The High Costs of Consumer Protection; CARD Act Penalizes the Prudent for Behavior of the Profligate

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Even though the Federal Reserve continues to keep its interest rates low, credit card interest rates are climbing. The spread between credit card interest rates and the prime rate in the United States has just reached a historic 22-year maximum. In the second quarter, the average interest on existing cards reached 14.7 percent, rising from 13.1 percent a year earlier. Why is this? Because of more folly from Congress.

The recently passed CARD Act limits the flexibility of credit card issuers to boost interest rates quickly on badly performing customers and also limits penalty fees. Under its provisions, issuers will have to give a 45-day notice before any increase in interest rates can be charged to their clients, which effectively disables them from penalizing debtors who miss their payments.

The supposed benefit of this regulation is that it increases transparency and consumers' awareness of the risks that come when running up excessive credit card debt. This degree of transparency comes at a fairly steep cost, however. Card issuers are now forced to charge everyone higher rates, regardless of their creditworthiness. What is even more disturbing, the new legislation is likely to encourage imprudent risk-taking and more patterns of the consumer behavior that contributed to the present financial crisis.

The CARD Act creates a redistribution of wealth among different groups of consumers. To understand this process, it is useful to distinguish among three categories of credit card holders. First are those who always repay on time, usually the wealthy and the responsible. Second are prudent consumers who nonetheless are liquidity-constrained and unable to pay off all of their purchases at once and thus carry a balance. Finally, there are the riskiest customers, who tend to make poor spending choices, miss their payments and run up large balances.

Obviously, those in the third group are now likely to pay less for their mistakes than they would if banks were allowed to charge them punitive interest rates. But who is going to pay more? As the Atlantic's economic and business editor Megan McArdle notes, it will not necessarily be the wealthy, because they already repay on time.

More likely, the group that will be hit the hardest will be those who are carrying a significant balance without being undisciplined in their spending. The rhetoric of consumer protection should not gloss over the sheer unfairness of shifting costs from the irresponsible onto the responsible but cash-strapped. …