I’ve already made it very
clear what I think about credit cards: this post is an attempt to flesh
out one theory of how and why they work the way they do – to the benefit
of banks and the detriment of consumers. On the one hand it’s all blindingly
obvious, but on the other it’s not something I’ve really seen spelled out in
quite this way, so I thought I’d take a crack at it.
Most people, if you ask them what their highest-value asset is, might point
to their car, or their heavily-mortgaged house, or something like that. In fact,
their highest-value asset is much more likely to be their job: the present value
of their future income is enormous, and almost certainly worth more than their
home even without a mortgage. But although people don’t really think that way,
they do understand it on a gut level, just as they understand asset-liability
mismatches on a gut level.
What I’m talking about here is the difference between stock and flow, and the
way in which credit card companies take advantage of that difference to make
enormous profits. In financial markets, of course, there’s always someone willing
to convert stock to flow or flow to stock: any given income stream is worth,
today, a certain fixed amount of money. If I have a stock of money, I can convert
it into an income stream by buying bonds, and if I have an income stream there’s
bound to be someone I can sell it to for a fixed amount.
When it comes to personal finance, however, the equivalence breaks down. You
can’t monetize the present value of your future income: I can’t go to some broker
and tell him he can have 10% of all my future earnings in return for an upfront
payment of, say, twice my annual income.
As a result, unable to switch at will between stock and flow, people like to
match their assets to their liabilities. If their main asset is a flow –
their income – then their liabilities should be flow liabilities too.
Why did so many people feel uncomfortable about privatization? Because it took
a stock asset (a national company), sold it, and then applied the proceeds to
flow liabilities – the general fiscal account. It was called "selling
off the family silver" to pay day-to-day expenses: an asset-liability mismatch.
The general idea is that flow liabilities – the monthly bills –
should only be paid with flow assets – monthly income. Selling off assets
to pay the bills is unsustainable.
The genius of credit cards is that they slowly and invidiously turn flow liabilities
into stock liabilities. A credit card is a wonderful way of paying for something
today if you’re not going to get paid until tomorrow. So long as you pay off
your debt at the end of the month, it’s an interest-free loan: free money. It
feels like flow debt rather than stock debt: you use your income over the course
of the month to pay for your purchases over the course of the month.
Credit-card debts increase in small increments: a purchase here, a purchase
there, a finance charge at the bottom of the statement. Any individual purchase
can be justified. Here’s a thought experiment: tell someone that he has a credit
card with a $5,000 credit limit, and let him make purchases until the credit
limit is reached. There’s a good chance he’ll do so, even if the interest rate
on the card is over 20%. Now, take that same person, and offer him a $5,000
loan, unsecured, at an interest rate of 10%, which he can then spend on whatever
he likes. There’s a good chance he’ll refuse, even though going that route would
save him money in the long term compared to going down the credit-card route.
That’s because the second choice is stock debt, and people don’t like stock
debt because they don’t have stock assets. The first choice is flow debt, and
that’s fine, because people do have flow assets – their income.
What’s more, people always underestimate their future expenditures. They’ll
buy something now, justifying it with the idea that they’ll spend less next
month – something they rarely do. Most people who max out their credit
cards don’t intend to max out their credit cards. It just happens, almost while
they’re not watching. That’s another reason why our thought-experiment guy will
refuse the $5,000 loan: even if he understands that it would work out cheaper
than a $5,000 credit-card balance, he doesn’t think he’d ever max out a $5,000
credit card. A loan carries debt service whether it’s spent or not, so in fact
it’s rational to take the credit card rather than the loan if you think you
won’t carry much of a balance on it.
But anyone who’s ever got a credit card bill, whether they’ve paid it off in
full or not, has suffered a certain amount of cognitive disconnect between the
large number at the bottom of the bill and the seemingly small numbers which
constitute it. How could a series of individually small transactions add up
to such a huge amount? When you’re out there spending, it really doesn’t seem
that big. But when the bill arrives, suddenly those flow transactions –
day-to-day monthly expenses – have been transmogrified into a whopping
great big stock of debt.
That’s why, individuals would be much better off if they took out loans to
pay their expenses than if they borrowed on their credit cards. (They’d be better
off still living within their means, of course.) But loans are large, up-front,
stock transactions. They can be justified in exceptional cases, such as buying
a house or a car, or starting up a business. But people won’t take out a loan
to pay a restaurant bill, because they’ll be paying off the loan long after
the asset they’ve bought with it has been literally flushed down the toilet.
What’s more, any fool can see that if you need to take out a loan to pay a
restaurant bill, you shouldn’t be eating at that restaurant. Increasing your
stock of debt for the sake of a flow transaction like eating out is a classic
asset-liability mismatch. And yet people pay for their meals on their credit
cards the whole time, and, as often as not, fail to pay those credit cards off
in full every month. To all intents and purposes, they’ve borrowed the money
for the meal, and they’re paying interest on it at exorbitant rates.
Credit cards, then, are a wonderful way for banks to help consumers delude
themselves that they’re living within their means. Most people who carry a revolving
balance on their credit cards are simply spending more than they’re earning,
month in and month out. It’s unsustainable, but the existence of their credit
cards lets them get away with it for a much longer time than if they had to
justify their expenditures to their bank manager. The key hurdle becomes not
"can I pay my entire bill off in full at the end of each month", but
rather "can I pay the minimum amount at the end of each month". The
answer to the second question is nearly always yes – until you’re in a
hole of enormous magnitude.
Eventually, this entire edifice of credit-card debt could come crashing down
onto the banks, causing them as much harm as it’s presently causing consumers.
For the time being, however, they’re making billions from it. If that annoys
you, you can do your bit. Pay off all your credit cards with a loan –
one secured on your home, if necessary – and always pay them off in full
every month from here on in. Otherwise you’re just pissing your money away.