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ROHAC: The high costs of consumer protection
CARD Act penalizes the prudent for behavior of the profligate
Question of the Day
Even though the Federal Reserve continues to keep its interest rates low, credit card interest rates are climbing. The spread between credit card interest rates and the prime rate in the United States has just reached a historic 22-year maximum. In the second quarter, the average interest on existing cards reached 14.7 percent, rising from 13.1 percent a year earlier. Why is this? Because of more folly from Congress.
The recently passed CARD Act limits the flexibility of credit card issuers to boost interest rates quickly on badly performing customers and also limits penalty fees. Under its provisions, issuers will have to give a 45-day notice before any increase in interest rates can be charged to their clients, which effectively disables them from penalizing debtors who miss their payments.
The supposed benefit of this regulation is that it increases transparency and consumers’ awareness of the risks that come when running up excessive credit card debt. This degree of transparency comes at a fairly steep cost, however. Card issuers are now forced to charge everyone higher rates, regardless of their creditworthiness. What is even more disturbing, the new legislation is likely to encourage imprudent risk-taking and more patterns of the consumer behavior that contributed to the present financial crisis.
The CARD Act creates a redistribution of wealth among different groups of consumers. To understand this process, it is useful to distinguish among three categories of credit card holders. First are those who always repay on time, usually the wealthy and the responsible. Second are prudent consumers who nonetheless are liquidity-constrained and unable to pay off all of their purchases at once and thus carry a balance. Finally, there are the riskiest customers, who tend to make poor spending choices, miss their payments and run up large balances.
Obviously, those in the third group are now likely to pay less for their mistakes than they would if banks were allowed to charge them punitive interest rates. But who is going to pay more? As the Atlantic’s economic and business editor Megan McArdle notes, it will not necessarily be the wealthy, because they already repay on time.
More likely, the group that will be hit the hardest will be those who are carrying a significant balance without being undisciplined in their spending. The rhetoric of “consumer protection” should not gloss over the sheer unfairness of shifting costs from the irresponsible onto the responsible but cash-strapped.
Fairness considerations aside, this economic transfer actually encourages unwise consumer behavior. The fundamental lesson of economics is that people respond to incentives and that whenever the costs of a particular behavior decrease, we can expect more of it. When others will be paying for their mistakes by being charged higher interest rates, we can expect that people will tend to miss their payments on a more frequent basis.
This mechanism ought to shed doubts on Congress’ ability and willingness to reckon with the fundamental causes of the financial crisis. After all, extending mortgages to those who did not have any realistic prospects of repayment was a central cause of the meltdown of 2008. This process also was encouraged throughout by the federal government’s interventions in the mortgage market, which was motivated by a desire to foster homeownership across a wide range of social groups.
If such policies were part of the problem, it becomes puzzling why the Obama administration has done so little to put housing policies on a more sustainable track. Even today, the structure of the tax code makes it economically irrational for most middle-class households not to own a house, an issue further compounded by indirect government subsidies through the guaranteeing of a broad category of mortgage-related loans.
But the financial crisis was not only about homeownership. It was also about using houses as piggybanks and about imprudent financial behavior at a whole variety of levels, including people’s mishandling of consumer credit. It is very disturbing to see the government encourage exactly the same forms of risk-taking behavior as those that brought us into the present mess.
Clearly, financial systems worldwide need more responsibility, more common sense in evaluating creditworthiness of individuals and more stringent sanctions for those who engage in unwise and overly risky conduct. This applies both to bankers and to individual customers of banks and credit card companies. Of course, there is a role for the government in encouraging the restoration of sound banking and financial practices. Unfortunately, as the CARD Act illustrates, the government is still contributing more to the problem than the solution.
Dalibor Rohac is a research fellow at the London-based Legatum Institute.
© Copyright 2014 The Washington Times, LLC. Click here for reprint permission.
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