Credit Distinctions: Revolving and Transactional

Megan McArdle...

[M]aybe it's worth remembering that the tyranny that credit scores exercise over our imagination have everything to do with the fact that we've built a society so utterly dependent on credit.

Kevin Drum responds...

[T]here's nothing per se wrong with the fact that modern economies are so dependent on credit. Widespread use of credit really does make life more convenient, really does make banking more efficient, really does enable useful advances like online shopping, and really does allow easier access to goods and services that would otherwise be difficult to get hold of. Used in moderation, it's good stuff. I sure don't want to return to the days of hauling around travelers checks whenever I fly off to Europe.

Speaking for myself, my jeremiads against the credit-industrial complex have never been meant as an attack on widespread access to credit itself. Used reasonably, credit cards are a boon and credit reporting is a necessary part of providing credit responsibly in a big, complex world. That said, credit is critically important to everyday living now, and that means that it needs to handled fairly and transparently.

We won't get very far in the debate about the role of credit in the US economy if we fail to distinguish between the role of transactional and revolving credit. These are two fundamentally different products, and much ill has come from conflation of the two. All of the good things Kevin attributes to widespread credit access are benefits of transactional credit. Because credit cards have often bundled transactional and revolving credit together, it is easy to attribute these good things to revolving credit. That's a mistake. Transactional credit is essential, and might even be publicly provided. Revolving credit is a double-edged sword.

Transactional credit is a means of decoupling the process of making payments from the form in which one's liquid wealth is held. More simply, if you have the money to pay for what you are buying, but just don't want to carry cash or keep track of your checking account balance every day, you are making use of transactional credit. Many people only use credit cards for transactional credit. They pay off their entire balance each month.

Revolving credit is a different product. It provides a means by which people can spread the cost of purchases over an indefinite period of time. If you wish to go on a vacation, and can afford to pay for it from your next six months' salary, but could not easily come up with the money now, you are making use of revolving credit.

Both transactional and revolving credit are useful, and conventional credit cards give consumers access to both. But revolving credit is much more prone to abuse than transactional credit. Though economists hate to admit it, it is a fact of life that human beings do not, in general, seem to have time-consistent preferences. If preferences aren't time-consistent then people are prone to making short-term deals that they will seriously regret in the distant future. Revolving credit is like morphine: When used properly, it can be very useful. But experience has shown that it can cause great harm if used incautiously.

Revolving credit needn't be bundled with transactional credit. The traditional American Express (AXP) card, for which you are charged a flat annual fee and pay your balance in full each month, is a transactional pure play. Transactional credit has different characteristics than revolving credit. In particular, consumers can get most of the benefits of transactional credit with low credit limits, perhaps twice a typical month's expenses. (If restricted to transactional credit, consumers may have to find other means of paying for occasional large purchases. They might need to put funds into a bank account in advance, and pay via debit. As long as such purchases are infrequent, this is not a terrible burden.)

If we set aside "tricks and traps", transactional and revolving credit products should inspire very different business models. Transactional credit resembles an insurance product, while revolving credit is like a traditional loan. The primary benefit a consumer receives from transactional credit is not the financing debt, but the option to purchase at any time without having to track specific account balances or coordinate transfers. This service is provided regardless of the size of any given month's balance. Consumers should be (and historically have been) willing to pay a flat fee for it. Even very modest interchange fees more than cover the cost of capital on the loans, so fees can be quite low and might go to zero for some customers. (A 1% interchange fee amounts to a 12% annualized rate for a low-balance, 1 month loan. Conventional interchange fees of 2-3% offers exorbitant returns on 1-month loans, part of which may be rebated via rewards programs.) There is no reason why transactional credit can't be a fine business, and it has been, both for American Express and every other credit card provider sending unsolicited offers to people whom they know pay their balances off monthly.

Revolving credit, when it is not about tricks and traps, is all about the interest rate. Revolving credit is prone to abuse, and should be made available cautiously, not automatically or indiscriminately. Credit card interest rates should simply be capped, which would prevent less creditworthy borrowers from gaining access to revolving credit lines. That is a feature, not a bug. In a world where agents have inconsistent time preferences, paying high interest rates for present consumption is prima facie evidence of selling out future selves for present goods. Rational high interest rate borrowers are either those who intend to default (thereby extracting a wealth transfer from the more responsible subset of the population), those who are financing goods that will yield benefits over time, and those who face an unusual emergency which requires the future be held hostage to the present. We want to deny credit to the first group, the rational defaulters. People who are financing goods that will yield benefits over time can usually get credit on much better terms by taking out securable, asset-specific loans.

We should encourage the resurgence of secured vendor financing, because that form of credit can offer huge savings to less creditworthy borrowers, compared with ubiquitous unsecured plastic. Finally, the usefulness of high limit credit cards as a kind of insurance is undeniable, but dangerous. Every day has its crises; that is the human condition. It is easy to err by taking on "absolutely necessary" debt today that leaves one absolutely destitute tomorrow. We should develop better forms of emergency insurance than unsecured debt. To the degree that we do rely upon access to credit as a reserve cushion, it shouldn't be attached to our instrument of casual commerce. It should be special, and have a "break-glass-in-case-of-emergency" feel to it.

Access to revolving credit should be rationed, but transactional credit should indeed be ubiquitous. Not having to carry and count cash, deal with paper checks, or even worry about some particular account's balance at the time of purchase are important benefits. Indeed, an efficient payments system is a public good. That's why states are in the business of establishing currencies, right?

In fact, while transactional credit provision is a perfectly good business, it might be reasonable for the state to offer basic transactional credit as a public good. This would be very simple to do. Every adult would be offered a Treasury Express card, which would have, say, a $1000 limit. Balances would be payable in full monthly. The only penalty for nonpayment would be denial of access of further credit, both by the government and by private creditors. (Private creditors would be expected to inquire whether a person is in arrears on their public card when making credit decisions, but would not be permitted to obtain or retain historical information. Nonpayment of public advances would not constitute default, but the exercise of an explicit forebearance option in exchange for denial of further credit.) Unpaid balances would be forgiven automatically after a period of five years. No interest would ever be charged.

Let's think about how this would work. For most people, access to various forms of credit — transactional credit, auto and home loans, unsecured revolving credit, whatever — is worth more than $200 per year. Although people might occasionally fall behind, for the most part borrowers would pay off their government cards, simply because convenient participation in the economy is worth more than a once-in-five-years $1K windfall. However, people with no savings and irregular income (for whom transactional credit is a misnomer, since they haven't the capacity to pay) might well take the money and run. The terms of the deal amount to a very small transfer program to the marginal and disorganized, and a ubiquitous form of currency for everyone else. People with higher incomes would want more transactional credit, or revolving credit, which they would acquire from the private sector.

I've posited that people often have time-inconsistent preferences. Am I, then, inconsistent to suggest that most people wouldn't take a free $1K today and be stuck without credit thereafter? No. The degree to which people underweight future costs varies widely, and is not fixed. Most people do work to avoid present choices that will create future hardship. (Many people arguably overweight the future.) However, high-limit revolving credit is a particularly nasty trap for those who even slightly underweight future costs. One nice aspect of a low-limit, indiscriminate, mechanical public credit system would be educational. Many younger people would spend some period of time modestly in debt and shut out of the credit economy. This would provide a more gentle lesson than the current practice of running up revolving balances in college and working desperately for years to pay them down.

The notion of transactional credit as a state-provided public good is speculative. Maybe it's a terrible idea. Regardless, the distinction between transactional and revolving credit is crucial. A modern economy probably does require widespread access to transactional credit. But revolving credit is a different story entirely, and we would be better off controlling it more carefully. We shouldn't be shy about adopting policies that would curtail the provision of unsecured revolving credit, as long as transactional credit is protected.

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Some of this was inspired by a conversation with the excellent keyholez over Twitter. (I have been playing on Twitter recently, and am still trying to decide what I think of it. If you're into that here's me and here's keyholez.)

Comments

[Leftfield:]

While I'm a believer that we are granted unalienable rights by God and shouldn't look to the state nearly as much, I see practical application in these ideas. The average credit card balance of a graduating college student with credit is now $4100.
Clearly these ideas are far better than the present where every credit company that can is becoming a bank to get bailouts when they've lent out to every wino and junkie they could find, jacked the interest to 30+% and are now everybody is stuck.

May 22 08:00 AM

[Crocodilian:]

Thank you for a thoughtful article. It did occur to me that way back when I got my first Amex card, they took great pains _not_ to call it a "credit card" -- I believe their awkward nomenclature was "sign and pay" . Some time subsequently, they blurred the line between rotating and transactional credit by introducing the "sign and travel" feature . . . the conceit being something like that you were heading to the jungles of Sarawak and being incommunicado amongst the headhunters, you might need to pay off the airline tickets in a few months.

That is, they take pains to contrive a scenario where you might need more than a month to pay off your bill -- but you are _not_ using the card for its revolving credit feature (eg, you're not delaying payment because you don't have the money, you're delaying payment because you're somewhere that you _can't_ pay)

This obscure nomenclature reflects the sense I have that Amex has never really known where they want to be with respect to be with respect to credit.

May 22 09:17 AM

[Sonia:]

If deadbeats are given a $1000 publicly funded credit card, who will pay the losses? We taxpayers. Bad idea. Both rates and availability of credit should be capped.

Those of us who pay our balances every month and get cashback or miles are going to lose, but fewer people will be suckered into mounting debt. Card companies deluge any name they get their hands on with offers ( my grandsons in high school and my cat have all received credit card offers,) then jack up interest rates to 26%, 30%, or more, pretend to be astonished when people default on the ever increasing debt, and expect the government (the taxpayers) to bail them out.

What did the credit card companies expect the end would be? Reminds me of our banks lending money at high interest to South American countries in the '80's, then lending more every year so the countries could "pay" that interest, and more to pay the interest on the interest... each CEO hoping he'd retire before the inevitable crash.

May 22 11:02 AM

[derryl:]

I also like the idea of the Treasury Express card, but like other rational approaches to finance it's contrary to the banksters' interests so it will never happen.

May 22 07:07 PM

[MattZN:]

It kinda sounds like a debit card. There's certainly no reason for the government to have to provide such a feature.

I kinda like the idea of capping credit card rates but it's rather anti-capitalistic. A better idea might be for the government to cap the amount of total indebtedness allowed at any given rate. So e.g. no limitation at 5% interest or below, no more then $50K at 5-10% interest, and no more then $10K at > 10% interest. Just as an example.

It's still rather anti-capitalistic so this is really just a fantasy.

Maybe a better solution instead of putting limits on amounts or rates, is to put limits on the amount restitution possible through bankruptcy. If a CC issuer is charging someone 25% interest and that person goes into bankruptcy, the issuer should be last in line (or not in line at all) in bankruptcy court.

-Matt

May 23 01:40 AM

[D. McHattie:]

It's called a debit card. Anyone can get one no matter how bad your credit record is. As long as you have money. And if you don't have money, hey, perhaps you shouldn't be spending it?

The author and other commenters are correct in faulting time-inconsistent preferences and bank abuse of this natural human weakness. Debit cards are still the solution.

I would normally be against capping interest rates since card companies will learn from the mistake of extending credit to bad risks and jacking up the rates.

But because governments can't resist bailing out the usurers we need to cap rates so that cc companies will restrict credit to bad risks and thereby ensure cc companies never need to be bailed out.

May 23 09:23 AM

[dorafacol:]

I agree with the idea that debit cards are the option for people who do not wish to use revolving credit. The "debit card" image is of a low-income person who cannot rate a regular credit card, but this just goes to show how stupid are the people who create these impressions.

You either have money or you don't. You either have a means of paying it out for things that you want or you don't. I believe that sheer pressure will result in more efficient and least-cost options. Anything standing in the way will be discarded and avoided. What it should be is prosecuted!

It's our money.

May 23 01:33 PM

[nathanredondo:]

I think that its extremely important to distinguish between transactional and revolving credit from a consumer standpoint, particularly when enacting policy. The current credit card legislation that just went through congress, while adding some reasonable transparency measures (requiring credit card providers to "do the math" on your bill to show how underwater you are), misses the point. I disagree with the idea of rationing credit to prevent the less credit worthy from getting in over their heads- they will simply turn to loansharking and other means to make up the difference instead.

The better solution is for the Fed to simply let interest rates rise to market levels, rather than manipulating them through the open market window. This will naturally limit the supply of money and thereby the credit limits that borrowers are willing to lend to those with a high credit risk- there is a reason why, when I was in college, I couldn't get a credit card with more than a $500 limit (nor should I have been able to).

Further, I think that government intervention to create another slush "emergency" fund for the consumer to tap on a rainy day will solve one problem partially in the near term while creating further, greater problems down the road. In the cases of social security and medicare, we have done exactly this, creating an "emergency" fund to take care of us in our later years in case we can't do so ourselves through our own planning and thrift. In reality, this "asset" has been turned into a liability as politicians frequently raid it to move deficits off the balance sheet. I have a feeling any sort of "emergency" fund will face a similar course.

Higher interest rates in the long term (not necessarily right now), along with perhaps tax credits for savings in the form of interest exemptions, would reward savings, discourage accumulation of debt and allow people to create their own "rainy day funds". This is the 95% solution the free market offers. The government 99% solution costs ten times as much, is 10 times as complicated, and comes with significant unintended consequences.

May 25 01:20 PM