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Two Cheers for Credit Cards

February 22, 2010

Tags Financial MarketsFree MarketsEntrepreneurshipMonetary Theory

Ever since someone in grad school deviously introduced me to the concept of "irrational" debt aversion, I have been carrying credit-card balances that are far too high. Believe me, I understand the tricks these companies pull, like the clause in fine print where you unwittingly pledged away your firstborn.

I have had credit-card employees explain matter-of-factly to me that it was in my interest that they apply payments to the balances with the lowest interest rates first, and I was once driven to vulgarity on the phone by a representative who got philosophical with me when I was trying to close an account with a zero balance.[1] So believe me when I say that I get it when people complain about credit-card companies.

Yet in the present article I want to describe some of the benefits of these seductive tools of a modern financial economy. Although many critics would argue that credit cards show the flaws of capitalism, they also showcase its strengths.

Convenient Short-Term Loans

The most obvious benefit of credit cards is that they offer a very flexible and convenient method for individuals to borrow money. Some people understandably will say, "If you can't pay cash, you can't afford it!" But that view is a bit glib in certain circumstances.

For example, not too many people oppose mortgages per se — especially in the traditional arrangement where the borrower needs 10 percent for a down payment. And by the same token it supplements a household's finances to have access to an emergency credit line. Most people have no problem with a new business issuing debt in order to finance equipment purchases, and for the same reason there is nothing irresponsible per se about a lawyer (say) buying a bunch of new suits with a credit card when he gets hired by a big firm.

In terms of basic economics, a credit transaction makes both parties better off, so long as the deal is voluntary and both sides understand the terms. In reality, this standard economic explanation can become strained, because most people don't read every last clause in a new contract — it would be a foolish use of their scarce time to do so. These people might be surprised to get a letter from the company announcing a "Change to Your Cardholder Agreement," which alters the interest rate and other terms, and in which the borrower has one month to agree to the new terms or to pay off the balance in full.

Notwithstanding these somewhat shady practices, it's still the case that anyone who is "in over his head" with credit-card debt agreed to the debacle, and in fact got to enjoy goodies earlier than would otherwise have been possible. In retrospect, many customers of credit-card companies might regret their experience, but often the error was in "taking things too far," not in the principle of having access to short-term loans.

The responsible use of credit cards, in which the balances are paid down in full every month, can be a good way to build up a credit rating. Of course, a credit rating is only necessary for people looking to borrow money. But credit cards are an extremely convenient introduction to debt for the average consumer. Naturally, it is this very ease and accessibility that infuriates some people. On the other hand, without credit cards there would be many responsible but poor households that would have to turn to even-less-reputable methods of borrowing when true emergencies arise.

Security

Ironically, the widespread use of credit cards actually promotes the safety of an individual's assets, or at the very least allows a much wider scope for purchasing without a proportional increase in the danger of theft. For example, someone going on an extended vacation wouldn't want to take, say, $3,000 in cash with him, and he wouldn't even want to rely solely on the debit card to his checking account, because he could lose the card or it could become demagnetized. Having two or three credit cards solves these problems.

"The widespread use of credit cards actually promotes the safety of an individual's assets."

J.H. Huebert has written an excellent article explaining the beneficial role that large credit-card companies serve as intermediaries.Download PDF When a consumer buys an expensive product from a merchant — especially through the mail — the consumer is in a much stronger position if she paid with a credit card. If the product never shows up or is defective, the credit-card company can intervene and deal with the merchant. The merchant is obviously much more responsive to such a large source of his business than he would be if just the consumer threatened to never buy from him again.

On this topic, let me share a personal anecdote. Recently I was on a business trip and got a call on my cell phone. It was the fraud-prevention division for one of my credit cards, asking me about liquor-store purchases in New Jersey. As I exclusively buy my liquor from stores in Rhode Island, I explained that these were fraudulent transactions. They immediately canceled the card, and got the process in motion for sending out a new card to my home address. On the next billing statement, I saw that they had reversed the disputed transactions, so the ordeal only cost me the hassle of being without a card for a few days.

On the very same business trip, I got a call from another fraud-prevention division, this time in reference to the debit card on my business account. Again the transactions were clearly not mine, so they canceled the card and issued a new one. Now here I must confess that originally I was worried I would be stuck with the bill, since the charges had gone to my business checking account. Yet my fear was baseless; the bank credited my account within one or two business days after I went in and talked to the relevant person.

Now on the one hand, my personal experience might be taken as an example of the dangers of "using plastic." I am still not sure how thieves could have gotten both card numbers at the same time, since I don't even handle the payments for those cards in the same way. (The physical bills even go to different addresses.) Yet in the grand scheme, I was inconvenienced only for a few days without the relevant cards, which really was no problem because I had at least one backup. Furthermore, the companies issuing the cards caught the suspicious transactions in time to limit them to only a few hundred dollars.

It's this last aspect that impressed me. I travel a lot for my business, and only once has my card been rejected by a merchant (presumably for safety reasons). That means that the fraud divisions must have fairly sophisticated algorithms to be able to distinguish my sporadic business-trip spending from the habits of the thieves.

Of course, on a business trip I don't first hit the gas station and then load up on booze, but the thieves involved with my other card made a large purchase at a grocery store, which I do all the time. And yet the computers knew that their charge was suspicious, whereas I never have a problem making my own grocery-store purchases.

Sorting

Another interesting aspect is that "exclusive" cards often entitle the holder to perks. For example, with my American Express Platinum card I can hang out in the fancy airport lounges during my layovers rather than rub elbows with the riffraff and listen to Wolf Blitzer for three hours. If I use that card, I also get preferential treatment at participating hotels and restaurants. (No, American Express is not paying me to promote their card — my agent says we should hold out for the endorsement contract from Calvin Klein.)

Now, at first blush it seems a bit odd how this process works. It's true that there is an annual fee associated with the AmEx Platinum card, but it more than pays for itself when I add up just the perks that I actually use, let alone the ones that I could exploit in theory. I think part of the explanation is that these card memberships provide a sorting mechanism by which merchants can get a much better idea of the type of customer the holder is.

So, for example, someone using a Platinum card to make a reservation at a fancy French restaurant is more likely to be a big spender who will dress appropriately than is someone making the same reservation with a generic Visa card. By offering a slight discount (or giving preferential seating) to the Platinum-card holders, the French restaurant makes it more likely that the hoity-toity big tippers are in the best part of the restaurant served by the best wait staff.

The Power of the Free Market

Finally, the most interesting aspect of the giant credit-card industry is the simple fact that it works. Suppose Alice meets up with Tom, who has somehow never heard of credit cards. They might have the following exchange:

ALICE: There are companies that issue plastic rectangles to people, which they can use to buy thousands of dollars worth of stuff from stores all over the world.

TOM: How does that work? Why would the stores give you valuable merchandise just because you showed them a plastic card?

ALICE: Oh because the company issuing the card directly pays the stores. The buyer is actually just taking a quick loan from the issuer and then paying cash to the merchant.

TOM: Huh? Why would a company lend out millions of dollars to teenagers going shoe shopping?

ALICE: Because the teenagers and other customers pay interest if they don't pay off the loan within a month.

$10 $8

 

TOM: Well, what happens if you don't pay the companies their money back? They must call the cops on you, right?

ALICE: No, they usually just turn off your card and then have some other agency harass you with phone calls.

TOM: You're pulling my leg. There's no way this system would work. It sounds like something a libertarian economist would dream up.

As I have argued elsewhere, the credit-card industry shows the feasibility of allowing markets to police themselves without government enforcement. Besides their intrinsic honesty, the ultimate reason most people pay their credit-card bills — enough so that the industry is profitable — is that they don't want to ruin their credit score. Some of the schemes for "private law" sound fanciful and even far-fetched, but so does the success of credit cards.

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Notes

[1] I am not making that up. When I explained that I wanted to close the account, the guy argued with my reasons two or three times. Then he said something like, "Haven't you learned in life that good things eventually happen if you give something more time?" That's the point at which I swore at him, and he lectured me on how he didn't need verbal abuse from a customer. In retrospect, the only thing I can figure is that it was his last day on the job and he was having fun.


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