If you’ve followed the debate closely, it’s probably a narrative you’ve heard before. What surprised me is how explicit CEOs of credit card companies were in stating things about the relationship between poor and rich borrowers. Former Providian CEO Shailesh Mehta, and pioneer of the new credit card marketing techniques, says directly that the most affluent consumers pay the least, while the poorest pay the most. It’s not exactly the same as when a risk quant reader of Felix’s said: “The industry is just a giant wealth transfer mechanism from poor people to wealthly people. The profits from below (subprime) serve to subsidize the interest rate and rewards cost of people in the ‘super prime’ category”, or some of the emails I got after I went digging into what is going on with credit card interest rates. But it also points in the same direction.
The review is titled “How Credit Cards Rob the Poor to Spoil the Rich” and the comments are worth reading. They include my new favorite comment ever: “Seems more a transfer from the ignorant and foolish to the informed and prudent – certainly something I feel should be incouraged [sic].” Indeed. As you can imagine, several readers thought this was grossly inaccurate. Well, Shailesh Mehta said it, not me, and that dude knows a hella ton more than me about hidden fees, so take it up with him. From supplemental pbs material:
Mehta: Now, if somebody pays their monthly bill in full, and zero interest income, and if you don’t charge annual fee, zero fee income. So you have to make up everything from the merchant side, which you cannot. So what banks ended up doing is therefore they were subsidizing this whole group, because still two-thirds of the people were not making full payment. And that interest income covered the losses of the people who were paying in full.
So overall, the business looked profitable. But … in a strange way, the banks were charging borrowers higher interest rates in order to give the wealthy people a break — in a strange way, if you look at it, because the people who have money were paying in full, and they were getting the break at the expense of the people who couldn’t pay in full.
PBS: So it was sort of an unintended transfer of wealth.
Mehta: It’s unintended, exactly. I don’t think anybody thought through that. But correct.
I see the transfer in two dimensions. First: Picture 100 consumers, and it costs a firm $1 to give them each a credit card. Now instead of charging $1 to each person, you give the card to everyone ‘free’, but charge 10 people $10 at random. That’s the movement that is made here. If you speak micro, there’s some fantastic theory work being done on why, even in perfect markets, “It is also not possible to profitably lure either myopes or sophisticates to non-exploitative firms. We show that informational shrouding flourishes even in highly competitive markets, even in markets with costless advertising, and even when the shrouding generates allocational inefficiencies.”
Now all I’m pointing out is that the 10 people here aren’t entirely randomly chosen. Some are chosen because they aren’t as sophisticated as others. Some are chosen because they have health problems, or were in an accident, or have had a spell of unexpected chronic unemployment. But no matter what the story of how they are chosen, they tend to be chosen from the bottom end of the distribution.
The other dimension, less interesting from a distributional point of view but interesting in the dynamics between payment types, is that there tends to be only one price charged regardless of whether or not you use a credit card. If your card gives you some sort of reward that is paid for by the merchant, which the merchant has to take from you in increased prices, even if you would rather pay cash it’s a nash equilibrium for you to have to use your credit card. We looked at this back here:
Let’s assume that the interchange fee is 2% to the business. If I buy a $100 stereo from a store, they only make ~$98 if you pay with a credit card, but they make $100 if you pay with cash. Now if I pay with a credit card, I get about 1/3rd of that interchange fee in some sort of credit card payment reward. Frequent flyer miles, an inflatable grill, whatever. Let’s say that I end up with a $1 if I use my credit card in this case.
Now I have to decide whether or not to use my credit card, and the business has to decide whether or not to charge $100 or $102, the $102 reflecting a break-even from a customer using their credit card. The stereo costs the business $100 and is worth $100 to me. What’s the payouts?
…This isn’t an academic exercise. A small business I was at had a sign noting that they get charged over 2% every time a customer used a credit card, so why don’t you pay cash or with a check? But as I was about to pay cash, I wondered: “Don’t the prices already reflect that I will use a credit card? I might as well get points towards my plane ticket or whatever comes with the card.”
Note that if you don’t have access to a credit card, you pay that price regardless.