Let’s hop into the time travel machine this Monday morning and go back to the year 1973.
The proposed credit card interest rate cap legislation, courtesy of Democratic presidential hopeful Senator Bernie Sanders and Rep. Alexandria Ocasio-Cortez is in serious need of an almost half-century-old refresher course in the unintended consequences of price caps on the American consumer.
A 46-Year-Old History Lesson
In 1973, the world’s energy market was a hot mess. The price of crude oil went from $3 a barrel to $12 almost overnight, and the Organization of the Petroleum Exporting Countries (OPEC) imposed an embargo on shipments to the U.S. (and other countries) over political differences.
That year, President Nixon imposed price controls on both crude oil and gasoline to protect consumers from paying higher prices at the pump. Any station found selling gasoline at a price higher than the cap could be found guilty of fraud.
Demand massively outstripped supply at the capped prices by about 1.4 billion gallons of gasoline each day, economists found.
So, the government rationed gas to consumers by imposing an odd/even license plate numbering system that determined when consumers could go to gas stations to buy it. A bill was also signed into law to roll back speed limits to 55 mph in order to conserve fuel.
Gas station operators followed the government’s rules.
Since capping prices also limited their ability to make more sales to cover their operating costs, they capped the number of hours a day they were open. Gas was sold on a first-come, first-served basis, and the stations closed up shop when their tanks ran dry. Flags were flown outside the stations to signal whether they had gas (green), were running low (yellow) or were all out (red).
It was not uncommon for people to wait in line for an hour to fill their tanks, or to drive around to find a station that had fuel available. Station operators also began charging for services that were once offered for free, such as washing the windshield and checking the tires and oil. The cost of an oil change and other services provided by gas station operators also increased to make up for lost sales and profits.
Those who were willing to pay more for those services got to cut to the front of the line. Gas station operators gave preference to those who booked oil changes and bought car washes.
In the end, consumers didn’t really save money, even though prices paid at the pump were estimated to have saved the U.S. consumer, collectively, about $5 billion to $12 billion a year. But time spent sitting in line waiting to get gas cost consumers money, too – they lost wages and, more importantly, valuable hours they could have spent enjoying themselves.
Those same economists estimated that it raised the cost of a gallon of gasoline for U.S. consumers by as much as 40 percent.
So who got hurt the most?
Not the oil companies, and not the gas station operators.
It was the average, hard-working consumers who were “supposed to” have benefited from not having to pay “exorbitant” prices.
But, of course, they paid – just in a myriad of other ways, including even losing their jobs.
Lots of Pain and No Real Gain
Every time governments try to implement price controls to prevent market-based prices from balancing supply and demand, they eventually experience the law of unintended consequences.
One of the reasons the Chinese economy has had explosive growth over the last several decades is because the government dismantled most price controls, and let the market do the talking. And that’s true for many countries around the world that ended price controls in favor of a market-based system.
So, what makes credit card interest rates any different?
Well, nothing, in fact. It’s just the price of extending and accessing credit.
But unlike gasoline, people pay different prices because they have different likelihoods of defaulting on the debt.
The Definition of Insanity
We’ve even seen the “taming the big banks and protecting the little guy by capping credit card interest rates” movie before.
The Hollywood film, scripted by interest rate caps in the past, always has a happy ending.
Standing-room-only crowds applaud.
But not so much in the real world.
The basic economics are pretty simple.
Many people need credit to get by — to smooth out income, to handle an emergency expense, to finance an essential household purchase. Some of those consumers are in bad financial straits — a real problem that requires a real solution.
But until that happens, people actually need credit to manage their households.
Some people aren’t such great credit risks, because stuff happens that is outside of their control and they just aren’t very reliable in paying back the money. The card issuers give them credit because they end up getting paid, but they charge them higher rates because of the risk they take in doing that.
Even if you grant the argument that sometimes card issuers trick people into paying high rates, most of the time they don’t. We, of course, know that when the economy takes a hit, as it always does, credit card defaults skyrocket and banks take a bath.
We also know that no matter what the interest rate might be, people don’t always pay the money back — and banks need to adjust their pricing for that.
On average, economists say, across the board, those interest rates average roughly 15 percent. Here’s why.
Statistics from the card networks state that approximately 50 percent of card volumes are paid in full each month. The balances that revolve do so, on average, for a period of five months. At an average interest rate of about 18 percent across all cards, the average APR for the total amount of outstanding credit card debt is about 15 percent.
When the Government Doesn’t Know Best
But what would happen if the government steps in and regulates a cap on credit cards?
Well, just as long lines form outside of gas stations when fuel prices are capped, card issuers will reduce credit availability to higher-risk individuals.
Unfortunately, those higher-risk individuals are often the more desperate consumers – and the ones who will be hurt the most.
Maybe that just means not getting that big-screen television – (I mean, shouldn’t they just be reading more books anyway? she writes sarcastically) – but sometimes it means not being able to afford to get medical care or put food on the table.
That’s where the law of unintended consequences really kicks in.
When people really need credit, they will figure out some way to get it.
And businesses – some above board, some unscrupulous – will fill the gap.
Stores will offer credit, and if that’s capped, they’ll offer installment loans or rent-to-own fees or some other way to finance the consumer. But all of that will probably come at much higher interest rates than the card issuers offer, simply because the stores are less efficient in running credit operations.
Also, they are more likely to capitalize on desperate customers with installment credit that is designed to penalize consumers when they slip up even the tiniest bit – which they often do.
Or the consumers will be pushed to payday lenders or other similar, higher-cost options.
But, Sanders and AOC may say, not so fast – we’re going to regulate all of those things, too.
Then those desperate consumers who this Loan Shark Prevention Act is supposed to help will very likely, and very ironically, be pushed into pushed into the world of loan sharks and pawn shops and illegal lending.
That’s not being dramatic – that’s just stating reality.
We have documented as much in our own Financial Invisibles study conducted over the last year how consumers today who can’t get credit turn to pawnshops and friends and family to get by.
When Past Is Prologue
But the Hollywood movie version of the credit card interest rate caps is really great.
Those big bad Wall Street “loan shark hoodlums” are put in their place. Poor families relieved of high-interest credit card debt can rejoice.
It’s a wonderful life.
Or maybe not.
The movie that plays out in real life is quite different.
Short-sighted policies — like price controls — foist terrible pain on the American people.
Sure, interest rate caps would put those so-called big bad banks in their place. Some people may even cheer.
But most won’t, because people all across the country are denied credit and forced into high-cost alternatives.
And that’s because history — over decades and centuries — has shown that price caps don’t work.
It’s not such a wonderful life after all — except, perhaps, for the policymakers.
It takes a long time for unintended consequences to show up – and by then, the perpetrators are long gone.