or immigration from poor countries, in the case of African Americans and Latinos, and childcare-related absence from the work force, in the case of women).
Working out these issues over the long term went against the utopian spirit of the era. The Johnson administration masked its redistributionist agenda by rolling out a series of purportedly self-financing loan-guarantee programs, all of which eventually incurred huge losses. It established federally subsidized student loans (1965) and flood insurance (1968), privatized New Deal–era Fannie Mae (1968), and expanded Federal Housing Administration (FHA) loan guarantees to high-risk borrowers (1968). Competing for moderate votes, Republicans colluded with Democrats to expand the guarantees still further by creating Freddie Mac (1970) and reframed questions of wealth distribution as mere matters of credit discrimination, culminating in passage of the Equal Credit Opportunity Act (1974) and the Community Reinvestment Act (1977).
These changes did have some positive effects. African Americans, who had effectively been locked out of new suburban housing by discriminatory federal loan-guarantee programs, were able to enter the housing market, and segregation decreased in the fast-growing Sun Belt. Women, with their work-force-participation and divorce rates soaring, also got direly needed access to credit. But the emerging crony consumerists blamed the inequalities that continued on present discrimination (which in reality was a minor factor) and demanded ever more credit for previously excluded groups.
At its core, crony consumerism is about getting something for nothing. People with low, variable incomes and little wealth sometimes want credit, either to tide them over a temporary cash crunch (a demand traditionally met by pawnbrokers and payday lenders) or because they want to own expensive capital assets (houses, furniture, cars) before they have saved enough money to buy them. With these borrowers’ high expected default rates, lenders have to charge high interest rates to make even a modest profit.
Thus, as historian Louis Hyman demonstrates in his book Debtor Nation, 19th-century usury laws that set maximum interest rates led loan sharks to charge very high interest to compensate for the collection risk (since they could not use legal proceedings). Another technique was the sale of durable consumer goods on installment contracts that hid high financing charges. Those who borrowed at high rates often did not understand what they were getting themselves into.
The same situation persists to this day. Most people, especially low-income borrowers, have difficulty doing simple arithmetic, let alone understanding concepts such as compound interest and opportunity cost. When people with little money borrow—legally or illegally, and explicitly or implicitly (as with the installment plan)—they have to pay a crushing rate of interest. The crony consumerists’ response to this basic fact of economics is to command it to disappear.
Instead of acknowledging the inescapable tradeoffs among credit availability, contract enforceability, and cost of lending, crony consumerists present a morality play in which consumers always want to borrow prudently for important reasons, but evil, discriminatory businesses gull them into paying exorbitant rates (even in perfectly competitive markets) for useless loans. Since it’s all the lender’s fault, requiring borrowers to repay their debts is flat-out wrong.
Soon after the massive expansion of federal consumer guarantee programs, technological, financial, and legal changes (including the lifting of usury caps) led to enormous growth in the credit-card industry. It became characterized by widely available unsecured credit, with no federal guarantees. Consumer bankruptcy was the chief means of restructuring excessive debt, with correspondingly high interest rates to offset the lenders’ high writedowns. This mostly free-market sector has been bubble-free for the last 35 years. While it may have enabled excessive spending, it has mainly funded consumption of short-term goods, which make it easy for consumers to compare current prices and assess value, so its effects have not been too harmful.
In contrast, those who borrowed for housing and higher education were acquiring expensive assets that were inherently difficult to value. These sectors were the “beneficiaries” of heavy government regulation, extensive loan guarantees, and a government-sponsored ideology that virtually gave consumers a civic duty to overextend themselves. When President Barack Obama said that everyone should have at least one year of college, he deliberately avoided discussing its cost or value. Inevitably, this sort of thinking and regulation has fueled a series of bubbles in housing and education, from the 1970s through today.
While crony consumerism promised to help lower-income people build wealth by acquiring assets, it actually loaded them up with debt in order to fund the explosive growth of a new set of crony non-capitalists. These were nominally nonprofit entities, some of which lent money, some of which directly or indirectly subsidized lending (e.g. Fannie Mae and Freddie Mac), and some of which agitated for more lending (e.g. the Neighborhood Assistance Corporation of America) or connected borrowers with lenders (e.g. various “community development” groups). These organizations were often run by political insiders who effectively capitalized the value of forced below-market lending and federal guarantees in order to enrich themselves.
Activists and liberal politicians called lenders “redliners” if they refused to make below-market mortgage loans, and “predatory” if they made high-cost market-rate loans. The effect was to funnel an ever-greater share of the lending market to crony non-capitalists, who made money not by obeying economic principles but by ignoring them. Fannie Mae (whose former chairman, James Johnson, got the job in the 1990s after running Walter Mondale’s failed 1984 presidential campaign) and Freddie Mac are the most famous examples, but they are far from alone.
Thus the Community Reinvestment Act enabled the Association of Community Organizations for Reform Now (ACORN) to accuse banks of inadequate lending in low-income neighborhoods when they sought to merge. Before ultimately collapsing in scandal, ACORN acted as a troll at the bridge, extorting fees for managing bank programs that made high-risk mortgage loans to low-income borrowers. The FHA enabled a separate money-laundering scam in which a low-income borrower would receive “down-payment assistance” from a nonprofit in order to buy a house from a developer, with the mortgage loan guaranteed by the FHA. The developer then turned around and made a “contribution” to the nonprofit, effectively funding the down payment while paying the nonprofit a substantial fee, and leaving the FHA guaranteeing a mortgage where the borrower had put no money at risk. By 2008, “down-payment assistance” loans were 12 percent of the FHA’s portfolio but 30 percent of its foreclosures. The Center for Responsible Lending even has its own affiliated lending institution. Meanwhile, colleges and universities went on an expansion binge, featuring skyrocketing tuitions and administrator salaries along with luxurious, ego-driven facilities upgrades.
The bill came due in waves: the FHA’s Section 235 homeownership-subsidy fraud in the 1970s, Fannie Mae’s de facto insolvency in the 1980s, the late-1980s housing crash, waves of student-loan defaults (which in 2005 led to legislation that made student loans nondischargeable in bankruptcy), and the effective insolvency of the federal flood-insurance program. In each case, the crony non-capitalists (assisted by crony capitalists who also benefited) prevailed on the federal government to double down on its guarantees rather than shut the programs down. Consumer debt kept increasing.
This system of government-mandated below-market credit and guarantees finally crashed in 2008. Consumers, the purported beneficiaries of the whole arrangement, found themselves maxed out on debt with little to show for it other than underwater houses (literally so in the case of Hurricane Sandy–hit areas that were overdeveloped thanks to federal flood guarantees) and worthless higher education (which in many cases had not even culminated in the student’s receipt of a meaningless degree).
The crony non-capitalists could no longer resort to their favorite remedy—pressing for even more guarantees—because underwater consumers were paying down debt rather than taking out more. So, having forced decades of below-market loans, the crony consumerists now attacked loan-collection efforts. Deadbeat borrowers who had stopped paying their loans were cast as victims of evil mortgage servicers. The legal arm of the crony-non-capitalist movement—the federal and state attorneys general—got into the act, claiming fraud and stalling foreclosure to the point where defaulted borrowers could remain in single-family houses for over two years in New Jersey and New York.
Meanwhile, the Obama administration further gutted collection efforts through loan-“modification” programs that provided some relief but rarely brought borrowers up to date on their payments. The push extended beyond the federal government: In Detroit, where half the water utility’s customers were in arrears, crony consumerists have loudly protested service shutoffs for homeowners who don’t pay their water bills.
The Obama administration administratively enacted a series of deferrals for repayment of student loans that allowed the government to disguise spiraling default rates. Following the pattern that had been established for mortgages, crony consumerists excoriated for-profit colleges for their high tuition fees and low graduation rates while turning a blind eye to the same practices in crony-non-capitalist institutions such as nonprofit and state universities. Income-based repayment schedules and forgiveness programs allowed those institutions to keep charging exorbitant tuitions, to the point where the Georgetown, Columbia, and University of Chicago law schools—bastions of the future 1 percent—have promoted a virtually debt-free education for graduates who join the crony non-capitalist sector by working in nonprofit or public-sector jobs for ten years after graduation.
And now the economy’s gradual recovery has emboldened the crony consumerists to start shoveling out the guarantees again. Federal Housing Finance Agency chief Mel Watt wants Fannie and Freddie to resume guaranteeing and acquiring 3 percent down-payment loans. Congress gutted the Biggert-Waters Flood Insurance Reform Act of 2012, which had discouraged construction in flood zones by charging market rates for federally guaranteed flood insurance.
Breaking out of crony consumerism won’t be easy, given the power of crony non-capitalists and the allure to the general public of the promise of something for nothing. One way to start would be by amending the Federal Credit Reform Act of 1990 to require fair-value accounting for government loans, including marking to market for distressed loans. Deadbeats who are in default on their loans should be barred from stalling foreclosures; at most, they should be able to collect actual damages for any procedural irregularities. It should be easier for consumers to file for bankruptcy, so that lenders (as opposed to government guarantees) bear the risk: If residential borrowers can go bankrupt and, in exchange for giving the keys back, walk away from their mortgages, or if student-loan borrowers can zap their liability so that lenders collect just pennies on the dollar, then lenders will be far more concerned with prospects of repayment. (In the credit-card industry, this has worked for 35 years.) Careful lending will inevitably have a disparate impact in terms of race and sex, but only intentional discrimination on invidious grounds should be illegal.
– Mr. Weiser is an associate professor of law and real estate at Baruch College of the City University of New York.