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© Frank


Buy Now, Pay Later

by Martha Olney
September 2, 2020

This interview with Martha Olney, Professor in Berkeley's Economics Department, was conducted and condensed by franknews

Martha Olney | My name is Martha Olney. I'm a faculty member at UC Berkeley in the economics department. I've studied economic history and macroeconomics. I'm most known for the work I've done on consumer debt in the 1920s to 1930s.

frank | How did the practice of using credit to pay for things become so commonplace? 

Debt has been used by producers and governments forever. The switch that we see in the 1920s is centered on consumer debt.

So, people who would borrow in order to buy a home or people who would borrow in order to buy a farm or people who would borrow in order to buy farm equipment - none of those people are taking on consumer debt. Consumer debt is borrowing in order to buy consumer goods.

In the late 19th and early 20th centuries, there were societal norms about “good debt” and “bad debt.” If you were going to use credit or going to buy something “on time” as it was called then, it was because the good would generate an income stream, and you were going to use that income stream to discharge the debt. If you bought a plow, you are going to use the plow to plow the fields, to grow the crops, to sell the crops, to get the money from the crops, and to pay for the plow. In the late 19th century it was not the norm to use credit to buy something just for pleasure.

We see a change in society over the course of the 1920s. Buying on time becomes not the exception, but the norm. It loses its moral tone. Buy now, pay later - that is the push.

Why would you wait when you can buy this thing now? Why deprive yourself and your family of the joy of these things?

You see a big increase particularly in credit sales of appliances and automobiles and furniture in the 20s. 

To have that sort of societal shift happen in a decade seems pretty remarkable. How did it happen so fast? 

A lot of marketing from several new industries.

For one, this is also the electrification decade, so there's a whole lot of new electrical appliances that are being pushed on people - because if people are not paying for electricity, the very costly process of getting electricity to these places is not getting paid for. 

Additionally, each of the major car manufacturers established a credit company. The car manufacturers are pushing the use of credit to buy a car because these are expensive purchases and also because they are trying to reduce the seasonality in car purchases. 

What are some other shifts in credit that lead us to the modern version of the way we use it? 

Well, FICO scores started in the 1980s. FICO is an algorithm that uses different points of information to give you a number to reflect the riskiness you pose to a lender. Before the FICO score, sales finance companies would report to a bigger company that kept basically records of the same information that builds FICO scores today. They used three by five cards for every individual and would write down the same information now that FICO gathers electronically. So that information has been gathered since the 1920s, it is just now in a computer file. 

What role does consumer debt play in a financial crisis? Does it cause a crisis, or does it just make it worse? 

I think you have to be careful with what it means to say, "to cause the crisis." Some people hear that and say, "Oh, they're blaming the 2008 crisis on people who took out debt or they're blaming the Great Depression on people who took out debt." That's not the way in which I would say that the household debt contributed to both the Great Depression and the Great Recession. 

In the Great Depression, household indebtedness contributed to the crisis because the terms under which people had borrowed were very strict. It created an incentive for people to cut back on consumption rather than default on contracts, which had a macroeconomic impact.

Cutting consumption makes the recession worse.

Whereas, if they were to default on the contract, it would hurt the lender, but not the borrower. 

To understand the extent that that has a macroeconomic impact, you have to add in some of the work that has been done more recently about the differences in the marginal propensity to consume between high income and low-income households. People in really high-income brackets losing some of their income has a smaller effect on consumption than those in low-income brackets losing their income

You wrote a paper in a paper called “Avoiding Default: The role of credit in the consumption collapse of 1930” that stated, “whether high household indebtedness will lead to a collapse of consumption when expectations changed, depends on the consequences of default.”

What would the designing credit contracts with the right incentives look like to you? And what role does default have on the macroeconomic impact of debt? 

I don’t have an answer to what the perfect contract is. Talk to Elizabeth Warren. This is her field of research; she will have a better answer. But I do understand the scope of the problem. 

Specifically what I was writing about in that paper, was that when credit was new in the 1920s and early 1930s, stipulations in the credit contracts were very severe. If you missed a payment, they would repossess the item and the creditor would keep any money that you had paid on the contract. Today, if your car gets repossessed, they'll sell the car, they'll pay off the debt with the proceeds, and if there's any money left over, it goes back to you. 

In the 1920s and the early 1930s, that wasn't the case. The difference between the value of the car and what you still owed on was retained by the creditor. Because of that threat, in the 1929 downturn, you did not see people defaulting on those car contracts. Instead, you saw consumption collapse. In order to not default on the car contract, people have to cut back consumption in other places. 

We saw that type of reduction in spending again in the wake of the 2008 crash. People were at risk of losing their homes when they couldn't make HELOC payments or other mortgage payments. Covering those payments caused big drops in other consumption. We had pay cuts here in Berkeley that hit the faculty and the staff. When I would walk along the street with restaurants that are usually full of staff and faculty, and once the pay cuts were instituted, there'd be just one table occupied, if that.

People just stopped going to restaurants in 2009 and 2010 in order not to default on their debt - on their mortgages or on their car payment.

In either period repossession is costly because you lose your wheels, but it was more costly in the 1930s because you lost your wheels as well as the money you had already put into the car.  

The concern on the part of lenders is always that if the cost of default is too low, then people will strategically default -- they will have a plan basically to default on their debt if it's not too costly. They'll buy a car and use it for three months and then not pay and let them repossess the car because they don't need it anymore. And there's no cost to them of doing so.

That happens now on larger scales with large corporations, right? Giant companies have bankruptcy as a backup plan? 

It is different. A company can dissolve itself and then reform as a different company. An individual can't dissolve themselves and reform as a different individual. That's where the personal and the corporate bankruptcies are really different. 

How do race and credit intersect today? 

The technical legal answer is that lenders are prohibited from taking race into account in making loans. The actual answer is it shows up in a whole lot of different ways.

You have to start with the racial wealth gap. Individuals who start out with less wealth, are going to have a different credit history and therefore a different credit score than people who start out with more wealth.

The existing wealth gap is perpetuated from generation to generation and that is going to have an impact on what's called the “creditworthiness of individuals.”

(At the same time, it’s important to remember that these are averages across demographic groups. There will always be people who are on the tails of any distribution.)

The second piece is going to be when you look at when people buy homes and take out mortgages. The mortgage company can't gather information about race before they decide to lend; these days, they're not allowed to have any information in their files about the race of the borrower. But what they do know is where the property is, and we still live in a country with quite segregated neighborhoods. The segregation of neighborhoods contributes to the difficulty in getting mortgage credit. An article in the New York Times this last week discussed racial differences in the appraisal. If you want to borrow $300,000 and the appraiser says the house is worth $340,000, you're not going to get the loan. The value of the house has to be sufficient so that the loan to value ratio meets the standard guidelines. If the appraisers are lowballing the value of houses in traditionally Black or Hispanic neighborhoods, it is going to be harder for those folks to get loans. 

So, in terms of credit and race, there's a bunch of different pieces that all play in, none of which are you walk into a bank or a lender and they say, "Oh, we don't make loans to Black people." 

I am curious if there are other parallels you see - beyond even macroeconomics, or credit or bankruptcy - between the 1930s and today? 

The one thing I'll say is that as somebody who's done a lot of reading on the twenties and thirties I keep going back to how dark and scary everything felt in the fall of 1932 when we were coming up to a presidential election. There's an awful lot of parallel to today. We can look at the rising levels of inequality - the twenties and the last ten years are very similar in that respect. We can look to the language of the conservatives. The conservatives were constantly painting FDR as a socialist who was going to lead to the downfall of America. Then and now, conservatives are very much focused on the idea of individual responsibility. They would blame the people who had lost their jobs and were unemployed then. 

At the same time, in 1932, the majority of the country on average was ready for really big changes. We may be in a time where enough forces are coming together at the same time that people are ready for a big change. I try to hold that thought.