Debtor Nation

The History of America in Red Ink

Louis Hyman

• Publisher: Princeton University Press
• Year: 2011
• ISBN:
  9781400838400
• Topic: History
• Subtopic: North American History
• Index: History

The story of personal debt in modern America Before the twentieth century, personal debt resided on the fringes of the American economy, the province of small-time criminals and struggling merchants. By the end of the century, however, the most profitable corporations and banks in the country lent money to millions of American debtors. How did this happen? The first book to follow the history of personal debt in modern America, Debtor Nation traces the evolution of debt over the course of the twentieth century, following its transformation from fringe to mainstream—thanks to federal policy, financial innovation, and retail competition.How did banks begin making personal loans to consumers during the Great Depression? Why did the government invent mortgage-backed securities? Why was all consumer credit, not just mortgages, tax deductible until 1986? Who invented the credit card? Examining the intersection of government and business in everyday life, Louis Hyman takes the reader behind the scenes of the institutions that made modern lending possible: the halls of Congress, the boardrooms of multinationals, and the back rooms of loan sharks. America's newfound indebtedness resulted not from a culture in decline, but from changes in the larger structure of American capitalism that were created, in part, by the choices of the powerful—choices that made lending money to facilitate consumption more profitable than lending to invest in expanded production.From the origins of car financing to the creation of subprime lending, Debtor Nation presents a nuanced history of consumer credit practices in the United States and shows how little loans became big business.

Chapter One

Making Credit Modern

THE ORIGINS OF THE DEBT INFRASTRUCTURE IN THE 1920s

WHEN THE NEW INSTITUTIONS of the modern credit system took shape after World War I, its innovations frequently went unnoticed. Even to some trained financial experts, it appeared like nothing had changed at all. As one banker, Charles de B. Claiborne, later remarked in the 1930s, “We have always had installment buying, in my mind, for few ever bought for cash. The housewife bought and bought; she paid and paid, from month to month and from time to time.”¹ The “charge account” or “open book account,” where a retailer put a purchase on the books and a customer repaid at some uncertain future point, was the most common form of consumer credit for rich and poor, urban and rural, throughout late-nineteenth-century America.² Understood as a convenience, not as a profit source, charge accounts imposed no fees on the customer, unless the retailer had “credit” prices higher than “cash” prices. In some sense, Claiborne was superficially right: Americans still borrowed. Behind that borrowing, however, emerged new networks of capital that changed the meanings, the institutions, and the possibilities of lending. After World War I, personal debt in American capitalism began to become commercially profitable, institutionally resellable, and legally available on level unknown before.

Modern debt after World War I was defined through two new debt practices, installment credit and legalized personal loans, which reflected the social and economic order that emerged out of the new industrial economy. Installment credit allowed consumers to buy more, retailers to sell more, and manufacturers to make more, all at lower prices. Personal loans, meanwhile, enabled those industrial workers who made all those goods weather the uncertainties of capitalism’s labor market. In tandem, the two debt practices developed for two distinct purposes inaugurated a new relationship between credit and capitalism, connecting personal lending to the larger circulation of investment capital in the American economy.

Retailers, perhaps, experienced the greatest transformation as debt became resellable. While the butcher, the baker, and the candlestick maker had always allowed their customers to charge their purchases, no retailer liked it. Consumer credit was a losing proposition that all retailers sought to avoid.³ Lending, particularly the “open book credit” that small retailers used, was the surest way to the poorhouse. Customers didn’t always pay. Record keeping was complicated. Credit bureaus did not exist yet for consumers as they did for businesses. Nonetheless, competition forced many merchants to offer credit, usually losing money in the process. Charging more for “credit prices” could drive business away, even as offering liberal credit could bring customers in. Retailers were not banks and did not have the excess capital to tie up in what amounted to unsecured loans to customers. Retailers were caught between the need to expand volume and consumers’ desire for credit. This common sense thinking, that lending was unprofitable, is exactly opposite from our intuition today, when lending drives our economy. Retailers, unable to resell their debt or to finance it in other ways, had to perform the roles of bank, merchant, and collector—an untenable situation. Self-financed retailers tended to charge customers more and, through the mechanisms of repossession, had considerable incentive to cheat their customers. Only the largest self-financed merchants and manufacturers, like Singer, who financed its sewing machines or Sears, Roebuck who seemed to finance everything else, could do so without withering their own business and their customers’ wealth. Even these large enterprises lost money on credit, but were able to make up for those losses on volume, something that a local merchant could not.

In the 1920s, for the first time, retailers could sell their debts to another institution—the finance company—and this simple possibility inaugurated the rise of the financial infrastructure that backed the proliferation of personal debt in the twentieth century, beginning the long process of realigning our financial common sense. This reselling of debt began through that most quintessentially American of inventions—the automobile. Financing the vast inventory of automobile dealers and the vast appetites of Americans for autos initially proved too large for auto companies, creating an entrepreneurial role for the finance company. In turn, the finance company enabled the profitable expansion of other forms of installment lending, expanding the flow of capital into nearly all areas of consumer durable spending. Through installment credit, working- and middle-class Americans could enjoy the fruits of the industrial economy, budgeting the payments to coincide with their now regular paychecks.

While consumers slaked their desire for former luxury goods like phonographs and automobiles through installment credit, Americans after World War I could also legally borrow for more pressing essentials—personal loans. If the industrial economy produced automobiles at prices Ford’s workers could afford, it also produced structural unemployment, work injuries, and all the other hazards of industrial life beyond the control of individuals. Such hazards for working people were nothing new. Working-class Americans pressed for emergency cash had traditionally turned to personal networks of friends and family, themselves often financially constrained, and when those networks ran out, the local loan shark. With the legalization of personal loans—what was called “small loan” lending in the 1920s similar to what is called “payday” lending today—Americans discovered a means of financial self-reliance outside the judgmental eyes of family and community and outside the grasp of predacious loan sharks.

All Americans needed financing to benefit from and survive in the new modern world. Whereas the installment plan enabled middle-class consumers to enjoy the modern products such an economy made, personal loans enabled workers, who were always also consumers, to weather its brutal vicissitudes. While borrowing grew, the great suppliers of capital, the commercial banks, and the great organizers of capital, the manufacturing companies, initially kept the business at arm’s length, leaving its risky lending for the hungriest entrepreneurs seeking the last scraps of profit. At a time when banks were distracted by the spectacular profits from manufacturing investments and the stock market, the unorthodox business models of finance companies and personal loan companies bridged the banks’ capital to the consumer. Loan sharks began to move their capital from dank backrooms into the legal personal loan businesses, forming legalized national lending networks. At the same time, new independent finance companies, initially just connected to the automobile industry, eventually extended to all durable goods. Linking credit to the larger circulations of capital made credit cheaper and safer for consumers. Consumers finally had an alternative to the expensive, self-financed retailers and the illegal collection methods of the loan shark. Contrasting these new forms of credit with what came before—loans sharks vs. personal loans and self-financed retailers vs. automobile dealers—shows how the new credit system helped manufacturers, retailers, and consumers. For the middle-class, and the native-born whites of the working class, this new credit system displaced the old. For African Americans and for immigrants, access to this new credit system was more uncertain, and for those without access, lending remained as predatory as it had been before.

The rise of these new forms of debt was neither entirely beneficial nor entirely detrimental for borrowers but both at once, in complicated and often unexpected ways. Entrepreneurs, as well as reformers, created new institutions to meet these needs—creating profit for some and penury for others. Installment credit enabled people to achieve a level of consumption unattainable without the use of debt. With this improved standard of living came, at the same time, the risk of losing a family’s possessions if the debtor missed a single payment. Did debt make good the promise of democratic consumption or was it only a quixotic dream of modern luxury for everyone? The Americans of the 1920s, of different classes, moral outlooks, and economic interests, had a variety of answers to these questions. For reasons of class, race, or nationality, those who did not have access to this credit paid more than those who did. Modern debt, whatever its benefits and drawbacks, refashioned the ways in which Americans bought, worked, and lived, in keeping with the harsh demands and unparalleled delights afforded by the modern industrial economy.

The Price of Risk: Loan Sharking and Small Loans

If a single place had to be pointed to as the origin of the modern debt economy, one might choose the backroom of a Minneapolis jewelry shop in the late 1870s, where a young John Mackey, a thirty-four year old man with a “substantial” inheritance, had recently set up shop to loan hopeful “settlers from both the East and from Europe” money as they made their way to the Dakota territories.⁴ Mackey’s small operation would eventually become, by the 1920s, the most widespread small loan company in the United States, the Household Finance Company, and then eighty years later, find itself at the center of American subprime and credit card lending. The story of his business represents, in some sense, a long thread of the history of American debt. Mackey’s business could charitably be called a pawnshop, but the pawnshop was just for show. John Mackey was a loan shark, lending money at 10 percent per month, which added up to 185 percent per year.

Loan sharks, like Mackey, existed because there was no legal alternative for personal loans. In a utopian world, profit would not be necessary to get people what they need. Loans, for instance, could be lent with little or no interest and repaid when the borrower found it convenient, as many charitable societies attempted, with little success, at the turn of the century. Constrained by a lack of capital, these societies withered. Loan sharks, however, prospered. No legal alternative existed.

Profitable lending required the borrower to pay enough in interest and fees to offset the risk that debt would not be repaid. Charging interest on loans, per se, was not illegal, just usurious rates like those that Mackey charged. The definition of usury varied by state, but was always so low—typically 1 to 1.5 percent a month or 13 to 20 percent annually—that reputable businessmen could not make money lending to consumers. Though 13 percent seems high enough to us today, consider how much more difficult it would be to collect from a customer around 1900. Personal loans, by virtue of their size and the customer, made them more expensive to provide profitably under existing usury laws. Administering small personal loans was much costlier than commercial loans because the office work was at least as much for a small loan as for a large loan, if not more. Businesses had a paper trail of income and expenses, while individuals, few of whom paid income taxes, could be less transparent. Borrowers tended to have few assets to use as collateral. A unique identity, without a social security number, would be hard to ascertain. Without a phone, contacting references would have been arduous. Even if you knew someone personally, knowing who was a good credit risk was impossible without a credit rating, or at least expensive. The interest rate had to cover the risk of the loan, and without information, the risk was always high. Between paperwork and higher risk, small loan lenders needed a higher rate of interest than the 6 percent common in business loans to make a profit.

For loan sharks, the difficulty of collection was compounded by their having operated illegally. No court would enforce the loan. No bank would lend money to grow his business. Mackey had access to only a limited amount of money to lend. The scarcity of capital and the risk of borrower default made his money more valuable to him. Thirteen percent interest would not have allowed him to operate profitably. It is more than enough to offset risk today, but the relative cheapness of our credit is made possible through today’s technology to enforce debts, regulation to compel us to pay, and lenders’ ability to resell our debt to investors. These differences make possible profitable lending at 13 percent rather than 185 percent.

Mackey’s business, despite these obstacles, grew with these high interest rates and by 1881 he opened an office separate from the shop.⁵ Quasilegal, these loan-sharking syndicates operated in the open, but with furtive methods to conceal their usurious rates. In 1885, he had the first of many usury lawsuits brought against him for charging exorbitant interest rates, which in annual terms topped 300 percent (he had evidently raised his rates). Though the lower courts found in his favor, the supreme court of Minnesota reversed the lower court’s decision, finding Mackey guilty of usury. Despite the loss, however, Mackey took his fine in stride as a business expense and expanded his enterprise. In the next two decades, despite breaking the law, Mackey opened a chain of lending offices across many states.⁶

Why did people borrow from loan sharks like Mackey? Banks would not lend small amounts to ordinary people. For those who had exhausted the limits of charge account credit, there was no alternative. They had to pay their bills at the grocer or the butcher before they could get more food.⁷ For those without access to other working-class credit sources, like a benevolent bartender, an ethnic credit circle, or friends and family, or were fearful of the ensuing shame of needing to borrow from someone they knew, the loan shark was often the only alternative.⁸ Loan sharks, like Mackey, were an active and important part of working-class life in early twentieth-century cities.

Records from Mackey’s Illinois offices in 1917 reveal that the firm served the needs of people working in diverse occupations—yet ne...