Boots theory

Boots theory is the idea that being poor is expensive. It comes from a Discworld novel, where a character observes that being poor, he can’t afford a good pair of boots. Instead he buys cheap boots that don’t last nearly as long. The cheap boots cost less money upfront, but are ultimately more expensive since they frequently need replacement.

Taken literally, I’m not sure how accurate the story is. Is it really true that cheap boots are less efficient in durability than expensive boots? It could be, but the cost of boots might also be driven by characteristics besides durability, such as comfort or appearance. Hard to say, since I don’t wear boots.

But if we forget about the boots, then boots theory is obviously true. The boots represent capital. Capital is anything that costs resources now, and provides value later. Capital costs money. If you can’t afford to buy capital, then you ultimately lose out on the value of capital. Being unable to afford capital is therefore expensive.

Boots theory highlights the hidden cost of low quality consumer goods, such as boots. However, there are other forms of capital that loom larger in personal finance. For example: housing. Housing is capital. If you can outright buy a house, then you get value out of it. Otherwise, you have to pay rent, or mortgage, or live without.

Another example: skills are capital. If you can afford an education, or can afford the spare time to teach yourself, then you can learn valuable skills that will help you on the job market. If you can’t afford an education, you may miss out on a lot of income.

One option, if you can’t afford capital, is to borrow money. Borrowing money costs money. The fact that borrowing money is still sometimes a good deal goes to show the value of having capital, and the cost of not having it. Loans are very common for both housing and education. Using credit cards, or BNPL, you can even take out a loan for boots (although it’s dubious whether this is a good deal).

I want to put more focus on loans, because they’re a quantifiable representation of the cost of capital. I’d like to break down why loans cost money, and view it through a political lens. (There are of course many politically neutral explainers, and here’s one I recommend.)

Loan pricing

If you take out a loan, you are obligated to pay it back plus interest. The interest rate can be thought of as the “price” of the loan. Similar to ordinary goods like bread, the price is determined by market forces. Broadly speaking, you can think of it in terms of supply and demand. Banks have a limited supply of money to lend out, so prices are set such that supply is roughly equal to demand.

There are additional complications, especially since not all loans are equal. Some loans charge higher prices, others charge lower prices. Again, I would compare to the price of bread. But imagine you’re looking at a whole shelf of breads with varied pricing and quality. You suspect the more expensive breads might be higher quality, although that’s hardly guaranteed until you do a taste test, by which point you’ve already bought the wrong bread. That’s what loans are like.

Generally speaking, loans are more expensive for individuals with lower credit scores. Credit scores are a predictive measure of how reliably you pay off loans. Credit scores are unsurprisingly correlated with income. So, poorer people generally pay higher prices for loans. If you’re keeping track, that means that not only is it expensive to be poor, it is nonlinearly expensive. Poor people have a greater need for loans, and they tend to pay higher interest rates on loans.

Now with bread, the price you pay for bread is not the same as the cost to produce and distribute the bread. Producers and distributors expect to make a profit, after all. Likewise with loans, the price of loans is distinct from the cost to “produce” a loan. I make this distinction because I want to make clear, people with low credit scores pay higher prices not because profit margins are higher. Rather, those loans are actually more expensive to “produce”.

Components of loan cost

Some of the cost of loans is operational. For example, it cost money to advertise the loans to you. It costs money to procure and evaluate your credit data. If you interacted through a website or app, it costs money to develop and maintain those things. If you have to speak to customer service, it costs money to run the call center. If you fail to pay back the loan, and debt collectors start calling you on the phone seven times a week until you die inside, it costs money to make that happen.

Many innovations in finance are essentially about reducing operational costs. For example, running credit data through an algorithm is more efficient than manually underwriting a loan. Having a nice website probably reduces how often people have to interact with customer service. These days, some companies are exploring generative AI to replace customer service, although that doesn’t necessarily work out. But that’s not to say that there’s anything wrong with technological solutions, if effective. Reducing operational costs is a good thing–makes it a bit cheaper to be poor, don’t it?

Another major source of cost, is the cost of capital itself. The money for loans comes from investors, and investors want a certain return on their investment. If they don’t get sufficient returns, they could have invested the money elsewhere instead.

The way I would frame it, capital is that which produces value over time. If you take out a loan, and that loan does not produce value over time, then you’re basically wasting society’s capital resources, which could have been allocated elsewhere. That’s the cost of capital. Although the precise mechanisms may differ, I think the cost of capital is fundamental, and would exist in any reasonable economic system. Even a non-capitalist society would still have housing and skills and boots, and some method to allocate them. What would be reconfigured are the mechanisms for allocation. Or at least I think that’s the idea. I’ve never really understood what it means to move beyond capitalism, and I don’t think anybody does, which is why it’s good to have other concrete policy goals like more welfare.

The next component to consider is the risk premium. All things being equal, investors want the return on investment to be reliable, predictable. But a little bit of variance is acceptable, for a price. This component gets more expensive for people with worse credit, since there’s a chance that those people won’t pay their loans back.

I would distinguish two components of loan risk. There’s the predictable loss rate, and then there’s the variance in loss rate. For example, if you hand out loans to people of a certain credit score, you might find that on average 5% of the loans don’t get paid off. Those losses can be deducted from interest rates in order to predict the rate of return on investment. That’s the predictable part. Then there’s also the unpredictable part, where the actual losses might be higher or lower than 5%. The “risk premium” refers to the cost of unpredictability. But even apart from the risk premium, there’s just the aggregate cost of loans not getting paid off. This is the final component that makes loans more expensive to people with worse credit.

Loans as welfare

The predictable loss rate is interesting to me, because that’s money that isn’t going to the investors. It’s going to other borrowers, and specifically the borrowers who don’t pay off their loans. Often people don’t pay off their loans due to some hardship, such as suddenly losing a job. So we could even think of loans as a form of welfare, redistributing wealth from those who can afford to pay off their loans, towards people who can’t.

Granted, loans are not a good welfare system. For one thing, loans are not accessible to everyone; people with poor credit scores or low income simply get declined. Loans also lack any of the class solidarity of welfare. All wealth distribution occurs between people of similar credit scores, while people who are well off either get cheaper loans, or just don’t need loans in the first place. Being the recipient of this “welfare” is a pretty negative experience. Your credit score is ruined, you get hounded by collections agents. If the loan was secured, then your assets may be repossessed. Finally, not all the money goes to people undergoing hardship, some of it is just going to fraudsters.

In my opinion, the thing about loans, is that it’s not that loans are bad. Provided that people are properly informed to make good decisions, I think it’s good actually that people have a way to buy the boots they need. It’s just that… welfare would be better.