Credit Confusion

As I write this, the Congress is preparing to pass a bill that would place restrictions on the ability of people to get credit. Personally, I have mixed feelings about the bill. On the one hand, when you make it harder for (mainly poor) people to get credit cards, you encourage them to turn to less savory means of obtaining credit. On the other hand, it’s at least arguable that some of the common irrationalities demonstrated by behavioral economics are present in the credit card market (whether the bill will actually address these problems is another story). And then there’s this.

But I don’t really want to argue about the credit card bill. Rather, I wanted to note an odd premise that both the pro and anti credit bill folks seem to be relying on in making their respective cases.

Let’s start with the pros. Here’s Ezra Klein, writing in the Washington Post:

The credit card industry, in recent years, has developed something of a tiered model. Good customers are treated extremely well. There are rewards programs, favorable terms, and high limits. But those who don’t prove as assiduous about their bills, or slip up amidst their payments, fall into a second tier that’s as punishing and deceptive as the first tier is serene and straightforward. Hidden fees, unexpected rate increases, universal default, and all the rest. The result is that low income credit card holders effectively subsidize high income credit card holders.

For the case against the bill, we have to turn to that notoriously right-wing rag, the New York Times:

Congress is moving to limit the penalties on riskier borrowers, who have become a prime source of billions of dollars in fee revenue for the industry. And to make up for lost income, the card companies are going after those people with sterling credit.

Banks are expected to look at reviving annual fees, curtailing cash-back and other rewards programs and charging interest immediately on a purchase instead of allowing a grace period of weeks, according to bank officials and trade groups.

“It will be a different business,” said Edward L. Yingling, the chief executive of the American Bankers Association, which has been lobbying Congress for more lenient legislation on behalf of the nation’s biggest banks. “Those that manage their credit well will in some degree subsidize those that have credit problems.”

As Bryan Caplan notes, the argument made by the credit industry folks doesn’t make much economic sense: “When you make lending to high-risk people less attractive, the result is not worse terms for low-risk people who have been profitable all along. The result is that high-risk people get less credit. They used to be able to get credit despite their credit-unworthiness by paying extra; if the law forbids this, why lend to them?”

Caplan is right, but by the same logic Klein’s claim that high risk borrowers are subsidizing low risk ones seems rather dubious. If people who always paid their credit cards on time were a drain on credit card companies’ profits, you would expect them to try to deny credit to such people, or at least offer it to them on less favorable terms. You certainly wouldn’t expect those companies to go out of their way to attract these very customers by offering them “rewards programs, favorable terms, and high limits.” The idea that if everyone who paid their credit cards on time were denied credit those who didn’t pay on time would get more favorable terms doesn’t make much more sense than saying car insurance companies would benefit if they only insured people who got in accidents, because then they could increase people’s rates.

The idea that lenders benefit when people don’t pay them back on time is one that is attractive to a lot of people (see here for a related discussion). Partially this may rest on an implicit zero sum fallacy; paying late is clearly not to the benefit of the borrower, so people assume that it must be to the benefit of the lender. Mainly, though, I think it’s an example of the seen and unseen. The benefits that credit card companies get from having people use their cards wisely (e.g. intercharge fees) tend to be invisible to consumers, whereas the money they pay in late fees and interest is highly salient.