Showing posts with label interest. Show all posts
Showing posts with label interest. Show all posts

Monday, August 16, 2021

Afterpay tells us we're suckers for the illusion of 'free'

There’s more to be learnt - sorry, there are more “learnings” – from the phenomenal success of Aussie “fintech” start-up Afterpay before it drifts off into corporate history. Learnings about human nature, public policy and what switched-on economists call “market design”.

Economists need to do more thinking about the way markets are – and should be – designed. The sub-discipline of market design recognises that, increasingly in the real world – especially the digital world – markets don’t work in the simple, transparent, what-you-pay-is-what-you-get way assumed by economics textbooks.

This means there’s more scope for “market failure” – market forces not delivering the benefits that economic theory promises they will.

Afterpay’s first “learning” is that, far from being “rational” – carefully calculating – consumers (and taxpayers) are hugely attracted by the illusion that something is free. Afterpay’s success seems explained by Millennials being greatly attracted by its promise to let them BNPL - buy now, pay later - without charging any interest.

It seems young people are turning away from credit cards and their very high interest rates in favour of BNPL. When you think about it, however, you see there isn’t much difference between a credit card and an Afterpay BNPL interest-free loan.

A standard credit card is also an interest-free BNPL loan provided you pay it off at the end of the month, in full and on the dot. Fail to manage that, however, and you soon see how high credit card interest rates are.

(Warning to all lawyers and judges: apparently, your legal learning robs you of the ability to understand the argument that follows. To a lawyer, any payment to a lender can’t be a payment of interest unless it’s wearing a label that says “interest” and is expressed as a percentage of the amount lent. You’d all make good Millennials.)

With an Afterpay BNPL loan, it’s only interest-free if you make four equal fortnightly repayments on time. If you’re late with a repayment, you’re charged a $10 late fee. And if you’re more than a week late you’re charged another $7.

The usurious nature of these charges is disguised by their small absolute size (but the amount borrowed is also pretty small) and by our practice of expressing interest rates on an annual basis (this loan is only for eight weeks, not 52).

But that’s not all. As Milton Friedman didn’t win his Nobel prize for discovering, there’s no such thing as a free lunch. Even if the borrower using either a credit card or BNPL manages to repay their loan without incurring any penalty, the lender still has to receive the equivalent of an interest payment to make the transaction worth funding.

In the case of both credit cards and Afterpay loans, this is achieved by a “merchant fee” paid by the retailer that made the sale. The fee is a percentage of the amount lent although, in the case of Afterpay, it’s a huge 4 to 6 per cent plus a flat 30c. (My guess is the 30c is there to fool lawyers into thinking the fee couldn’t possibly be payment of interest).

Whatever the reason, Afterpay has managed to convince the lawyers that, since BNPL obviously has nothing to do with borrowing and lending, it cannot be subject to the Credit Act, meaning Afterpay is not subject to the “responsible lending obligation” and so escapes the expensive obligation to do credit checks and verify the borrower’s ability to repay the debt. (We’re assured, however, that Afterpay and its many imitators are subjecting themselves to a voluntary code of conduct.)

This raises another “learning” right there. Almost invariably, the many market disrupters produced by the digital revolution – including Uber and Airbnb – amount to the combination of a genuine, productivity-enhancing innovation (something every economist wants to encourage) and a trumped-up claim that, because we’re so new and different, none of the regulation that shackles the existing industry applies to us.

“Their workers are employees, ours aren’t. The firms we’re disrupting have to provide employee super contributions, annual and sick leave, and workers compensation insurance, as well as comply with health and safety requirements, but we don’t.”

This, of course, is why we’re developing a two-class workforce, where those unfortunate enough to be able to find work only in the “gig economy” have badly paid, precarious employment with bad conditions and few rights.

The thought that this regression to feudal conditions for some should be allowed to persist in an economy as rich as ours is utterly repugnant. And to respond to it by introducing a universal basic income is an admission of defeat.

But before we leave Afterpay, there’s another learning. Using merchant fees to hide the interest cost of BNPL schemes, whether credit cards or Afterpay-style, involves an arrangement that’s both inefficient and unfair. It encourages retailers to recover the effective interest cost by raising their prices to all their customers, thus obliging those who pay cash or with a debit card to subsidise those who choose to BNPL.

Afterpay prohibits retailers from recouping the cost by asking those who choose BNPL to pay a surcharge. Just as Visa and Mastercard used to prohibit retailers from imposing a surcharge on those who choose to pay by credit card.

For obvious reasons, the promoters of supposedly interest-free loans want the true cost of this free lunch to remain hidden. The Reserve Bank – which has oversight of payment system regulation – laboured for years to get the prohibition on credit-card surcharges outlawed, and finally succeeded.

These days, credit-card surcharges have become common. My guess is that these surcharges, not just the advent of Afterpay and its imitators, help explain the big shift from credit to debit cards. This is just what the Reserve wanted to see.

But it’s utterly inconsistent for the authorities to stop the banks from banning surcharges while allowing Afterpay to ban them. Maybe they’re applying some kind of infant-industry argument. Let them get established, then rope them into the regulatory fold.

Final learning: look around and you find our human susceptibility to the illusion of “free” in lots of places. Starting close to home, free-to-air television and – until Google and Facebook stole our business model – almost-free newspapers and websites were so much a part of the furniture that it was easy to forget that the cost of all the advertising they carried was buried in the cost of most of the things we buy.

The internet still carries a host of free sites with interesting and useful information, even if the legacy newspaper companies have finally moved to making most of their money via subscriptions.

Then there are Google and Facebook, for whom the market-design people have invented a new bit of jargon. They are “multi-sided platforms” whose ostensibly free services are paid for by selling to advertisers the myriad information the platforms have gathered about the preferences, actions and locality of their users.

But our love of the supposedly free – our preference for having the true cost of things hidden from our sight – applies just as much to us as taxpayers. It took the Liberals a long time to realise how much voters loved Medicare, and didn’t want it fiddled with. Why the great love? Bulk billing. The way it makes visits to GPs and hospitals appear free.

Despite all their speeches on the evils of higher taxes, the Libs (like Labor) have never needed to be told of the one tax increase we don’t mind because we don’t see it: bracket creep. When it comes to kidding ourselves, we’re past masters.

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Wednesday, August 11, 2021

If Afterpay's interest-free loans sound too good to be true . . .

If you’ll forgive a bean-counter’s lament, it’s a pity our success at the Olympics overshadowed our much rarer, more valuable, commercial success, when two young Aussie entrepreneurs sold their business, Afterpay, to the American financial technology giant, Square, owned by Twitter co-founder Jack Dorsey, for $39 billion – making it our biggest-ever company takeover. Oh the honour, the glory, the recognition for poor little Australia!

Yes, I am laying it on a bit thick. It’s certainly a big deal but, as my mum used to say, I hae ma doots about how pleased we should be to see Afterpay and its ilk inflicted on our own young people, let alone young people around the world.

But welcome to the mysterious world of “fintech” – the application of the internet and digital technology to the formerly boring world of paying for things, borrowing money and moving it around.

We’re witnessing the migration to online retailing, we’ve seen Uber shake up – or shake down – the taxi industry, seen Airbnb do over the hotel industry, seen the digital disruption of the media moguls, and now it’s the banks’ turn in the firing line.

All these innovations have taken off because, whatever they’ve done to the careers and livelihoods of people working in the affected industries, they’ve brought benefits – often just greater convenience – that consumers find attractive.

The global tech behemoths – particularly Apple, with its Apple Pay – are moving in on the banks’ territory, while a host of start-up businesses are thinking of new ways to provide a financial service the banks don’t. The big banks are unlikely to take this lying down, but so far they haven’t done much.

This is where Afterpay comes in. In 2014, Nick Molnar and Anthony Eisen came up with a new way to BNPL – buy now, pay later; get with it – without having to pay interest. You buy something from a retailer – usually for a modest sum, say $1000 or less – then pay off the purchase price in four equal fortnightly instalments.

That’s it. No more to pay. Unlike the old practice of buying things on lay-by, with BNPL you get your hands on the purchase at the beginning, not the end.

The scheme has proved really popular with people under the age of 30 – who seem to have an aversion to using credit cards and the high interest rates that go with them. So you don’t just have one BNPL loan, you probably have several.

The idea’s been so popular that Afterpay’s had a number of competitors spring up, each with slightly different repayment rules. At first it was assumed Afterpay would be hit by last year’s lockdown but, but with everyone stuck at home and buying things online, its business has exploded.

You might imagine it’s making huge profits – especially considering what the Americans are prepared to pay for it – but that’s often not the way success works in the digital startup space, where the emphasis is on funding rapid expansion. Afterpay has yet to declare a profit – or a dividend. But don’t look at the profit, feel the rocketing share price.

By now, however, I trust your bulldust detector is flashing. They lend you money, but they don’t charge interest? There must be a catch. Two, in fact. The first is that Afterpay charges the retailer a “merchant fee” of 4 to 6 per cent of the value of the transaction, plus 30c.

So, it’s the retailer that pays the interest – in the first instance, anyway. And when you remember we think in terms of annual interest rates, 4 to 6 per cent on a loan for just eight weeks is a pretty steep rate.

How does the retailer cover the cost of the “merchant fee”? By raising the prices it charges – to the extent that competition allows. This could well mean customers who don’t use Afterpay help cover the costs of those who do.

But the second way Afterpay recoups the equivalent of interest is by charging a flat $10 fee for a late fortnightly payment. If the payment is still outstanding after a week, a further $7 is charged. On a $150 fortnightly repayment, $10 would be a quite hefty penalty interest rate.

But whereas all this looks and smells like interest payments to a bean-counter like me, it doesn’t to a lawyer. So the BNPL game isn’t subject to the Credit Act that regulates other lenders, including its responsible lending obligation, which requires the lender to perform credit checks and verify a customer’s income and ability to repay.

Someone who borrowed no more than they could afford to repay would come to no harm. But not all of us are so self-controlled and worldly-wise. Especially when we’re young.

I suspect the authorities are pleased to see the fintechs putting our hugely profitable banks under competitive pressure, and will leave it a while before they bring the innovators into the regulated fold. Until then, some poor people may learn financial literacy the hard way.

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Wednesday, December 9, 2020

We're having trouble learning to live without inflation

When I became an economic journalist in the early 1970s, the big economic problem was high and rising inflation. The rate of increase in consumer prices briefly touched 17 per cent a year under the Whitlam government, and averaged about 10 per cent a year throughout the decade.

It never crossed my mind then that one day the rise in prices would slow to a trickle – they rose by 0.7 per cent over the year to September – and I certainly never imagined that, if it ever did happen, people would have so much trouble living in a largely inflation-free world.

What? Why would anyone ever object to prices rising at a snail’s pace? Well, of course, no one does. Nor do you see many borrowers objecting to a fall in interest rates.

For savers, however, it’s a different story. Last month, when Reserve Bank governor Dr Philip Lowe announced what’s likely to be the last of many cuts in the official interest rate – it’s a bit hard to go lower than 0.1 per cent – there were bitter complaints from the retired.

“How do you expect us to live when you keep cutting the interest we get on our investments? How long are you going to keep screwing us down like this? When will you take the pressure off and start putting rates back up where they should be?”

Short answer to that last question: unless you’re only newly retired, probably not in your lifetime.

There’s something I need to explain. People like me may have given you the impression that our Reserve Bank moves interest rates up and down as it sees fit, cutting rates when the economy’s weak and it wants to encourage people to borrow and spend, or raising rates when the economy’s “overheating” and it wants to discourage borrowing and spending.

That’s true, but it’s not the whole truth. The deeper truth is that interest rates are closely related to the inflation rate. That’s because much of the rate of interest lenders require borrowers to pay them represents the compensation the lender needs to be paid just for the loss of purchasing power their money will suffer before it’s repaid.

(And when I talk about the lender, I mean the ultimate lender – ordinary savers – not the bank, which is just an intermediary standing between the ultimate lender and the ultimate borrower, probably someone with a home loan.)

So when the expected inflation rate is high, interest rates are high; when the expected inflation rate is low, so are interest rates. The other component of the interest payment lenders receive – the “real” interest rate – represents the actual fee the borrower pays for the temporary use of the lender’s money.

It’s only this much smaller real interest rate that the Reserve Bank is free to adjust up and down. So the main reason interest rates are so low and getting lower is that the inflation rate is low and getting lower.

And that’s not because of the pandemic and the recession it induced, so it won’t be going away when the economy recovers. It’s because, after rising steadily for about 30 years after World War II, the inflation rate in Australia – and all other advanced economies – has spent the past 30 years steadily going back down.

So inflation has gone away as a problem – leaving unemployment and underemployment as our dominant worry – and, as far as anyone can tell, it won’t be coming back for a long, long time.

If so, interest rates will be staying low, and it’s pointless to rail against the Reserve Bank. Rather, people reliant on their retirement savings will just have to adjust to a changed world.

If they want the safety of a bank term deposit, they’ll have to accept the tiny interest payment that goes with it. If that’s not enough, they’ll have to accept the greater risk and volatility that goes with share and other investments.

But let’s not exaggerate their predicament. If interest rates are low because inflation is low, that means their cost of living is low.

Indeed, the Australian Bureau of Statistics’ living cost index designed to measure the special circumstances of self-funded retirees shows their cost of living rose by just 0.7 per cent over the year to September.

Many self-described self-funded retirees take the view that their annual earnings from their superannuation should be sufficient for them to live on, thus leaving what they regard as the “principal” to cover future contingencies or be left to their children.

But, particularly for super payouts large enough to put retirees beyond being eligible for the age pension, it’s wrong to think of that payout as consisting of all your contributions (principal) plus interest. Well over half that sum consists not of your hard-earned, but of the government’s munificence in granting you 30 or 40 years of compounded tax concessions on both your contributions and your annual earnings.

Its generosity was intended to leave you with a sum sufficient to let you live comfortably in retirement, not to set up your kids’ inheritance. Trying to live without dipping into your payout isn’t a sign you’re doing it tough, it’s a lifestyle choice.

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