Credit cards — Photo

Payment must change – credit card is a systemic ripoff

This post originally appeared on ZeMing M. Gao’s website, and we republished with permission from the author. Read the full piece here.

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This is not a real long-term solution. It is a temporary solution, perhaps even necessary for the time being, but we must do better and can certainly do better.

The credit card system is the problem. What people don’t understand is that the credit card system is really a high interest short-term rolling debt/loan that is deceptively imposed on consumers. 

I’m not talking about the apparent monthly interest rate charged by credit card companies on sustained card balances carried over with making only minimal payments, nor the late fees when failing to make the minimum payment.

I am talking about the regular credit card monthly balances that most consumers pay off entirely and timely. It may not feel like a loan with interest, but it really is. The way credit cards work, it is really an average 15-day short-term debt/loan the customer borrows from the credit card company. 

But the consumer does not feel it is a loan, as no apparent interest is charged. The merchant, however, knows that there is a 3% fee for the transaction charged by the credit company. If you look at the entire economy as a whole, it is a 3% tax burden over more than $4 trillion annually in the U.S. alone.

My point, however, is not even about the 3% overall burden on the economy, but that there is really a hidden interest charged on the consumers, albeit indirectly. This is because ultimately it’s the consumers who bear the cost in terms of higher prices. The bulk of the credit card fees are transferred from merchants to consumers through the market.

Let’s just say two thirds (i.e., 2% out of the 3%) is really borne by the consumers. I would argue it’s higher than that in reality, but let’s go with this conservative estimate.

2% on a 15-day short-term loan is equivalent to an annual interest rate of 48%.

The fact that consumers don’t realize they are really borrowing a rolling short-term loan with extremely high interest rate is not good news, but precisely why the current system is so harmful. 

It is much harder to help a victim who is unaware of his condition of being harmed.

48% annual interest rate? How can it be?

48% annual interest rate sounds too dramatic to be true, and you might suspect that the estimate must be wrong, because people clearly don’t feel anything like that, and it is impossible to hide an interest rate that high.

But no mistake is made. The truth is that there are two separate things that mitigate and further camouflage the reality, so people don’t feel it.

First, because most consumers pay off the monthly credit card balance entirely and timely, the customer does not borrow the entire amount of his annual credit card spendings, but only 1/12 of it. For example, if the total annual credit card spending of the consumer is $18,000, on average, the consumer is borrowing an equivalent of $1,500 loan. Yes it is a much smaller amount, but the fact remains that the short-term loan has an extremely high interest rate at 48% annually.

Second, it is just human psychology that people don’t pay attention to the expenses that are not directly charged on them. Especially, if the truth is hidden behind a financial and accounting labyrinth, and finding it also involves a quite a bit of math, very few can even turn their mind on it.

Deception and prison effect

So you don’t feel you’ve been ripped off. But that’s the point. It is designed so that you do not feel it, and more.

When you think of it, you have to acknowledge that the business model of credit cards is extremely clever. If they had promoted a service to consumers with straight honesty that simply promises payment convenience but with a 15-day short-term loan at a 48% annual interest rate, the whole thing could have never succeeded.

Instead, by taking advantage of people’s ignorance and human psychology, the system was sold on terms of hidden costs, and consumers enjoyed the convenience but never realized the real cost they were to ultimately pay. Soon they were hooked. As the number of users increases, the network effect has created so strong an incentive to use credit cards that people never even suspect that they’ve been duped.

To make it even worse, it also creates a kind of a ‘prison effect’ that is extremely hard to break because:

(1) the consumer does not seem to suffer a disadvantage compared to others, and is therefore oblivious to the fact that he along with everyone else is sustaining losses both for now and for the long-term future; and

(2) the ecosystem creates a disincentive for early adoption of any alternative technology, even if the new system is vastly superior as a whole. This is because the consumer pricing is a systemic effect, and it is very hard to implement individualized consumer pricing. The goods and services in the modern society are seldom priced on an individual basis but always done on a mass basis. It is impractical to charge different prices for consumers who use different payment methods.

As a result, the early adopters of the new payment method don’t get to enjoy the full benefit of the cost-saving until the adoption reaches a mass level, and even then, the benefit is not overt but hidden in the background. Therefore, there is a requirement for the early adopters to have an unselfish vision of value, something that is extremely hard to generate and motivate. The new payment method must offer an additional compelling reason for adoption.

Sadly, this is not an isolated problem with just credit cards. It is just an unfortunate fact that a lot of business models take advantage of that human weakness. The whole freemium ad-based Internet platform business model such as Google and Meta is based on this deceptive psychology. The model turns a consumer into a product, but masks all the losses that consumers actually suffer. The consumer sacrifices part of his personal sovereignty in exchange for an attractive lure without ever realizing he’s been shortchanged both in terms of human freedom and in terms of economics and productivity.

The resistance

In a typical fashion, the credit card companies are now trying hard to embrace digital currency payments without realizing or acknowledging the inherent contradiction. They seem to think if they connect their current system to blockchain, they will be riding on top of the next wave.

Sure, because the entire economic system always benefits from better connectivity, this type of integration will see a short-term benefit. But in the longer term, the entire business of credit cards will be disrupted simply due to the very nature of what is been made possible by blockchain.

It’s hard to say whether credit card companies are just naïve and not understanding what they are riding on, or they do understand the danger but are trying to introduce a Trojan horse to the blockchain ecosystem. For the latter, the goal would be to either mislead the development or directly resist and even damage the real blockchain such that it loses its real disruptive capability and becomes subservient to the credit card Empire. Based on the history and the kind of projects MasterCard is doing, the latter scenario is not too far-fetched.

But I do suspect it is more of ignorance in a mix of both above.

I don’t mean credit card companies are intentionally evil, nor do I mean the service providers in the credit card ecosystem do not deserve to be paid. These are mature, largely efficient, and mostly honest businesses providing necessary services. This not only includes credit card companies, but also intermediary service providers, such as payment gateways, clearinghouses, and POS hardware and service providers, etc.

The Credit card was a necessary solution when better technology was not available. Despite the above-described high interest short-term loan created by the credit card system, it’s arguable that the credit card system has historically made a net positive contribution to the economy, because it has made transactions much more convenient, and many otherwise impossible transactions possible.

The problem is the business model itself. 

It’s time to change

But it’s time to change. The credit card system as it is now must go and be replaced by a new system. It will not be easy, one of the obstacles being people’s ignorance and laziness. But the change is inevitable. A technology that can solve so great a problem to the society cannot be stopped.

Yes I’m talking about blockchain, but only the real blockchain, not the makeshift solutions we have now. I’m only talking about a blockchain that satisfies all the following requirements:

(1) unbounded scalability on layer 1 without resorting to insecure off-chain solutions,

(2) extremely low transaction cost (sub 1/100 of a cent),

(3) true PoW (Proof-of-Work) consensus that avoids the corruption of hidden recentralization,

(4) compatible with integration at the base layer of the New Internet based on IPv6.

Nothing short of this will be enough to break the ‘prison effect’ created by the credit card system. The new system must go beyond mere experience of convenience, because the existing systems, be it credit cards in developed countries or mobile payments in other places, are already convenient enough.

It will be the true micro-payment, value-streaming and integration with the New Internet at the base layer that make the mass adoption possible, because the the existing systems simply do not have the capability to extend to reach these areas.

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