I often myself grouping critics of credit cards and the fees they charged with the folks I see screaming when their smartphone doesn’t have a strong enough signal, or when their supermarket is running low on quinoa. I don’t intend to discuss the economics of middlemen here, and why middlemen receive the brunt of so much of the vitriol spewed by economic illiterates. I simply want to remind readers of something rather remarkable about credit cards: they substantially reduce the cost of making transactions for both debtors and for creditors, and they do it in a particularly astonishing way.
How to credit cards generally work? When consumers and merchants agree to a transaction (the merchant delivering a good or service) the consumer is responsible for delivering to the merchant an acceptable means of payment. Sometimes it is delivered at the point of sale, such as when cash is used, or when consumers swipe their debit cards. Sometimes credit-instruments are used, like when a consumer writes a check. But increasingly, credit cards have been used to execute the transaction at the “store.”
What does the use of this credit instrument do? Well, what it does is that it extinguishes the relationship between the merchant and the customer (this is desirable). Instead of, for example, the customer writing an IOU to the merchant, and the merchant having to track down the customer for final payment, a bank issuing a credit card steps in an provides the ultimate means of payment to the merchant immediately at the point of sale. So for the merchants, this dramatically reduces the transactions costs of working with customers, and indeed, it makes them more confident and able to serve customers from a wide variety of locations (e.g. think of how confident you would be accepting a check drawn on Alexander Supertramp Bank from Alaska if you are selling shoes in Rochester). Compounded over all of the customers that merchants formerly would have had to run down IOU’s from, this is a drastic improvement, and of course they are “happy” to pay for these privileges.
Consider the debtors/consumers. Instead of having an outstanding credit relationship with a merchant, they instead will have one with the bank. So, the use of credit cards does not distinguish the need to come up with the ultimate means of payment, but it does transfer who that relationship is between. I, the consumer, end up owing the issuing bank the money, and not the merchant. Again this is terrific for me because I can do this for multiple transactions — and it is far more convenient to have one running balance owed to the credit card company (think of it almost like a clearinghouse) than it would be to have outstanding balances with all of the merchants that I deal with. So for the debtors/consumers, the existence of credit cards considerably lowers the costs of transacting as compared to a world where no such credit instrument was available. There are other benefits too, but let’s not discuss them here.
Finally, consider that banks issuing credit cards are doing so in an unsecured form. In other words, these banks are extending loans to customers with no regard for what those purchases are on, and with no collateral backing the loans. In other words, if you do not pay your credit card debt, the issuing bank will have a hard time taking your house as compensation for it (unlike a secured mortgage). Despite this, people still manage to go nuts when they see interest charges on credit cards in the double-digit range, or when they learn of the fact that banks charge merchants for the privilege of using this payment system. By the way, I find it incredible that the current delinquency rate on this unsecured debt is just 4.6%. Compare that to the 11% delinquency rate on secured residential mortgages. Ask yourselves how that could ever be the case (hint: in the attached data series, the delinquency rate on credit cards never came close to that on mortgages until the 4th quarter of 2008).