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.
Economic growth is measured by the Gross Domestic Product (GDP), which is really Gross Domestic Expenses. GDP measures cost of living, not what we produce. And much of GDP growth is due to population growth, not due to greater wealth per-person.
These raise GDP (a lot!), but how much do they help the average person?
- rising prices of existing homes
- defense (war) spending, about half of all the world total (why are we so insecure?)
- energy consumption, 3x per-capita that in EU (big deal, we drive bigger vehicles)
- health care, twice per-capita that of developed nations (but 37th in life expectancy)
(Note though: corporate profits DO rise uniformly with economic growth; investors benefit. This is why capitalism emphasizes growth.)
If the population is not rising - or even falling, like Japan - a system that requires growth to succeed is a pyramid scheme. US-style capitalism (Friedmanism) is exactly that. Any system that depends on growth is unsustainable.
It is not very good business practice to finance operations with credit card debt for more than a short period of time?
The added "convenience" is not worth the added cost?
That downsizing shows up as profit-- but what happens to the consumer base if every company does this?
That CDS and other borderline practices, which again look good on the books and of course generate commissions for their pushers, amount to pyramid schemes. Except it's more an inverted pyramid; when the base becomes shaky, it falls.
And that the term innovation can be applied to what is really extraction. Well, supply-side theory is the belief that only the financial sector is important. That manufacturing, mercantile, and labor are irrelevant. As if pushing paper, or nowdays electronic blips, means that no one has to actually make anything physically real anymore.
I once had to post my credit card for a cardless foreign business visitor to be able to rent a car and hotel room, for which they would not even accept payment in advance. I think that would not happen today (cardless business people), and that is probably a good thing. Other than that, I can't think of many financial innovations that have delivered obvious value since the invention of auto and home insurance, the fixed rate mortgage, and on-line banking. Maybe mutual funds. Maybe grain futures, as a tool for actual grain farmers. Reverse mortgages - no. Annuities - no. Credit default swaps- no!
The credit card is like any other tool- the results vary widely depending on the competence of the user.
Personally, I've lived on cash only transactions for most of my adult life. When my rent needs to be paid I get a bank check, which unlike a personal check, is always accepted. When I need a credit card I go to a currency exchange and load up my Visa debit card - no overdraft fees there and my utility bills get paid on time. Everything else gets paid for in cold, hard cash money. I have no debt, no overdue bills, no mortgage - renting may make me less "substantial" in the eyes of society, but I am mobile and flexible so that I can always move to where the jobs are. Most importantly, I have no stress from debt, no worries about paying my bills, and no fear of opening the mail or answering the phone. My credit score may suck, because I've never had or used any credit, but then, these days, I am not so different from millions of other Americans who did have credit and went bust.