Income inequality: Time for predatory lending laws?Yuliya Demyanykpredatory lending, fraud, income inequality, economic growth
This article first appeared in the October 2006 issue of The
Regional Economist: A Quarterly Review of Business and Economic
Conditions and is reprinted here with The Regional Economist's
permission.
Income inequality - the gap between the rich and the poor -
seems to indicate a higher probability of a predatory lending law
being adopted. States that recently adopted predatory lending laws
had higher than average levels of income inequality over the past
10 years than their non adopting counterparts.
Predatory lending - an illegal activity by lenders or brokers
leading to a further decrease of well being of relatively poor
individuals - could generate greater inequality between individuals
in the U.S. economy. Predatory lending laws - the laws aimed at
reducing fraudulent lending activity - may do the most good in
reducing inequality in states where inequality is larger.
Between 1999 and last year, 24 states plus the District of
Columbia adopted laws to combat predatory lending. The law in each
state is designed to restrict origination of specific types of
loans - mostly mortgages - and/or to require lenders to disclose
details about those loans to state regulators.
Predatory lending, even though it lacks an exact definition, is
most often associated with lending to relatively poor borrowers, to
those who are uneducated about the lending process and to those
whose credit scores are low. Borrowers with incomes and/or credit
scores below a certain threshold are usually not able to obtain
credit unless they pay higher prices for their loans. Such loans
are called sub-prime or high cost loans. Not all high cost loans
are predatory, though.
Lending is considered predatory or fraudulent when lenders or
brokers:
-Take advantage of borrowers by charging very high fees that are
not justified by a risk factor;
-Issue loans knowing they can never be repaid or would almost
certainly lead to home losses and complete bankruptcy; or
-Change the terms of a loan at closing, thus knowingly misleading
borrowers.1
The relatively weak are both the easiest prey for predatory
lenders and those most likely to suffer the greatest economic
losses. If predatory lending, which tends to hurt poor people
disproportionately more than those who are better off, is populated
in an economy, then inequality may increase.
Income inequality
Income inequality in the United States is greater than in any
other developed country. Moreover, it has been increasing during
the past 25 years.2 Whatever the actual level of an individual's
income, a person might be discouraged and unhappy if he is
relatively poorer than many other people in society. Therefore,
rising income inequality might be considered harmful to society not
only because it represents a disparity between people, but also, as
some research shows, because it can cause slower economic growth,
an increase in crime, worse overall well being, poor educational
outcomes and even higher death rates, the same way a higher level
of poverty (absolute, not relative) would.3
Besides predatory lending, there are a number of possible
factors that can be responsible for inequality in a society.
Differences in education and abilities create wage differentials
leading to income differences; race, gender and cultural
differences can give rise to discrimination in the labor market.
Also, income inequality can rise if wealth circulates only among
those who have the means to invest and to increase already existing
wealth.
Several countrywide economic factors may affect inequality as
well. For example, some research studies show that faster economic
growth and greater economic development in an economy would benefit
the rich and the poor equally. Because the "boats" of both would
rise the same, however, the level of inequality would remain the
same.4
Other studies show that countries with better developed
financial intermediaries experience faster declines in both
inequality and poverty.5 However, financial development that offers
greater credit availability to previously left out borrowers (those
with lower credit scores and incomes) can also open the door for
more fraudulent lending. The number and variety of loan products
available on the market these days are reaching enormously large
magnitudes. A single financial institution can offer more than 600
different types of mortgage loans, which can confuse borrowers
regarding what product to choose and allow unscrupulous lenders to
take advantage of not just the poor but all who don't know enough
to protect themselves. Such development, once again, can increase
income inequality.
If predatory lending leads to higher income inequality in an
economy, then laws that restrict predatory activity would seem to
be most needed in those states where inequality is relatively
large. The analysis conducted for this article shows that predatory
lending laws were indeed adopted in states where they might do the
most good in reducing inequality.
Income inequality in states with predatory lending
laws
To examine a possible link between income inequality and predatory
lending in the United States, an individual level income inequality
measure, a Gini index, is calculated separately for each state and
year for the past 10 years. The Gini index is one of the most
widely used measures of income inequality. The Gini index would be
zero in an economy in which everyone has the same income; the index
would be 100 percent in an economy where one person has all the
income and everybody else has zero income. The average income
inequality across the U.S. states was about 50 percent in the year
2000.6
It is too early to formally test for any actual real effects
that predatory lending laws have on states' economies and, in
particular, whether these laws are really fighting income
inequality. Future studies are needed to address this issue. In
addition, more studies are needed to test whether there are factors
that influence both predatory lending (and the probability a
predatory lending law will be adopted) and income inequality at the
same time.
Yuliya Demyanyk is an economist at the Federal Reserve Bank of St.
Louis. She can be contacted by e mail at
[email protected].
Footnotes
1. See www.hud.gov for more
examples of predatory lending activities.
2. The U.S. Census Bureau publishes different historical income
inequality measures at www.census.gov/hhes/income/histinc/ie6.html.
3. See Kennedy et al. (1996) and Kaplan et al. (1996).
4. For a list of references, see www.economist.com/inequality.
5. See Beck et al. (2004).
6. Author's calculations based on the data from the Current
Population Survey.
References
Adams, Richard H. Jr. "Economic Growth, Inequality, and Poverty:
Findings from a New Data Set." The World Bank, Policy Research
Working Paper 2972, 2003.
Aghion, Philippe; Caroli, Eve; and Garcia Penalosa, Cecelia.
"Inequality and Economic Growth: The Perspective of the New Growth
Theories." Journal of Economic Literature, 1999, Vol. 37, No. 4.,
pp. 1615 60.
Alesina, Alberto; and Rodrik, Dani. "Distributive Politics and
Economic Growth." Quarterly Journal of Economics, 1994, Vol. 109,
No. 2, pp. 465 90.
Beck, Thorsten; Demirguc Kunt, Asli; and Levine, Ross. "Finance,
Inequality and Poverty: Cross Country Evidence," NBER Working Paper
No. 10979, Issue December 2004.
Ho, Giang; and Pennington Cross, Anthony. "States Fight Predatory
Lending in Different Ways," Federal Reserve Bank of St. Louis The
Regional Economist, January 2006, pp. 12 13.
Kaplan, George A.; Pamuk, Elsie R.; Lynch, John W.; Cohen, Richard
D.; and Balfour, Jennifer L. "Inequality in Income and Mortality in
the United States: Analysis of Mortality and Potential Pathways,"
British Medical Journal, April 1996, Vol. 312, pp. 999 1003.
Kennedy, Bruce P.; Kawachi, Ichiro; and Prothrow Stith, Deborah.
"Income Distribution and Mortality: Cross Sectional Ecological
Study of the Robin Hood Index in the United States," British
Medical Journal, April 1996, Vol.312, pp. 1004 07.
The Economist, June 15, 2006.
