A Failure To Comprehend...

I usually read the Real Time Economics blog of the WSJ, more often than not there is something interesting there.

This one, however, takes the cake for egregious errors and a true failure to comprehend what credit cards are all about. Credit cards are a financial transaction instrument, one where you, the consumer, may access pre-approved short-term debt. Debit cards are basically the same, but where you access existing funds without having to carry around checks or cash.

In both cases, the key to understanding their use is the enormous convenience of credit cards: they allow you to make consumer purchases without cash or checks, reducing costs for the retailer (albeit it at a cost: the time lost waiting for a check to clear can be monetarized and compared to the discounted rate of reimbursement from the credit card companies).

However, and this is the egregious error from Mark Calabria of the Cato Institute, they are not in an of themselves credit instruments:

Credit cards allow the un- or under-employed to spend now out of future expected income. To limit credit solely to the financially stable leaves those most in need outside of our formal financial system, instead forcing such households to borrow from less efficient, and often more costly, sources, such as friends and family, or pawn-shops and loan sharks. The trend in recent months of households shifting away from mortgage debt to credit card debt has been essential in allowing households to maintain spending in the face of declining home values – absent such spending our economy would be in worse shape.

This understanding of credit cards is extraordinarily dangerous, to put it mildly: it assumes that those most in need cannot do the financially prudent thing, which is to forgo current consumption to achieve later financial goals.

This is called saving.

What a concept, I know.

Now, I'm taking this out of order, but he also writes:

The most basic function of all financial transactions is to allow households to more closely align their lifetime flows of consumption and income. While the most important mismatch between desired consumption and income happens over the life-cycle – workers earn less at the beginnings and ends of their lives than in the middle – shifting income from good economic times to bad also improves household welfare.

Uh, no: the most basic function of all financial transactions is to enable transfer of funds from one party to the other. What Mr. Calabria means to say is that it is the most basic function of all financial planning: this is not, however, what he says.

Financial planning is what we normally call budgeting: it may make sense to borrow money today to meet needs that will be paid back over future earnings, but that isn't what credit cards are about.

Or, more exactly, that's not what credit cards should be about.

Now, this makes more sense:

As credit risks in the economy change, so should credit pricing. While we want credit to be widely available, that credit should be accurately priced – to provide the right incentives for borrowers and lenders alike. Practices such as universal default – where credit card rates are raised upon the default of other loans – provides for a more accurate pricing of risk. Someone defaulting on their car loan is undoubtedly a higher risk to their credit card company than someone making their car loan. If we've learned anything, it should be that in times of stress, risks across various kinds of credit become more highly correlated.

Credit, unless accurately priced, will always distort markets. If the price of credit is too high, financing projects becomes difficult and they will then not be financed; if it is too low, resources are allocated poorly (at best) and are thus wasted, helping economies enter downturns when these scare resources, squandered on projects that failed to bring returns, are not available for needed investments.

Now, in the same article, Kathleen Keest  writes something significantly more sensible:

Sound, common-sense oversight doesn't constrain credit, lack of it does. That's because lack of oversight begets loans that borrowers cannot afford to pay, which causes losses to financial institutions and a lack of investor confidence. Investors no longer trust the lenders to know what they are doing because in fact lenders did not know what they were doing. That loss of trust and confidence has limited credit. 

Bingo. The problem is: whose oversight, and with which goals?

Equally simplistic – and misdirected — is the notion that more debt is required to encourage more demand. Americans have lost confidence in their financial future, and too many households are grappling with too much overpriced and risky debt. Credit card penalty rates, for example, can double the rate on existing balances and can be imposed for almost any reason, even if the cardholder hasn't violated the contract. We recently calculated that one year in the "penalty box" for an average revolving line of credit costs around $1,800 per year. That's money that cannot be spent in the real economy. The credit card reform bill being debated in the Senate would limit card issuers' ability to apply such rates retroactively and would ensure that being sent to the "penalty box" wasn't a life sentence.

Here is where Ms. Keest goes wrong: it's not so much that Americans have lost confidence in their financial future, it's much more that the banks, those granting credit, have lost confidence in the future of their customers, which leads to a re-evaluation of risks and, for the most part, a more appropriate setting of basis point differentials to compensate for that risk. While the blame for this can be spread all around, the one paying the piper is the one who wanted the money in the first place. Retroactive rate increases (not on unpaid balances, but on the original balances) are unlawful - it is a violation of the original deal - and that can be addressed directly: however, you cannot take the right to set rates appropriately away, as that means that granting credit will become highly restrictive and more expensive.

Why? Because if I cannot change the interest rate on outstanding balances due to an increase in the risk, I will become significantly more hesitant in granting those credits in the first place, and I will, as behooves due diligence, increase my risk rating calculations to take into account the risk of someone becoming a greater risk candidate during the lifetime of the balance.

Note that this is only a problem with credit cards, where outstanding balances can change quickly: it is not a problem with a fixed-term loan for a specific project that is secured by the tangible assets enjoined in that project.

The current business model of maximizing revenue in the short term is not working well because it's pushing more credit card customers over the edge. It's certainly not good for consumers. And it's not good for the economy, because access to more unsafe, unsound and uncertain debt is not what American households need to encourage them to face their financial future with confidence. Worse still is that abusive lending practices often end up in the taxpayers' lap, as the mortgage crisis illustrates. Who benefits when companies have to take massive losses on unsustainable loans? No one.

This is not maximizing revenues: it is, rather, a return to realistic assessment of risks and the application of risk premiums. Of course this is pushing more credit card customers over the edge: they are people who should never have had those lines of credit to begin with. What those people have to do is consolidate their debt and lose those credit lines in order to avoid paying high rates of interest: that, however, is prudent financial planning, rather than some sort of punishment.

Fundamentally, both writers seem to fail to undestand what the real problem is: a failure to live within one's means.


Credit cards are wonderful instruments for short-term consumer purchase financing, be it a new stove or a family vacation. They are terrible instruments if you carry a balance for any length of time, as the interest rates are usually quite high: they are supposed to be high, in order to ensure that people don't start using the credit cards as a permanent financing instrument, which is an indication of some sort of financial difficulty. Once someone has entered that path, they automatically become a higher risk: someone who carries a balance, say, of more than 30% of the credit line, for several months is showing behavior that is risky: no one should willingly pay high rates of interest if they can avoid doing so.