The death of the credit card economy

Daniel Gross

The most revolutionary notion in commerce today is one of the oldest. If you want to buy something, you may actually have to pay for it. We are reverting from a "borrow and buy" economy to the "cash and carry" model of our grandparents.

The Olesons may have extended store credit to Ma and Pa Ingalls in Little House on the Prairie, but widespread consumer credit is a very recent phenomenon. It began in the 1920s, when expensive consumer durables—cars, refrigerators—were first produced in mass quantities. It wasn't until Bank of America began carpet-bombing California with credit-card applications in the 1960s that the debt wave started in earnest.

In the decades since, consumer credit became so pervasive that paying cash became passé. Want a new €40,000 Dodge Ram Crew pickup? Take a lease. Sick of your old house? Get a 100 percent mortgage and trade up. Face lift? Round-the-world cruise? New PC? Three-hundred dollar sushi dinner at Nobu? Whip out that plastic. It was this behaviour—the endless willingness of lenders to lend and borrowers to borrow—that kept the consumer economy humming uninterrupted from the early 1990s, straight through the brief recession of 2001, until the credit meltdown of 2007.

Cry baby cry
But many of the lenders who extended credit recklessly are now acting like a single twentysomething who, after having a few bad dates, takes a vow of celibacy. Students returning to college are finding that student loans have vanished. Retailers who freely extended credit to any customer with a pulse are deploying bean counters armed with sophisticated software to sniff out potential deadbeats. And when higher rates and fees don't deter their borrowers, credit-card companies resort to slashing credit lines. "We predicted there would be some degree of spillover from the mortgage meltdown," said Curtis Arnold, founder of CardRatings.com. "But the credit line reductions by big credit card companies in the last six months have been fairly unprecedented."

This shock to the system may further damage the already-fragile psychology of the consumer. Writing a cheque or deducting the price of a pair of shoes directly from your bank account packs a much more potent emotional punch than charging the pair of Allen Edmonds loafers on your American Express platinum card. Chalk it up to a concept called "the pain of paying," said Dan Ariely, the author of Predictably Irrational. (It's a concept the parents of his students at Duke University feel every semester.) Imagine that a restaurant, rather than charging €30 per meal, charged 50 cents per bite, with a waiter standing tableside collecting after each chomp. That would be an extremely unpleasant meal. But credit puts a safe distance between the ecstasy of consumption and the agony of payment, and thus makes us feel better. Said Mr Ariely: "If it's more difficult to get credit, it might make people feel more pain of paying and therefore spend less."

The availability of credit also changes the calculus people use to determine what they can afford. Blowing €6,000 on a week in Tuscany might be tough to swing if you have to pay for it all next month. Convince yourself it's a once-in-a-lifetime experience that you can pay for over three years, and it becomes a bargain. With credit, Saturday night means dinner and a movie. When you pay cash and have a fixed budget, it's dinner or a movie.

Leveraged credit
The tightening of credit is forcing more people to confront these uncomfortable choices. In the second quarter, credit giant MasterCard reported that the gross dollar volume, or GDV, of credit charges processed in the United States rose just 0.7 percent from 2007, while the GDV of debit charges rose 15.8 percent. The huge retailer Target in late August said that in the second quarter, for the first time in memory, the percentage of sales charged to credit cards fell, while the proportion of purchases made with debit cards rose. That's partially by design, since the company has undertaken an "aggressive reduction of credit lines and significant tightening of all aspects of our underwriting." (Translation: No credit for you!!)

Leverage is an appropriate synonym for credit because it allows you to lift more than you could with simply your own financial muscle. Take away the leverage, and the power lifter becomes a 98-pound weakling. That's clearly a factor in the housing market. In 2007, according to the National Association of Realtors, 45 percent of first-time homebuyers put no money down, and the median first-time homebuyer financed a massive 98 percent of the purchase. But no-money-down mortgages, like Rudy Giuliani's presidential candidacy, began fading in late 2007 and largely disappeared in the cruel winter of 2008. No wonder existing home sales fell 13.2 percent in July from last year while new home sales plummeted 35.3 percent.

In effect, the lack of credit makes things seem more expensive to consumers, even if prices are holding steady. And in a world of scarce credit, consumption is likely to resemble a meal at Dan Ariely's nightmare restaurant: a series of small bites rather than an all-you-can-eat extravaganza.

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