Why The Interest Rate Caps Would Be A Profound Mistake

Proposing a novel channel for the harms of price caps

The stigma of usury is an enduring one. Throughout history, people have tried to forbid the lending of money at interest to others. Such laws falling into abeyance has been a not-insubstantial part of sustained economic growth – during the industrial revolution, for example, greater access to credit led to more patents, and banking led to greater industrialization. We need lending both because we have diminishing marginal utility, and so we would prefer our consumption to be divided evenly over time, and because many goods are indivisible. We cannot consume a quarter of a house, and slowly build up the rest of it as we save – instead, we get money now and pay it off later. A poor person who needs their car to get to their job does not get slightly falling utility as their car breaks down – either it works, or it doesn’t. Credit cards allow people to avoid disaster from small emergencies.

We have recently had an unfortunate outbreak of bipartisanship regarding interest rate caps on credit cards. The rates, they say, are too high. Alexandra Ocasio-Cortez and Anna Paulina Luna have proposed a cap of 10%. The arguments for it are either pure economic illiteracy, or a more sophisticated argument relying on the myopia of unsophisticated borrowers. We expect price caps to reduce the supply available, and cause rationing. It is striking how the two schools of thought for interest rate caps argue, in turn, that it won’t happen, and that it happening is good.

We have empirical evidence that price caps will cause a decrease in quantity supplied and a reduction in consumer welfare. Chile imposed interest caps on loans in 2013. (Cuesta and Sepulveda, 2019) Observed interest rates fell by 9%, but the total number and volume of loans fell by 19%, and most of all for risky borrowers. This had an impact equivalent to income falling 3.5%, which is a simply enormous negative impact. In the United States, enforcing interest caps drives out lenders with better screening technology, and once again penalizes the riskiest borrowers.

The argument from myopia agrees that this will happen – they just believe that this is good, and keeps poor people from trapping themselves with stupid decisions. Poor people, they argue, are persistently over-confident and trap themselves in cycles of debt. This is possible, but I am extremely doubtful that price caps are the right mechanism – they are like setting the house on fire to be rid of termites. In addition, people have other options for getting money fast, like pawn shops – they’re just universally far worse than simply putting a price on credit card debt.

The empirical evidence being strongly against such caps has been noted by other authors. I want to focus on a novel way in which interest rate caps are bad. It has an unpleasant interaction with monetary policy. For the purposes of this section, we’re going to refer to the interest cap on credit cards as being an interest rate cap on all lending activity; in fact it must be a cap on interest rates in lending in practice, or else it would be totally toothless as people switch their borrowing to other outlets.

Suppose that the central bank was flexibly targeting an average of 2% inflation. During times of unexpectedly high growth, the central bank will allow inflation to be lower than usual, so that during times of unexpectedly low growth, we can allow the inflation rate to be higher. The intuition here is that supply shocks occur in some sectors, but not others. Suppose that there is a fixed cost to adjust prices. In order to keep inflation lower, the central bank would need to induce a change in the plans of all the unaffected sectors. Better, then, to keep inflation higher. For more, read Caratelli and Halperin (2025). There are other reasons, but that is not the point of this article.

The real interest rate is simply the nominal interest rate minus the rate of inflation. If inflation is unexpectedly high, then the nominal interest rate has to go up to match, pushing many loans over the 10% threshold. The central bank’s hands are tied – pursuing the optimal course of monetary policy would have real and extremely unpleasant consequences.

Throughout I’ve been implicitly holding velocity constant. Velocity is the number of times a given unit of currency is used in a period; if I am paid a dollar, which I deposit in a bank, who then lends it out to another person, who then spends it in a shop, it is as if there are many dollars in the economy. MV = PY, or money times velocity equals price times output. If an increase in P, or inflation, causes velocity to decrease, and we assume that quantity of money is constant, Y, or output, must go down to make things balanced. That’s really bad! We shouldn’t be doing this!

We already have experience with changes in credit availability worsening downturns, during the GREAT DEPRESSION. Ben Bernanke’s academic work, before he became Fed chairman, highlighted how bank collapses exacerbated the fall in MV, leading to a yet deeper fall in real output. I see no reason why we should be pursuing a policy which is not only bad on the merits, but would increase the volatility of the business cycle. “It’s popular” is not a good reason. It is ironic that a policy whose best argument is checking the myopia of borrowers, would be argued for on the grounds of the myopia of the voters.

I’m strongly skeptical that this even benefits the poor. Banks are able to discern the riskiness of borrowers, and offer different rates to those with different risk profiles. If we grant that the savings rate is exogenously determined (which seems plausible to me – how else are you to explain why Japan saves so much at such low interest rates?), in a perfectly competitive world all loans above 10% stop, and loans for people below 10% get cheaper! If the supply of loanable funds is unresponsive to the profitability of savings, then the price of a loan should fall for those who remain in the market. This accords with the evidence from Chile, where the fall in availability was only for riskier borrowers.

You can say that it will redistribute to poor consumers if and only if poor consumers are lower risk consumers (laughable on the face), or if there are markups on loans and the caps are perfectly calibrated so as to bring marginal cost in line with price. It’s a rerun of the debate around the minimum wage – a cap which improves outcomes for one group will induce severe rationing in another group. There is evidence for markups in credit card lending, but 10% happening to be the right target at all times of the business cycle, for all borrowers, is an improbable bankshot.