We will begin with a little experiment in behavioural economics. Which would you prefer – receiving $100 today or $200 one year from now? If you are like most people, you would take the $100 today. Once you stop to think about it, the decision to take the $100 today is really quite silly, as you would receive 100% more money in one year’s time, and unless you are a very savvy investor, there are few opportunities to make that kind of return. But we humans consistently choose the $100 today, a phenomenon which goes by the cumbersome name of hyperbolic temporal discounting. Made famous by George Ainslie who carried out his groundbreaking work in pigeons, temporal discounting is everywhere around us but we rarely take note. Moreover, temporal discounting applies not only when we think about getting money, but even more insidiously, the same thing happens when we are borrowing money.
The arena of modern life in which temporal discounting plays out with perhaps its most disastrous consequences is the spectacle of payday loans. The idea behind payday loans is simple: the loans are short-term (usually one to two weeks) and allow people to get an advance on their paycheck. Typical rates are $15 for a two-week advance of $100, which seems reasonable when you are hungry. Or need a roof over your head. But if you do the math, the numbers turn out to be terrible. The nominal annual percentage rate or APR is a whopping 390% (15% x 26). That is what you will be charged if you payback your loan on time. In order to get around usury laws, payday lenders generally require you to completely payback your loan at the end of the loan period, in this case two weeks. What happens if you don’t have the cash? Well, your friendly payday lender will be happy to advance you another loan to cover your losses, again at the rate of 15% for two weeks. As you can imagine, by the time payday comes around, many people are again in trouble, and have no choice but to take out another loan. If you continued doing this for an entire year, you would now be paying 3,685%, which is called the effective annual rate. Sound confusing? It is. And unless you have a mind that pays more attention to figures than desires, you will completely ignore the interest rates, nominal, effective, or whatever, and just go for the cash. Today. In your pocket.
It does not take a great deal of experience in the field of neuroethics to recognize the issue here. The payday industry capitalizes upon a very common mental trap – temporal discounting – to allow charging rates of interest that are, without invoking too much hyperbole, outrageous.
It is hard to know whether the architects of the payday loan industry know much about temporal discounting as described in the psychological literature, but it is pretty clear that they have a robust folk psychological understanding of the phenomenon. Daniel Brook published a remarkable article about the subject in Harper’s last year, profiling W. Allan Jones, one of the inventors of the payday loan industry. According to Brook, “In the early 1990s, there were fewer than 200 payday lending stores in America; today, there are over 22,000, serving 10 million households each year—a $40 billion industry with more U.S. locations, in fact, than McDonald’s.” Of course the real tragedy of payday loans is that they prey upon some of the most downtrodden members of society – people who, in the classic phrase, are living paycheck to paycheck. Except that they aren’t.
Resisting the temptation of temporal discounting is fundamental to self-control, and it can be learned with with great difficulty. You can see the perils of temporal discounting in children when they are quite young – in a thoughtful essay in The New Yorker, Jonah Lehrer recounted the much described marshmallow experiment. Young children sit at a desk, and a marshmallow is placed in front of them. Then they are made an offer. They told a girl named Carolyn that she could,
either eat one marshmallow right away or, if she was willing to wait while he stepped out for a few minutes, she could have two marshmallows when he returned. He said that if she rang a bell on the desk while he was away he would come running back, and she could eat one marshmallow but would forfeit the second. Then he left the room.
“A few kids ate the marshmallow right away,” Walter Mischel, the Stanford professor of psychology in charge of the experiment, remembers. “They didn’t even bother ringing the bell. Other kids would stare directly at the marshmallow and then ring the bell thirty seconds later.” About thirty per cent of the children, however, were like Carolyn. They successfully delayed gratification until the researcher returned, some fifteen minutes later. These kids wrestled with temptation but found a way to resist.
It turns out that the ability to resist temptation is an excellent predictor of success in many realms of life. The other side of that coin is that people who have difficulty resisting temptation – who fall into the trap of temporal discounting most easily – often end up at the lower end of the socioeconomic spectrum. And if life didn’t hold out enough temptations for them, there are payday loans satisfy that burning desire for the marsmallow. Today. Right now.
The Center for Responsible Lending has a great deal of useful information about payday lending, and efforts to put forward legislation that might reduce this onerous practice. Payday lending is legal in 37 states and all the provinces of Canada save for Quebec. Although mostly regulated at the local level, the US federal government has passed legislation making it illegal to charge more than 36% APR to military personnel, and a bill has been proposed in Congress to limit APR to 780% [recall that APR is quite a bit lower than the effective annual rate that arises when one rolls over their payday loan week after week]. One can only imagine what kinds of rates are being charged out there if the legislation aims to limit the APR to 780%.
All in all, payday lending is a tragedy that we have brought upon our fellow humans, capitalizing upon a known weakness in our brains ability to calculate the costs of, well, everything.
For another view of payday lending, listen to Rachel Maddow who pulls no punches.
Link to George Ainslie’s classic paper
Link to Daniel Brook’s article on payday loan industry
Link to Jonah Lehrer’s article on resisting temptation
Link to Gary Rivlin’s book Broke, USA
Link to the Center for Responsible Lending’s page on payday loans
Image credit LoansTillPaydayOnline.com