James Surowiecki, a writer at The New Yorker who covers economics, business, and finance, says that credit-card debt is part of the problem which has added up to the world’s present financial crisis. And though it could seem that the answer is an easy one—simply have everyone pay off their balance—things in our globalized, interconnected world are never as simple as we would like. In his fascinating piece, “House of Cards,” Surowiecki provides insight into how the credit-card business works:

For decades, they’ve been deluging Americans with come-ons (in 2007, 5.2 billion offers for new cards were sent out), so much so that, as of 2006, there were nearly 1.5 billion charge cards in circulation. And these cards did not go unused: between 2000 and 2006, even as Americans’ real income was essentially stagnant and their savings rate negligible, credit-card borrowing rose by about thirty per cent. Our willingness to spend beyond our means served the credit-card companies well: their profits jumped forty-five per cent between 2003 and 2008…

But credit-card companies have created a strange business, in which there’s a fine line between good and bad customers. Their best customers aren’t those who dutifully payoff their balance every month; instead, they’re the ones who charge a lot and pay only a little every month, carrying a sizable balance and racking up interest charges and late fees. These are the “revolvers,” and the credit-card business feeds on them. Credit-card companies don’t necessarily want revolvers to payoff their debts; if they did, there’d be no interest or fees to collect. They want their loans to be, in the words of a banking regulator, “a perpetual earning asset.” And they’ve thought a lot about how to keep those interest payments coming. For instance, they used to keep minimum payments relatively high. But, over time, companies started lowering minimum payments, sometimes to just two per cent of the balance. The lower the minimum payment the less people pay off each month and the longer they stay on the hook.

The catch is that while revolvers are the companies’ best customers, they’re also more likely to default, which would make them the worst. That’s why credit-card companies have had to rein in their lending and shed accounts. Since that risks shrinking profits, they’re also trying to get as much as they can out of their existing customers, by doing things like sharply increasing their interest rates. This increase is partly a response to the greater risk of default, but it also takes advantage of the recession. Many cardholders don’t have enough money to pay off their balance in full, so when interest rates rise they aren’t able to just close their account and get a different card. Effectively, they’re captive customers. And since credit-card companies, unlike most lenders, are allowed to change the terms of their loans at any time, people who borrowed a big chunk of money at, say, nine per cent may now be paying seventeen per cent on the loan.

These tactics are not going to improve the credit-card industry’s dismal reputation. They’re also not going to help an economy in recession, since reduced credit lines take away an important cushion for consumer spending, and higher interest rates and increased fees are likely to drive more people to default. But the odd thing is that while less access to revolving credit is a bad thing for us in the short run, having people rely less on credit cards is a good thing in the long run. The easy availability of credit cards encouraged people to live beyond their means—studies suggest that people really do spend more when they can pay with a credit card, and that big credit lines further encourage extravagance. And the high price of credit-card debt meant that billions of dollars in interest and late fees went to credit-card companies instead of to more productive uses. Smaller credit lines and less borrowing make sense. But in the short run they’re going to throw a lot of sand into the economy’s gears.

Source: “House of Cards” (The Financial Page) by James Surowiecki in The New Yorker (March 16, 2009) p. 45.