Commentary

Will Credit Card Legislation Curtail Consumer Credit?

The most basic function of all financial transactions is to allow households to more closely align their lifetime flows of consumption and income. While the most important mismatch between desired consumption and income happens over the life-cycle — workers earn less at the beginnings and ends of their lives than in the middle — shifting income from good economic times to bad also improves household welfare.

Credit cards have been an essential element of these efforts. Credit cards allow the un- or under-employed to spend now out of future expected income. To limit credit solely to the financially stable leaves those most in need outside of our formal financial system, instead forcing such households to borrow from less efficient, and often more costly, sources, such as friends and family, or pawn-shops and loan sharks. The trend in recent months of households shifting away from mortgage debt to credit card debt has been essential in allowing households to maintain spending in the face of declining home values — absent such spending our economy would be in worse shape.

Of course, financial contracts are like any other form of contract — should they be unconscionable, fraudulent or lacking in consideration — they should not be enforced by courts. And that decision should be judged by courts on an individual basis — and not driven by politics.

As credit risks in the economy change, so should credit pricing. While we want credit to be widely available, that credit should be accurately priced — to provide the right incentives for borrowers and lenders alike. Practices such as universal default — where credit card rates are raised upon the default of other loans — provides for a more accurate pricing of risk. Someone defaulting on their car loan is undoubtedly a higher risk to their credit card company than someone making their car loan. If we’ve learned anything, it should be that in times of stress, risks across various kinds of credit become more highly correlated.

Mark A. Calabria is director of Financial Regulation Studies at the Cato Institute think tank.