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The Credit Model


The Atlantic's Conor Clarke slaps down a credit card skeptic with a defense of the very concept of credit. And he's right! Credit is a good thing. And credit cards can, and should, be a good thing. But they're a more complicated thing than simple credit. And you see it in the example Conor chooses. "It's pretty obvious the widespread extension of credit can increase social welfare," he writes. "This is easy to see if you think about a college student paying her way with credit in anticipation of a higher future income, or a small business owner making an investment in his business in an anticipation of higher future sales."

Which is, again, true. But not the point of a credit card. A business owner making an investment generally goes and gets approved for a loan. He has to present evidence that the investment is wise and the loan likely to be repaid. We tend to think this due diligence a good thing. Indeed, the breakdown of similar mechanisms in the mortgage market is considered partially responsible for the current crisis. And there's been, of course, a similar deterioration in the credit card market. You don't go to a credit officer to present your plans for using the loan wisely. The credit officer mails you a letter to assure you that you've been pre-approved to use the money however you please.

Another way to put this is that credit cards look a lot better from a neoclassical standpoint than a behavioral economics standpoint. Rational and wise economic actors can do a lot with an easy line of credit. But we're not rational and wise economic actors. The main finding of behavioral economics, arguably, is that we're short-term actors who tend to discount long-term consequences. And credit cards exist, in part, to tempt that bit of irrationality.

Other credit markets -- like, in theory, the mortgage market or the small business loan market -- have developed systems to enforce long-term planning among credit users. Their business model relies on the loan being paid back. The credit card market, however, has done the opposite. And that's because its business model isn't really built on people using credit responsibly. It was built -- as the credit companies are admitting in this debate -- on penalizing people who use credit irresponsibly. The fact that easy credit is bad for some people, in other words, was a key part of the industry's strategy. They weren't simply looking to extend credit that would be responsibly paid back. They were looking, in part, to extend credit that would not be paid back. That's a very different approach.

(Photo credit: AP Photo/Chuck Burton)

By Ezra Klein  |  May 22, 2009; 3:00 PM ET
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The question remains (rhetorically asked of defenders of capitalism's dynamic ability to solve all problems): where, then, is the entrepreneurial bank that chooses a contrarian policy in credit card issuance. That is, why hasn't anyone tried the responsible credit card route? Be a little more choosy about who you issue the card to; but also offer non-usurious rates. I'm pretty good at paying my credit card every month, so the interest rate doesn't much apply to me whatever it is, but I still fear it because I have, on occassion, been bad about paying bills on time and missed the deadline. That friggin' $40 fine on top of the interest charge makes me want to put my fist through a window. (Bank of America's window, to be specific.) So if someone offered a card that had no fine for late payment and only an 8% interest rate (or lower!), I'd switch in a heartbeat (and Working Assets be damned!). So... the responsible, consumer friendly credit card company should garner masses of customers. It won't pull in money hand over fist from the "bad" customers the way the current credit card companies are doing, but it would probably make a pretty satisficing profit, no? Maybe it's out there and I've just never heard of it.

Posted by: JonathanTE | May 22, 2009 4:25 PM | Report abuse

I can't read this post! That photo is giving me the heebie-jeebies.


Posted by: ajw_93 | May 22, 2009 4:31 PM | Report abuse

Credit card companies lose money when people don't pay their credit card bills. That's obvious right? They have to account for this risk by charging risky customers higher interest rates and late fees. If they didn't they would just lose money and that is not a winning business model. To put it a different way; if lending money isn't profitable then no one will lend money and that hardly seems like a wise way to increase liquidity in the credit market.

It seems that a lot of these policy ideas are predicated on the belief that people are stupid but what they are forgetting is that the Government is run by PEOPLE!

Posted by: fallsmeadjc | May 22, 2009 11:14 PM | Report abuse

No, the very article that you quoted previously on credit cards shows that credit cards have two functions that are welfare enhancing for rational actors, and that most people use them that way.

Some people are bad at things, and kid themselves that credit cards are a good way to get long-term finance, but that's different from credit cards existing to trick people - that's a few people making bad decisions. If you want to legislate against that *behaviourally* then a policy that would mitigate that would be to e.g. require lenders to include comparisons with the cost of using a different credit product that they offer.

Posted by: albamus | May 23, 2009 5:47 AM | Report abuse

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