Charging Ahead


Solutions to the U.S. Credit Card Debt Problem

The average American carries more than $8,000 in credit card debt. In an adaptation of his book Charging Ahead, Professor Ronald Mann suggests solutions for addressing debt and default.

Since its introduction a half century ago, the payment card has transformed the American economy. It has revolutionized our habits of payment and borrowing. It contributes to the consumerist ethos on which our economy depends. It is a major cause of our burgeoning over-indebtedness. Perhaps most importantly, the power of those who profit from credit cards drove the recent retrenchment of our bankruptcy laws.

Yet, for a subject so important, we know little about the most central questions: How does credit-card use relate to bankruptcy filings? Why are credit cards more common here than in the similar economies of Japan and the United Kingdom? Why do issuers continue to extend credit to cardholders who are such bad credit risks? How specifically can we react?

This brief essay emphasizes two broad themes: First, despite the efficiencies it brings to payment and borrowing, the credit card, particularly as it is used in the United States, contributes to excessive spending, borrowing and financial distress; and second, the problems with the credit card suggest several ways to improve the existing regulatory scheme.

To make sense of the payment-cards phenomenon, I situate the rise of the payment card in the shift from paper-based to electronic payments. The United States is far behind other developed countries in abandoning paper checks. Not until 2003 did electronic-payment usage surpass checks as a retail payment device. Given the resources spent on processing paper checks — about one-half of 1 percent of the U.S. gross domestic product — it would not make sense to stifle card-based payments as a retail payment system.

Payment cards also play a unique role in the accumulation of debt in the United States. As compared to other developed countries, the United States has uniquely high levels of consumer debt, credit-card spending and credit-card debt. The reasons for this unusual pattern of usage lie in some typical features of our post-World War II society — a fragmented banking industry, the interstate highway system, poor accounting systems at some of our largest banks and the early introduction of the credit card, rather than the debit card. As my book explains, collectively those circumstances combined to make the United States uniquely suited to the credit card as we now know it.

Other countries, with different institutional settings, use payment cards much differently. One common pattern — the global norm for developed countries — is exemplified by Australia, Canada and the United Kingdom, which display an increasing use of debit cards, but a substantially lower use of credit cards and credit-card borrowing than the United States. The other common pattern appears in countries like Japan and the continental European Union where credit cards are rare; cash or debit cards are much more common. In these countries there are rules protecting consumer data, which make it difficult for modern credit card products to develop at all.

Quite simply put, Americans’ routine and pervasive use of credit cards is not the normal or inevitable result of a competitive process. It is a path-dependent endpoint, contingent on the happenstance of our particular institutional history.

One of the principal contributions of my book is a model of credit-card use that works out three specific risks: that of spending more, borrowing more and failing more.

First is the relation between cards and spending. Is there something about the credit card that makes us spend more than we would with a checkbook? Although it is not easy to unravel the psychology of spending, the relation is intuitively obvious. Slot machine designers, for example, understand that gamblers will spend more with a card that they insert into a machine than they will with cash that they must drop into a slot.

Similarly, consider the rapidly increasing acceptance of payment cards at McDonald’s and other fast-food restaurants, which were once bitterly opposed to paying card fees. They have since turned to cards at a lightning pace, convinced at last that customers spend more with cards than with cash. Contactless cards (which require users to wave their card over a reader, bypassing a swipe and signature) are only accelerating this trend.

Not surprisingly, consumers who spend more tend to borrow more. To quantify that point, the book collects and analyzes aggregate nation-level data about credit-card use and overall consumer debt levels. The data shows a significant connection between credit-card spending and consumer debt. Generally, holding macroeconomic variables constant, an increase of $100 per capita in credit-card spending in one year is associated with an increase in total debt loads a year later of about $105 per capita.

What is most striking, however, is the relation between credit-card debt and consumer bankruptcy: Even holding total borrowing levels and macroeconomic variables constant, credit card debt and consumer bankruptcy filings share a close and robust relationship. Holding macroeconomic conditions and other debt levels constant, an increase of only $100 per capita in credit card debt is related to an increase in consumer bankruptcy filings a year later of about 200 filings per million (which would be about a 5-percent increase in total U.S. filings).

Changes in the level of consumer bankruptcy filings correspond to changes in credit-card debt loads. There has been a lot of talk about how some supposed decline in “stigma” provides the best explanation of increased consumer bankruptcy filings. But those who tell that story pointedly ignore the role of the credit card, and their models do not explain trends in consumer bankruptcy filings nearly so well as my simple model resting on the assumption that credit-card usage is the most important single predictor of consumer bankruptcy.

That finding, coupled with the costs that financial distress imposes on society as a whole, provides a strong case for some form of regulation of the credit-card market. Although my book delineates a lengthy menu of reforms, I emphasize here two first steps that respond directly to the “sweatbox” model of credit card lending that has become a dominant strategy for the large debt-holding card issuers. The key to that model is that credit card lenders know they can make quite a bit of money from credit-card borrowers even when loans are never repaid; the trick is to get borrowers to pay small sums for long periods. If the loan accrues interest at a high rate and if the borrower pays minimum payments on the loan for several years before defaulting, it rapidly can become profitable. A typical lender might break even on a cardholder who makes three years of payments, even if the borrower then defaults and the lender charges off the remaining balance.

The sweatbox model emphasizes the acquisition of financially naïve cardholders who will borrow without appreciating the risks of semipermanent indebtedness. Just as cigarette companies market their products to teens who do not yet understand the tragic costs of cigarette use, card marketers foster card use at the earliest possible age. My book starts with a chilling anecdote from the CEO of Barclay’s, testifying in a British legislative hearing that while he himself doesn’t use credit cards, he is frustrated over his inability to keep his children from using them.

The troubling implications of that model drive my two most important policy recommendations. The simplest response would be a ban on marketing directed at minors and college students, the last remaining undeveloped markets. Britain already has such a ban, at least for minors. The rapidly accelerating focus on products for college students underscores the urgency to extend the rule to them. Banning youth and college marketing would disrupt the sweatbox model by making it harder for issuers
to acquire the lifetime customers who are so important to the model’s success.

A more ambitious reform would impose mandatory minimum payments. The comptroller of the currency has been working in this direction for the past few years. Currently, the comptroller justifies those requirements as improving the safety and soundness of the regulated institutions. Indeed, as the experience of the past year shows us, rules that require larger mandatory minimum payments are much more likely to undermine the profitability of credit card lending. Because those rules force relatively prompt amortization of credit card balances, they make it harder for issuers to retain customers indefinitely. The effectiveness of those rules could be buttressed by effective point-of-payment disclosures that would give cardholders personalized disclosures of how long it would take them to pay off their credit card debt if they continued making payments at the level of the prior month’s payments.

The goal of my book and this essay is to foster informed policymaking that addresses the complex situation surrounding consumer debt and the credit card industry. I will be delighted if any of my readers come away from either with a willingness to think seriously about the problem.

Professor Ronald Mann, who joined the faculty in July 2007 from the University of Texas School of Law, is among the few scholars in the country who have written and lectured in the fields of commercial law and electronic commerce. He has published two widely used commercial law casebooks and co-authored the first American legal casebook on electronic commerce. Last year, Cambridge University Press published
Charging Ahead, the first comprehensive treatment of credit cards in the global economy.

To view this story as it appeared in Columbia Law School Magazine (Spring 2008), please click here.