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Wallet Reform: Should Congress Protect You From Your Credit Cards?

After a weekend compromise between the leaders of the Senate Banking Committee, a new bill tightening regulations on credit card issuers has a good chance of making it out of the Senate this week. (The House already passed a weaker version of the bill.) However, the American Bankers Association is attempting to sink or water down the legislation, claiming that it would "have a dramatic impact on the ability of consumers, small businesses, students, and others to get credit at a time when our economy can least afford such constraints."

The battle is over new restrictions such as one limiting the ability of credit card issuers to increase interest rates on existing balances; the Senate may even consider an amendment to impose a strict cap on credit card interest rates. While the practical stakes are relatively clear -- banks want higher interest rates; consumers don't -- this issue also illustrates two types of economic thinking.

There is a version of the banks' position that is not simply "we want to make more money." (Felix Salmon has a great post on the lengths the banks are going to in order to sink this bill, but for now I'll assume that their motives are pure.)

Credit card loans are risky because they are not secured by any assets of the borrower, and therefore interest rates have to be high and correlated with the riskiness of the borrower. If a bank thinks a borrower is very risky -- because of either his initial application or his behavior after getting the card -- it needs to charge him a high interest rate. If it can't charge that high rate, it just won't give him the card in the first place, and who's better off then?

This position is founded in classical, first-year, textbook microeconomics. On the one hand, firms have to make money, and if you cap their prices below what they have to charge to make money, they won't offer the product or service. On the other hand, from the consumer's perspective, choice is always good. It's better for the consumer to have the option of a credit card with a 30 percent interest rate than to not have the option at all. If he goes ahead and gets the credit card with the 30 percent rate, that is proof, in and of itself, that it is good for him, because all choices are rational and utility-maximizing.

Unfortunately, this position is not founded in common sense. People do all sorts of things that are bad for them because of all sorts of cognitive errors. Put a big pile of doughnuts in front of a group of children, and see whether they eat the utility-maximizing amount. Look at the number of active stock trades people make, and ask them if they are above-average investors. See Barbara Kiviat's article in Time describing the way these fallacies affect the selection and usage of credit cards.

Behavioral economics, the hottest fad in economics since rational-expectations macroeconomic models (and much easier to discuss at parties), describes the ways people actually behave, as opposed to the rational utility-maximizing assumption, and suggests policies to take advantage of our irrational inclinations and producing better outcomes for individuals and society.

I'm not saying that the credit card bill is a product of behavioral economics. It isn't. But behavioral economics describes a world in which such a bill might be a good thing because it takes away options that people would choose to their own detriment, while according to classical economics (and the bankers association), such a bill is never a good thing.

Even if it's helpful, though, such a bill can feel paternalistic. Can't consumers watch out for themselves? And why should the government be taking options away from them? According to classical economics, if consumers really value a card whose interest rate can't rise on existing balances, then some company will create and market such a card; then the only people who are subject to rate increases will be people who choose that option.

While the classical view gives you the best of all possible worlds -- complete freedom and optimal economic outcomes -- the behavioralist view creates a potential conflict between doing whatever you want (say, eating lots of doughnuts) and what is good for you.

Do you think the government should be looking out for you? Let us know in the comments.

By James Kwak  |  May 14, 2009; 6:07 AM ET
Categories:  Banking , Regulation  
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Next: Credit Card Reform: Do the Banks Own the Senate?


I agree that credit card regulation is paternalistic. This is the government telling you what is good for you and what is bad for you, and that you're unable to make this decision on you're own.

Credit cards are revolving loans - it's like getting a new loan each month. If a card company wants to change your rate month to month, they should be free to do so.

Additionally, since when did having a credit card with a low rate become some sort of a right? If you obtain a credit card then you must be willing to agree to the rules of the lender who is assuming your risk.

Posted by: msgnet | May 14, 2009 7:42 AM | Report abuse

See my April 10 posting on for my thoughts on the criminal behavior of credit card lenders.

Posted by: thefest | May 14, 2009 8:11 AM | Report abuse

Paternalistic is to blip four letter words on TV.
The lack of elegance at talking never bankrupt anyone, the very confusing explanations about your credit card conditions and the way the Fico score works on it does.

Posted by: anieto | May 14, 2009 11:27 AM | Report abuse

Although it may seem paternalistic, one thing that seems to be escaping the debate is the strangle-hold that credit card companies have on the American consumer. To assume one has the option of participating in the credit card market, and therefore should be prepared for both the costs and benefits of such an arrangements is a false choice. Credit ratings are used, not just for mortgage rates, but can be used to keep people out of rental housing and is sometimes used as a screen for new job hires. And to not have a credit rating is considered just as bad as having a poor credit history. These consequences of not buying in to the credit industry are an added variable not addressed by classical economics, which assumes a true freedom of choice.

Posted by: withcommonsense | May 14, 2009 1:58 PM | Report abuse

withcommonsense has a good point, I think. Also, allowing confidence schemes to become common banking practice (and persuading people to pay usury is a con) puts con men in charge of banking with results, well, that we can see.

Posted by: TheRaven2 | May 14, 2009 2:39 PM | Report abuse

It is kind of paternalistic but given the relative power of the parties it is appropriate. Loan sharks make exactly the same argument that credit card companies make. They loan to the most risky group and of course charge huge interest rates and back up payment demands with force. But economically it's the same. In answer to the question isn't it better to extend credit even at high interest rates the answer is no. It is better for the potential borrower to not get credit and it is better for the bank to not extend it. Haven't we learned this yet?

Posted by: sactoman | May 14, 2009 3:15 PM | Report abuse

One must count to ten a few times before commenting on the whining of credit card bankers. If there is a class of people lower than lawyers and the mafia, credit card bankers populate it.

Don't expect more than cosmetic changes to the laws and regulations regarding credit card banks. They are holding back at the moment and will weigh in at the appropriate time and gut the proposed law providing some protection to consumers. Remember, as Senator Durbin as stated on multiple occasions, the banks own the Congress and nothing will pass without their approval.

As pointed out in earlier comments, credit is part and parcel of our economy yet we leave it in the hands of greedy, bonus-debased bankers who hire double shifts to think of ways to screw the public.

It starts at the universities where the banks set up tables handing out credit cards" establish your credit so you can survive when you graduate...." There is a low credit limit the kid believes he or the parents can easily pay should blah, blah, blah. The credit limit is the raised into the thousands, the kid can't pay, is late, or puts his pants on two legs at a time and the bank charges usurious fees and 30% interest, contributing to the bank's most profitable source of income. The data on credit card debt of college grads is staggering.

A side effect is that credit cards have delayed universal health coverage far too long. Since the hospitals insist on full payment (or we will keep your baby) by the millions of people who don't have any health insurance, credit cards are used. Needless to say, hospital inflated credit card balances are the primary cause of personal bankruptcies. Instead of the public focusing and insisting on action at the primary indebtedness source, the hospital, they use a credit card and stay in debt for the rest of their lives or have to file for bankruptcy. Not to fear, says the bankers, we will simply have the bankruptcy laws changed ", Senator Dodd/Shelby, have a few million...." and fix it where consumers forced into bankruptcy can't get out of debt, ever. Shazzam! It happened.

The examples of responsible consumers of thrift, good will, and almost biblical devotion to paying their debts, being screwed by credit card bankers are too numerous to mention here. Something must be done to rein in these now legal plunderers. I fear it won't happen during this Congress.

Posted by: Lazarus40 | May 14, 2009 4:06 PM | Report abuse

Another aspect that hasn't been addressed is when credit card companies knowingly extend credit to people with poor credit history. They send pre-approved cards to people who have demonstrated poor credit worthiness. The credit card company sees value in providing credit to this group of high risk borrowers because this justifies them charging high fees and interest rates. I think that a more regulated environment with limits on how and when lenders can charge fees and increased interest rates would preclude them from extending credit to this group in the first place. It's a form of preditory lending.

Posted by: SaraG | May 14, 2009 4:26 PM | Report abuse

We need to publish the list of politicians who voted against the credit card protection bill. We need to publish it now and at election time. These same politicians have bailed out the corporations but offer no protection for us. They are owned. They don't serve we the people. They serve Bank of America, Chase, and the rest of the credit industry. All the Republicans and all of the Democrats who voted against these protections need to be voted out of office. We should march on their offices now and let them know how we feel. They are crooked. And they will continue bleeding us until they are ousted. We got some of them out in the last election. We need to get the rest out. And we need to publish a list of credit card companies who bought politicians. They are subverting our democracy.

Posted by: WildaHughes | May 14, 2009 7:14 PM | Report abuse

No credit card - no problem!

Posted by: PalmSpringsGirl | May 14, 2009 9:52 PM | Report abuse

Transparency is key. Credit card terms are opaque by design. Perhaps it's clear from experience that rates can change, but it's not clear what the upper limit of those rate changes are -- especially to younger consumers who are entering a brave new world of finance that even their parents might not have experienced.

Targeting young consumers too is no different than the habit forming approach that tobacco companies used. We see some role for government in protecting the young from predatory behavior in other areas -- it's not clear to me why those principles get thrown out the window when we are dealing with these kind of financial practices. The opaqueness of credit card terms are a kind of legalized fraud.

As far as credit tightening because credit card companies are forced to be more transparent in their practices -- this is all for the best. Clearly the credit card industry is no better at risk management than many consumers who use credit cards. An ounce of federal regulation can spare the need for a pound of federal intervention during these crisis periods.

Right now the credit card industry functions as a kind of back door tax on middle class families. It's a drain on long-term purchasing power of families, and it has negative long-term consequences -- as we are finding out -- for sustainable, long-term consumer demand.

The government performs its function when it balances competing interests.

In recent years, thanks to lobbying efforts, and purchased legislation, it's clear that the balance of interests is tilted against consumers and in favor of creditors. Some kind of balance needs to be restored. The financial sector is screwing ordinary American families with the complicity of legislators. Those practice need to change -- or the legislators need to be changed.

Posted by: JPRS | May 15, 2009 10:22 PM | Report abuse

Isn't behavior economics an extension of what is well known on Madison Avenue? We shouldn't be surprised if ad agencies have psychologists, sociologists and all other forms of "ologists" on their payroll.... then, why wouldn't banks?

Posted by: 1234xyz | May 16, 2009 1:30 AM | Report abuse

Credit cards are not an entitlement.

Posted by: cidernosekiss | May 16, 2009 11:52 AM | Report abuse

I don't see why people have to be constantly bailed out of or protected from their own foolish behavior. If you don't like the high interest rate or the terms on your credit card, then don't have it or use it.

Posted by: brewstercounty | May 16, 2009 12:09 PM | Report abuse

I read a book, Credit Card Nation, a couple of years ago and the author made it clear that he things credit is an integral part of modern life, the public is entitled to it and the credit card companies should be pursued.

But extending credit is allowing someone to use your money. I don't see any right of a borrower to dictate terms to a creditor.

Nobody is forced to take credit. As mentioned in a previous comment, FICO scores are often used to determine approval for a variety of things but a good FICO score can be obtained by taking out a small amount of credit from time to time and repaying it on schedule. As a youngster, I bought a TV as a means of establishing credit this way.

To treat us all like children invites moral hazard when people feel they are relieved of the consequences of what they do. Should pay day loans be abolished? The interest rate is horrendous but it is an option for the consumer. Is there anyone alive in 2009 who doesn't know the terrible consequences of indebtedness?

The consumer does need protection from voluminous legalese that obscures the rules and regulations. There is an appropriate need for clarity and simplicity in the terms offered for credit, just as we want the contents of our food identified clearly.

But as for an interest rate ceiling - let the credit card companies charge anything they want and set whatever conditions they want as long as these are clearly described beforehand.

The main thing to know is that credit means using someone's money, not yours. Do everything to avoid it and make minimal use of it when you can't.

Posted by: Clif | May 20, 2009 4:47 PM | Report abuse

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