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.
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