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Dean Baker

Dean Baker is co-director of the Center for Economic and Policy Research

March 5th, 2010 8:11 AM

Financial Innovation: What Is It Good For (I)?

Brookings economist Robert Litan picked up the gauntlet thrown down by Paul Volcker and others, and put out a lengthy paper defending the major financial innovations of the last four decades. Litan surveys the field and pronounces most of what he sees to be good.

While there is certainly some merit to many of the points that Litan makes, he presents a very incomplete picture. A fuller discussion is likely to be more critical of recent innovations.

Credit cards are a good place to start. Litan notes the explosion of credit card use over the last three decades and sees this as a great advance. He notes the enormous convenience of credit card use over cash or checks. Litan dismisses the idea that credit cards increased consumer indebtedness, noting that the ratio of credit card debt to mortgage debt did not rise over this period. He even claims that credit cards have helped foster growth by providing financing to many small businesses in their start-up phase.

There is a lot here to chew on. Certainly credit cards do facilitate payments. However, it used to be very common for businesses to accept personal checks. Don't try that one today. For the vast majority of people who do have credit cards, they certainly are easier to use than checks, however those with mixed credit histories, who can't get credit cards, don't stand to gain from their convenience.

Of course almost anyone with a bank account can now get a debit card, so this should leave them as well off as when they could pay with a check (unless they hoped to use a bad one). But in the post-credit card, pre debit card era, credit cards did not unambiguously increase access and convenience for everyone.

There is also the obvious point that banks have found ways to slip fees into credit and debit card bills that many people would probably not pay if they were fully aware of them. The most notorious of these fees is the overdraft fee attached to debit cards, which can often be several times the size of the purchase being made. While new legislation is limiting the ability of banks to impose such fees and requiring greater transparency, any assessment of the merits of credit cards should acknowledge these costs.

This raises another important issue with credit cards - their cost structure. The industry imposes a fee that averages close to 2.0 percent per transaction on credit card purchases. (It's worth noting that these fees are about half as large in most other countries.) Since the credit card companies generally prohibit retailers from offering cash discounts, this means that cash paying customers must subsidize those who pay with credit cards. (Fees are somewhat lower on debit card purchases.) If lower income customers are more likely to pay with cash or debit cards, then the banking industry has effectively created a sales tax, the proceeds of which go to subsidize the purchase of higher income consumers.

The issue of cross-subsidies also comes up in reference to the fees that the industry charges. In the debate over increased regulation, the industry claimed that if they could not charge high late payment fees and were limited in their ability to jack up interest rates, then they would have to curtail the frequent flyer miles and other bonuses that they offer to their customers. It remains to be seen whether the industry will follow through with this threat, but if they do, it implies that another way in which their credit card innovation might have been used to subsidize higher income households at the expense of lower income households.

In examining whether credit card debt has led to lower savings, Litan picks a very low bar. Mortgage borrowing exploded, as homeowners were eager to borrow against bubble-inflated house prices. They got a further push from lenders anxious to have mortgages to sell in the secondary market. The fact that the growth rate in credit card debt didn't exceed the growth in mortgage debt over this period can hardly be seen as a compelling argument that credit cards did not negatively affect savings.

In fact, the ratio of credit card debt to disposable income nearly tripled from 1980 to 2008, rising from 2.7 percent of income in 1980 to 8.9 percent by the end of 2008. Of course, this doesn't prove that access to credit card borrowing led to a lower savings rate, but we may not want to cross it off the list of suspects as quickly as Litan. Credit card borrowing is no doubt a mixed picture. In some cases it gives households an opportunity to sustain their standard of living through bad economic times. However, many families do have problems managing their money and easy access to credit cards could make their situation worse.

This brings up one final issue with credit cards. Litan gives credit cards an unambiguous plus for their impact on growth because many small businesses have been financed through credit cards. This one requires a bit more reflection.

More than half of small businesses fail in their first four years. A small business that is only open for a year or two is probably not benefiting the economy. The resources that are diverted into this business could likely have been better used elsewhere in the economy. Instead of making capital and labor available for a viable business, the failed small business owner has diverted it to some hare-brained scheme - just as a pointed headed government bureaucrat might do.

Obviously, all small business start-ups do not provide a benefit to the economy. Now, let's take the subset of small businesses that are turned down for bank loans by our highly innovative financial sector and which therefore must rely on high cost credit card borrowing. Presumably a much higher share of these businesses fail than small businesses in general.

If credit cards make it easier for people with hairbrained schemes to start small businesses can we say that they have helped foster economic growth? That seems a bit of a leap. I don't have the data on this and neither does Litan, but until one of us does, we better take away the plus that he gives credit cards for their impact on economic growth.

In sum, the story of one financial innovation, credit cards, is much more mixed than Litan claims in his assessment. They certainly have increased convenience but at a considerable cost. It is noteworthy that the credit card transaction fees are much lower in Old Europe than in the United States. Also, East Asia is far more advanced in allowing the use of electric money transfers from cell phones. So, we may want to hold off on the celebration for the U.S. financial industry's development and promotion of credit cards.

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