The smartest behavioral economists in the world run credit card companies. I’ve always believed that. If you ever wanted absolute proof that the ‘rational actor’ model of economic behavior is completely unrealistic, you need look no further than the way the credit card industry makes money. They understand exactly how to get people to spend money (often, money they haven’t got) and extract the highest possible amount of profit out of their customers.
In a rational world, people would make decisions on the basis of what the economists call ‘expected utility’ theory. In other words, you’d assess the riskiness and desirability of an expenditure by weighing the value (to you) of an outcome multiplied by its probability of happening. But in the real world, nobody actually makes decisions that way – instead, they make judgments about the ‘utility’ (or benefit) to be gained by reference to some experience they have had in the past, and often weight probabilities in a non-linear fashion. In the case of credit cards, few people think about what might happen if an event they didn’t anticipate causes them to miss payments, while the immediate gains to buying something they want or need are a sure thing. A second rational idea in economics is that all future cash flows are subject to ‘exponential discounting’. That’s a fancy way of saying that if the math works out identically over time, people should not prefer one option over another if it’s time-value is the same. Totally not true. Firstly, we like immediate gratification. Studies have shown that people prefer getting $100 now over getting $110 in a week. Introduced delayed gratification, however, and their choices change—they prefer getting $110 in 11 weeks to getting $100 in 10, even though the value of waiting a week is $10 in both cases. Our strong preference for immediate gratification so dominates economic logic that it plays right into the hands of credit card issues—I mean, the whole thing is about buy it now. Finally, rational economists posit that people making decisions will gather all available information and base their decisions on it. Instead, what actually happens is that people over-weight easy-to-get information (such as what your sister told you about her great credit card deal), and tend to give more credence to information that is supported by lots of examples of others doing the same thing (witness all those souls who invested with Bernie Madoff because everybody else was investing with Bernie Madoff!). So when college kids get a credit card offer, they’ll believe the person making the offer and do what all their friends are doing—and Lord know how facebook and related resources are reinforcing this particular bias.
Which brings me to a very welcome bit of news in today’s Wall Street Journal
. Regulators, the article reports, are going to introduce rules that rein in some of the most egregious practices of credit card issuers. The two headliners are:
- Increasing interest rates on existing credit card balances
- Increasing rates on customers who have not fallen behind on their payments to the credit card company but who may have missed payments on some other bill – such as a phone bill
In my opinion, these new limits are long overdue. With their insight into human behavior, card companies have facilitated a great deal of foolishness on the part of their customers. I’m not an apologist for people who overspend – they should indeed pay their debts and pay the companies that effectively lent them the money interest. But I think changing the expense retrospectively, often when a consumer has absolutely no way of extricating themselves quickly from the revolving debt is not an attractive, fair, or customer friendly practice. And punishing people for failure to pay other people when they have been good customers of yours seems grossly unfair (and yes, I do understand the argument that failure to pay the phone bill means a consumer is in a riskier class – but you should have assessed their credit worthiness when you made the loan, not after the fact).
The Journal reports that the amount of revolving debt in the United States stands at $976.1 billion. That’s an amazing amount of money to be subject to practices that most people would agree defy any sense of fairness or good business practice.