Promoting Justice in Credit Markets

Can principles of justice guide economic regulation?

In a recent article, John Linarelli argues that regulators should consider the extent to which different groups—such as low-income or minority households—can access credit. The current regulatory approach, he cautions, ineffectively promotes access to credit because it increases costs for lenders and fails to increase consumer financial literacy. Linarelli recommends that regulators incorporate two distributive justice principles when evaluating regulations for credit markets.

The “economic, political, and social frameworks” in society—such as laws and institutions—help determine the extent to which different groups have access to resources. Distributive justice—the philosophy underlying Linarelli’s argument—claims that all individuals should have access to resources such as income and wealth that are essential for freedom, equality, and the pursuit of a “good life.”

Linarelli argues that distributive justice should apply to credit markets because credit is an essential resource that affects life outcomes for “children, and entire families.” The mortgage market, for example, determines “access to good schools, a clean environment, and low-crime communities.” Outcomes in the mortgage market demonstrate how credit has become an essential resource for individuals trying to improve their quality of life.

Furthermore, the structure of credit markets, Linarelli claims, exacerbates inequality. He notes that debtor-creditor relationships are marked by power imbalances, which lead to insidious racial discrimination. The U.S. government, for example, participated in redlining—a practice of excluding African Americans from home mortgages—on the pretext that African Americans were risky clients. Redlining resulted in “the exclusion of entire minority communities from mortgage credit,” with effects that spanned “across generations.”

Despite the importance of credit as a societal good, Linarelli cautions that the existing regulatory framework—comprising mandatory disclosures, product regulation, and cost-benefit analyses—does not reduce inequality in credit markets.

Regulators have widely implemented mandatory disclosures—which require lenders to share contract details with consumers—in consumer protection regulation because such measures are, according to Oren Bar Gill, the “least intrusive form of regulation.”

Mandatory disclosures, Linarelli argues, are ineffective because consumers lack financial literacy and do not read their online contracts. As credit contracting increasingly occurs online, the limitations of mandatory disclosures will affect transactions in credit markets.

Another reason mandatory disclosures fail, Linarelli notes, is that disclosures were designed to address disparities in consumer bargaining power by requiring lenders to share information with consumers. But regulations must focus on the overall structure of credit markets to promote distributive justice, he recommends.

In addition to mandatory disclosures, the government regulates credit products. The Credit Card Accountability Responsibility and Disclosure Act, for example, includes provisions regulating credit card terms and fees. Linarelli argues that credit product regulations are motivated by paternalism, but still do not address the structure of credit markets.

Finally, regulators use cost-benefit analyses to evaluate the success of consumer protection regulations. Linarelli contends that cost-benefit analysis is problematic because it “aggregates costs and benefits across everyone regardless of their luck, circumstances, position in society, historic injustice, and so on.”

Under a cost-benefit analysis, regulators could consider as a success a regulation that confers small benefits to many people while disproportionately burdening vulnerable communities. This approach, Linarelli warns, could justify credit market regulations that exclude the poor or middle class.

Given the limitations of the current regulatory approach, Linarelli recommends that regulators incorporate two principles of distributive justice when evaluating regulations for credit markets.

First, the fair equality of opportunity principle states that individuals should have the same economic opportunities regardless of their income. In the credit market, low-income individuals are more likely to have low or no credit scores, suggesting that income may affect access to credit. Linarelli stresses that regulators should incorporate the fair equality of opportunity principle when evaluating access to credit markets to ensure that income does not determine whether a person has access to credit.

Second, Linarelli argues that the difference principle—which states that any regulation contributing to inequality must improve circumstances for those who are currently disadvantaged—should guide evaluations of regulations in the credit market. If a proposed regulation fails to improve low-income households’ access to credit, the regulation should not take effect.

To implement the difference principle, Linarelli recommends using a pairwise comparison method. Although this method traditionally requires comparing “individuals, one at a time, to see how worse or better off they would be with the law or policy,” he suggests that this process would be feasible using algorithmic decision tools and demographic data.

Linarelli concludes that the proposed principles will promote what John Rawls “called a property owning democracy” and “a pro-market, pro-private ownership approach” because these principles will encourage widespread access to property and capital.