Bankruptcy

The Future of Consumer Credit...Today

By Adam Levitin

Paige and Jeremy have had some wonderful posts this last week, and although I have not been deputized to be their official host, I want to thank them for really pushing the behavioralist perspective.

I want to take up the final question Paige and Jeremy posed, however. They ask "Will the terms of consumer credit improve (lower interest rates, more frequent flyer miles) or worsen (higher late fees, more invasive collections practices)?"

We already know the answer, because the future is here today.

This isn't an "either/or" question. Over the past two decades we've seen both trends happening in the credit card industry. The card industry is the most sophisticated consumer lending industry in the world, and thus may represent the future for other types of lenders.

The card industry has realized that they can capitalize on consumer cognitive issues (not just hyperbolic discounting and underestimation, but also simple inability to process multiple complex price points). Thus the highlighted interest rates (teaser rates and base rates) are lower and rewards programs have grown (but with lots of fine point restrictions that makes them quite hard to value rationally). Teaser rates and frequent flier miles encourage card usage--it looks like a great deal. But at the same time back end fees have soared (160% and 115% for late and overlimit fees from 1990 to 2005). And billing tricks and traps have sprouted up like crabgrass. There are now so many price points for cards that disclosure is meaningless--even if consumers read the terms and understood them, it is impossible to process them all an know the effective cost of using credit before borrowing. This is venus flytrap lending: lure the consumers into card usage with teaser rates and bundled benefits and then catch them with tucked away fees and billing practices.

So how do the increased benefits and increased costs net out? There's really no way to tell. Most likely, some consumers (transactors or revolvers who never pay late and don't get hit with penalty interest rates for any reason) have benefitted from this situation and others have suffered from it (revolvers who fall into the penalties and fees).

But the fact that it isn't possible to net out the increased benefits with the increased costs is quite telling. Consumers simply do not and cannot know the cost of using credit cards prospectively unless they know with absolute certainty that they will never revolve a balance (i.e., not really using credit other than float) or make a late payment (which is not entirely in their control). The sheer number of price points, coupled with billing practices like unilateral retroactive term changes and cross-default clauses, make it impossible to anticipate the cost of credit. And if consumers don't know the cost of using credit cards, it follows that they cannot be using them at efficient levels.

We need to look at the net picture when we evaluate whether the terms of consumer credit are improving or worsening, but at the same time we need to recognize that within that net picture there may be some winners and some losers. Changes in consumer credit have different impacts on different consumer populations, and this complicates regulatory responses to manipulative lending practices. The sad truth is that we may not be able to do regulation that is Pareto optimal, at least in regard to consumers.

As much as I would love to see the gentle nudges of libertarian (or asymmetric) paternalism succeed, I suspect that going forward we will find ourselves having to debate the merits of employing the sharp elbows of old school paternalism for core consumer credit issues. Libertarian and asymmetric paternalism can be employed to overcome some cognitive issues on the consumer side. Whether they can be used to prevent business' exploitation of consumers' cognitive issues is another matter.

Full post as published by Credit Slips on March 21, 2008 (boomark / email).