Inside the Mysterious World of Credit Cards (with Patrick McKenzie)

May 19 2025

Patrick McKenzie explains to EconTalk's Russ Roberts how credit cards work, who makes money from them and how, and gives his take on whether cash customers and debit card users subsidize the users of credit cards with reward programs.

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Time	Podcast Episode Highlights
0:37	Intro. [Recording date: April 24, 2025.] Russ Roberts: Today is April 24th, 2025, and my guest is Patrick McKenzie. He writes about tech, finance, and as he describes it, the wonky geekery that underlies the modern world. He does that at his website, Bits About Money. He's also an advisor at Stripe. Our topic for today is credit cards--the economics of credit cards and various aspects of credit cards. Patrick, welcome to EconTalk. Patrick McKenzie: Thanks very much for having me. And, I'll give the obligatory disclaimer when talking about all things credit cards: I used to work at Stripe for six years. I'm still an advisor there, but I'm not necessarily speaking on their behalf. Russ Roberts: Absolutely.
1:14	Russ Roberts: We're going to talk about what you call, to start with, the 'good-fit, non-fraudulent user.' So, we're talking about, maybe me. I love using credit cards. They make life really easy. What's the economic transaction that's happening there? What role are they playing besides convenience for me in not having to carry cash? Patrick McKenzie: I think honestly, and I've thought this since long before I was personally involved in them, credit cards are one of the infrastructural wonders of the modern world. The credit card networks are orchestrating a complicated five-to-six-party transaction every time you swipe plastic or tap your iPhone to pay for something. It's actually more when you tap your iPhone--more parties. But, there's multiple offsetting transactions, and we'll get into them. But, just from the point of view of your bank--which is how most people conceive credit cards as making money-- there's roughly four ways that credit cards make money. They have what's called an interchange fee, which is a fee ultimately paid by the card-accepting business or organization for use of what we in the industry call the credit card rails. And, 'rails' is just a evocative term to say that it's a complex mix of technology, organizational substrates, contracts, and system design that allows you to move money from point A to point B. Number two: Credit cards are both a transactional mechanism for many people, but they are also the largest source of consumer lending in many markets, including the United States. And so, some people will never use a credit card for consumer lending. They just pay off their balance every month. That's about 40% of users. But, for many people, lending is an important part of the offering. And, banks make money in lending in a pretty simple fashion. They get money from depositors and other sort of sources of capital at some rate. They will lend it out at a higher rate; and they make a spread between the two. And out of that, they pay costs for, for example, credit losses, fraud losses, and operating expenses. So, those are two ways credit cards make money. The other two are far less important, but I'll mention them for completeness. One is fees. You might be familiar with the annual fee for the credit card and also late payment fees. Late payment fees were very material for certain spectrums of credit card issuance for a very long time. They've been kept by regulation and other action over the last few years and they're far less material now. And, the fourth one is a sideline to a sideline, but it's money paid for marketing consideration by various businesses. And so, for example, if you have a system within your credit card, mobile application, or website which says, 'Hey, if you spend $40 on this business using this card in the next two months, we will give you $5 back.' There is a player in the middle that has done the business development to convince your bank to put that section on their website and convince the, 1-800-flowers, for example, that 1-800-flowers should spend some of its marketing budget for Mother's Day in giving people credit card rebates. And, both the bank and that player earn some consideration from 1-800-flowers for putting that essential ad into your credit card web application. But, the two main ways credit cards make money: interchange and net interest income.
4:51	Russ Roberts: So again, just to review: The interchange is the fee paid by the store--typically the vendor, the supplier, the producer--not me. The fee paid by the store for the privilege of using credit cards to facilitate transactions. And, the second is: Some people don't pay their balance. And, when they're late, they have to pay interest on that balance. And, it's typically been fairly high. When it was high, of course, and it was uncapped, I assume it was easier to get a credit card, perhaps. Now if it's capped--and it varies as I understand it by countries and maybe by states in America--it may be a nice thing that you don't pay these very high interest rates, but it means, for some people, they've lost the privilege of being able to borrow money at any rate at all because they can't get the card to start with. Is that true? Patrick McKenzie: Yeah. There's a rich history of regulation of usury coming down from literally earlier than medieval times. Some of that history is reflected in the laws of the several United States. And, there are different regulations based on country. But, broadly, across the spectrum of credit behavior and other socioeconomic status, there are some people who will be able to get credit in basically any usury regime. There are some people who will never be able to get credit in any usury regime. And then, there are some people who are on the margins. And, people in finance and particularly in credit cards understand thinking on the margins in a way that economists understand thinking on the margins. But, this is occasionally a more complicated thing to get broader audiences to understand. But, it's important that we are thinking on the margins. There are some people who are bankable--who can get a credit card issued to them or a checking account issued to them. Checking accounts are also a credit product. That's a digression. They're bankable at some interest rates and they are not bankable at other interest rates. And, they might get pushed from the sort of formal lending markets mediated by banks into what are called alternate financial services, such as, for example, payday loans, which have generally speaking much higher interest rates due to various shenanigans and offer comprehensively worse products, which is why they're, quote-unquote, "alternative." Or, they might be forced to use non-market mechanisms to access credit. For example, borrowing from friends and family at some sort of social cost, which doesn't conveniently have an APR [Annual Percentage Rate] associated with it. Or, doing activities in their life which essentially borrow from their future self, but which aren't mediated by the financial industry and which frequently have ruinous costs associated with them. So, for example, if you don't pay your electricity bill and you have your electricity turned off, you are in some sense borrowing from your future self--who would like to consume electricity to manage your payments for the month. So, this is one reason why access to credit is systemically important and an important goal of both the financial system and society. And, the financial system says--self-servingly but true--when you tell us that we are only allowed to charge interest rates up to some certain amount of percent, well, money doesn't come from nothing. And, there are people at the margin that will be affected by that decision. And, many of those people will be very sympathetic to you and their lives will get worse as a result of you putting that cap in there. And, that is a thing that I wish policymakers and the broader civil society would keep more close to the top of their mind when making decisions like that. Russ Roberts: One of the reasons we're having this conversation, Patrick, trying to spread the word. You mentioned APR. That's Annual Percentage Rate. Correct? That's the interest on the unpaid balances. I think one of the reasons the public--a lot of reasons--the public struggles to understand these issues--non-economists or non-finance people do--but there's a certain suspicion that financial intermediaries, credit card companies, banks, and so on, quote, "don't do anything." They don't make anything. And they only have profits. So, a higher interest rate is just obviously merely taking flesh out of the body of the poor borrower. But, we will come back to that. I would also just--you didn't mention baseball bats, but of course besides friends and family of social costs, there are other types of market transactions that are not formal. They're often called 'black market,' where people borrow from gangsters, crooks, thieves. And, those contracts are often enforced with violence--the threat of violence for sure--but also actual violence in the case of unpaid bills.
10:00	Russ Roberts: Now, so I want to focus for now for a while on 'interchange,' which is an awkward word because it is only used in everyday parlance to mean a junction of a highway. But, interchange, you said, was the fee paid by a merchant for the opportunity to process transactions via a credit card of a particular credit card issuer. And, one of the greatest things about economics, of course, is that when we use the phrase 'the interchange is paid by the vendor or the merchant,' we understand in economics that's not always literally the case, because the merchant or vendor can sometimes, if not always, pass on some or if not all of those costs to the customer in the form of higher prices. It's certainly not free to the consumer. So, the consumer is excited--consumer is excited that this merchant accepts a credit card that the consumer carries with them. But, there's a fee associated with it and that interchange. And, how that's divided between consumer and merchant is uncertain. It depends on market forces typically and market competition. Do you want to say anything about that before we go a little deeper into it? Patrick McKenzie: Sure. I'll give one clarification. Just for the payment industry nerds out there, that there is quite a bit of complexity in nomenclature in finance. And so, people who work at, for example, Visa, might say, 'Well, okay: Interchange means just one thing.' But, there's also scheme fees which are fees which go to Visa directly. And, there are, we prefer to call it, a merchant discount rate for the thing that you're saying. But I just prefer using the word interchange for simplicity. We don't have to care exactly about how it is divvied up. Some, I suppose, brief points I'll make. One: Interchange is not a constant number. So, across the sort of panoply of the United States, you can round it to about, call it about 2.2, 2.3% for credit cards. But, it isn't constant for each credit card product. And so, one of the things that Visa, MasterCard, and to a far lesser extent, Amex, have done is brought essentially every financial institution and every card-transacting business to the world, to the negotiating table, to hammer out some negotiation of the interchange fee is paid. And, there are massive PDF [Portable Document Format] files which list: If you are in this line of business by what the industry calls an MCC--a Merchant Classification Code--and, you are dealing with this level of Visa Card, this is the interchange you will pay. And, it's typically a percentage of the transaction size plus some fixed fee. And, off the top of my head, these are by the way, very difficult documents to understand. There was literally a team of Ph.D.-level people at Stripe that was attempting to predict in advance of getting the bills from our merchant processing bank. In advance of getting the bill from the bank, can we predict what the interchange will be for what percentage of transactions? And, it took many years of work from a team of literally Ph.D.-level people before we could predict that at least 99% of the time. And so, you can Google for these PDF files. Like, just Google "Visa interchange rates 2025". And, you'll get a PDF file; but it's difficult to get a signal of down to the dollars-and-cents level on, like, an individual. Like, 'What did someone pay for when I bought my coffee this morning from that PDF file?' But, broadly speaking, as you go up in socioeconomic status, your custom becomes more valuable to businesses across the economy. And, those interchange schedules will say, broadly speaking, for any business--whether it's an airline or a supermarket or similar--as you increase in socioeconomic status, you'll get into progressively more, unquote, "exclusive" card products. And, those card products will cause the accepting business to be charged more interchange than if they had used a less exclusive product. And, the trade that the payments industry made with the rest of the world many years ago was: Well, people who have money are great customers to have. We will identify the people who have money. We will market to them incessantly, and we will put a piece of plastic in their wallet that will cause them to come back to your business more frequently, spend more money when they do, and thereby contribute more to your enterprise. And, you'll pay us for that, in the same way that you pay, you know, the newspaper for advertising your goods and services. But, unlike the newspaper, we only get paid when someone actually comes into the store and spends money on you; and you have perfect visibility into when that happens. Versus, like, you spend $15,000 a month on a spread in a magazine and goodness knows if that generated anything for you at the margin. Russ Roberts: It's a fantastic example of how market forces--to the extent there are market forces in this business, and there are--but of course they vary by product. And I'm sure time and history and all kinds of things. I mention it only because there's a limited number of commonly used pieces of plastic. You said Amex--that's American Express. There's Visa, there's MasterCard. Used to be Discover. I don't know what else there is. I have an Apple Card. I don't even know what kind. I think it's a MasterCard. But, my point is that it's a beautiful example. The credit card company is providing a service that is not transparent to anyone other than the vendor, other than the merchant. Because, you and I as customers, as people going through the world: Yeah, we get an offer for a card: it looks good or it doesn't look good. We take it, we don't take it. But, what you're explaining is that there's information that's useful and actionable about the kind of people who generally take this card rather than another card, and that changes what they can charge. And, it doesn't necessarily mean they make an enormous greater amount of profit off of those cards with respect to merchants--because they incur other costs: to identify those people. Sometimes as they miss and fail.
16:52	Russ Roberts: I want to actually, though, back up a little bit because you have a wonderful paragraph--and I'll let you talk about it after I read it--that sort of summarizes why a credit card is attractive for the merchant. In the old days, as you point out in the essay that I'm quoting from--and we'll put a link to this essay and to other essays you've written on the topic--in the old days, stores offered credit and they kept a ledger. Sometimes it was a piece of paper. Eventually it became a computer program that they had. They had a bookkeeper. And they offered credit to their customers because sometimes customers didn't have sufficient cash to make a payment; and they were happy to take care of that as long as they were going to be paid eventually--and paid a little bit more, perhaps, for the opportunity to delay the reception of the payment. But this is what you wrote--this is the deal that the credit card issuer offers to the merchant. Quote: "You know, if you had a specialist doing that for you, it would be much more efficient. They'd have computers doing the math, not bookkeepers. They'd have departments doing collections, not clothing salespeople worried about offending customers who they'd need again at Christmas. They'd have access to cheap deposits to fund loans, rather than expensive working capital. They'd be adequately capitalized against losses, rather than having tiny margins backed by almost no equity, like most retailers. They'd diversify against regional and sectoral risk, rather than being all-in on the plant down the road still being open." [Quotation marks and italics in original] Endquote. So, just that simple explanation really gives a rich flavor for the power of this innovation. This is effectively an innovation. It's not just, 'Oh, it's convenient.' It is a transformation of the payment experience with a myriad of costs that used to be associated with it for the merchant now being reduced, if the price is right. Patrick McKenzie: Yep. And, there's a complex bundle of goods that didn't even get it into everything there. Businesses receive their money much faster when getting paid on a credit card versus being paid in other fashions. There isn't a 60-day invoice stance for businesses in the economy that are poorly capitalized. The difference between getting your money two business days after a transaction and getting paid 60 days after a transaction is really quite material. Money is useful. You can pay it to employees, and similar. And, it moves credit risk from the merchant to the issuer, which is a very important part of the transaction. So, this might not be obvious for people, so I'll just say it explicitly. You probably pay all your bills, but if something ever happens in your life--if you get laid off, if you have a medical catastrophe or similar--you always have the implicit option with a credit card of not paying the credit card; and you'll be assessed a fee, and you'll be sent to collections, and that will be very unpleasant for you. In that hypothetical world where you don't pay your credit card bill, the bank doesn't call up every company that you've bought a coffee from or bought a TV from and say, 'Well, they welshed on the bill, so I want my money back.' The bank takes the loss. And, they have carefully mapped out to make that a survivable loss given a portfolio of similarly-situated customers in the other lines of the business that the bank runs. But in the world--and again, we used to live in this world where retailers took the loss if you were less than credit-worthy--that had multiple negative consequences. Widespread economic downturns hurt retailers in multiple ways: one by depressing demand. But two: the combination of depressed demand in the current period plus credit losses for purchases that had already been made in past[?depressed?] periods, tended to kill retailers in downturns. So, moving that risk into the financial sector causes more problems at the margin for the financial sector, but less problems at the margin for people that can't afford teams of Ph.D. economists to do risk-catching[?]. And, the very real factor is that putting retailers on the hook for this sort of thing meant retailers would essentially be underwriting based on social capital and visible attributes of customers and similar. And, not underwriting based on, say, risk-scoring models that were adequately informed by actual data about behavior. And, that resulted in very sharply different experiences from people who are relatively advantaged in the socioeconomic system they find themselves in versus other people. And so, one of the--I think you could call it a triumph of the financial industry over the course of the last few decades--has been increasing financial inclusion to people who are not central examples of the socioeconomic system they find themselves in. I don't think we've mentioned, but I was an immigrant in Japan for about 20 years. And, the month I got off the plane, I was explained by--I will name the company, I won't name the financial firm. I got all my computers from Dell back in the day. I got to Japan with a suitcase full of clothes and immediately went to Dell and said, 'Can I please buy a computer? I would love to be able to'--we used Skype back in the day, so--'I would love to be able to Skype my parents. And, I assume you offer computers on credit.' And Dell said, 'We would love to sell you a computer. Talk to the finance people.' And, the finance people in Japan said, 'You're a foreigner who has been in the country for one week. No, absolutely no. Hell no. You have a paycheck? We don't care.' So, I did not--what was the old commercial? 'You get a Dell?' I did not get a Dell until I was able to convince a Japanese financial institution to take a risk on a lanky foreigner who had only a few weeks of being in the country. And, you know, the United States broadly is better at that than Japan. And, Japan has gotten much better in the intervening 20 years on that story particularly. Russ Roberts: How much was that Dell computer 20 something years ago? Do you remember? Patrick McKenzie: I am a bit of a gamer, so it would have been a little less than 2004-dollars [dollars in the year 2004]. But, you could get a reasonable computer back then for about $1,200, 2004-dollars. And of course, you could get adequate for your Word-processing computers for a few hundred dollars even back in the day. Russ Roberts: Okay.
23:48	Russ Roberts: I want to talk for a second about the interchange fee of 2.2, 2.3%. And then, you mentioned it in passing--and a fixed charge. I think most of us have experienced at some point in our life, we walk into a store, we have zero cash. And, by the way, I live in Jerusalem, Israel. I don't carry any cash with me, generally. Everyone here takes credit cards. But, let's say I want to buy a Diet Coke; and they might have a minimum that I have to pay--I have to be buying--to use a credit card. And I assume that's because of that fixed cost. And I'm curious, is that always there? In general, the reason you would do that is that there are costs associated with a transaction of any magnitude and there are costs that vary by the amount of the transaction. You might think, 'Well, I mean what's the variance in the amount of the transaction?' But of course, if you don't pay, it's a bigger loss for a big transaction than if you don't pay for a smaller transaction. So, that would be why you'd want to have a percentage rather than a fixed cost at all. So, do you have anything to say about that? I suspect you do, Patrick. Patrick McKenzie: Sure. So, the fixed cost is not necessarily fixed at a particular number for all businesses at all times. Again, they do heavy discrimination based on ability to pay based on what industry a business is in. And so, businesses with large margins, generally speaking, the banks negotiate more of that margin to themselves than businesses with very thin margins. The fixed cost does not primarily pay for an underlying cost of the rails that operates on a per transaction basis. It's simply part of the model, let's say. Credit card transactions are a complicated bundle of goods. Again, we talked about they are a risk transfer, they're a convenience mechanism, they're a marketing mechanism, and similar. There are parts of the bundle that are priced directly and that you can read on a statement. And, there are parts of the bundle that are unpriced because the businesses involved or the industry finds it difficult to charge for them, but which they nonetheless must offer by some combination of customer preference, regulation, contractual agreements between themselves, and similar. And so, for example, one interesting thing about credit cards is: If you are traveling abroad and you lose your wallet or get your card stolen and you find yourself in a city that you've never lived in with no payment method in your pocket. And you call your bank at 2:00 a.m in the morning, someone will pick up at 2:00 a.m in the morning. And, if you explain the circumstances, let's say, 'Yep, we have a process for this. We will overnight you a credit card.' And, it doesn't matter if you're in the middle of central Japan, your bank is in St. Louis. Nope. 'We can make that happen.' And, often that will be offered just as a courtesy for you. At some places they charge you a ticky-tacky fee like $5 or $20 for expedited shipping, but they'll usually waive it if you ask a [inaudible 00:27:14]. But, what pays for the person to be awake at 2:00 a.m in the morning, even though they can't charge you for a 1-900-number phone call, it's the broader revenues thrown off by the credit card business. Russ Roberts: So, as one of this aspect of the credit card world we haven't gotten to, but you just kind of hinted at it: I'm on a trip or I'm home--it doesn't matter--and I lose my credit card and a miscreant finds a bad person. In fact, maybe it's not--I didn't lose it: it gets stolen. And, I don't notice for a while and this person tries their darndest to buy things with my credit card. The risk to me has a ceiling. In my memory in America, in the old days it was something very small, $75. I don't know if that's right, still. But, the point was is that, what of course this means is that I'm not as careful with my credit card as I otherwise would be. I'm not as desperate to find it if I do lose it or it gets stolen. And, it also means that the credit card company is extremely eager to discover a stolen credit card transaction because they're going to eat that amount, not the store. In the literal sense, the store has transferred that risk as you mentioned, or at least in the explicit sense, to the issuer of the credit card. So, talk about what's going on there and how banks and credit cards deal with that. Patrick McKenzie: Sure. So, one: If your credit card ever gets stolen or you get defrauded using credit card networks, I apologize in advance, you are going to undergo some hassle, but your direct out-of-pocket expenses are capped. By regulation in the United States--the most salient regulation is called Regulation E--and there's a $50 cap if you give timely notice--which, there's a very generous definition of timely notice--to your bank. Banks in the United States virtually universally, as a marketing decision, waive the $50 deductible. So, your actual out-of-pocket costs are highly likely to be zero. Russ Roberts: Wow. Patrick McKenzie: And, in the case where you call your bank and say, 'This transaction was not authorized,' your bank is going to do a few things that will cause what the industry calls a chargeback. And so, in the case where you don't pay your credit card bill, that risk hits your financial institution. In the case where the card is used without your authorization, the bank will do a chargeback which ultimately flows to the card accepting business. And so, in that case, they have not successfully, in most cases, lain off their risk on the credit card ecosystem. They're internalizing that risk. There are products they can buy from the credit card ecosystem to insure them against that risk. And, like most forms of insurance, there's a cost that is associated with that insurance. Because banks--they do bear certain forms of fraud risk--identity theft and similar--and they bear non-payment risk, but they don't bear fraudulent usage of credit card risk, there is actually, let's say, less investment by banks with regards to quickly interdicting fraudulent usage of credit cards than you might expect in a world where hypothetically they bore that risk directly. The banks are incentivized to approve more transactions at the margin than otherwise, because approving transactions the salary get paid. And, I have a essay about this whose title I inadvertently snow-cloned[?] from Dan Davies, who is a wonderful English author and economist. The optimal rate of fraud is not non-zero. Russ Roberts: Correct. Patrick McKenzie: And, the businesses all over the world get to choose at which margins, what transactions they allow to go through and what transactions that they would stop or where they would impose other costs on the transaction going forward. You need to speak to a sales rep about this. You need to convince their fraud department you are who you say you are. You need to spend time out of your day versus simply typing in your credentials. And, businesses that have very high margins would like to push the friction of marginal transactions in most cases to very close to zero so that they can realize those high margins, even if that pushes fraud up a bit at the margin. [More to come, 32:01]

Time

Podcast Episode Highlights

0:37

Intro. [Recording date: April 24, 2025.]

Russ Roberts: Today is April 24th, 2025, and my guest is Patrick McKenzie. He writes about tech, finance, and as he describes it, the wonky geekery that underlies the modern world. He does that at his website, Bits About Money. He's also an advisor at Stripe.

Our topic for today is credit cards--the economics of credit cards and various aspects of credit cards. Patrick, welcome to EconTalk.

Patrick McKenzie: Thanks very much for having me. And, I'll give the obligatory disclaimer when talking about all things credit cards: I used to work at Stripe for six years. I'm still an advisor there, but I'm not necessarily speaking on their behalf.

Russ Roberts: Absolutely.

1:14

Russ Roberts: We're going to talk about what you call, to start with, the 'good-fit, non-fraudulent user.' So, we're talking about, maybe me. I love using credit cards. They make life really easy. What's the economic transaction that's happening there? What role are they playing besides convenience for me in not having to carry cash?

Patrick McKenzie: I think honestly, and I've thought this since long before I was personally involved in them, credit cards are one of the infrastructural wonders of the modern world. The credit card networks are orchestrating a complicated five-to-six-party transaction every time you swipe plastic or tap your iPhone to pay for something. It's actually more when you tap your iPhone--more parties. But, there's multiple offsetting transactions, and we'll get into them.

But, just from the point of view of your bank--which is how most people conceive credit cards as making money-- there's roughly four ways that credit cards make money. They have what's called an interchange fee, which is a fee ultimately paid by the card-accepting business or organization for use of what we in the industry call the credit card rails. And, 'rails' is just a evocative term to say that it's a complex mix of technology, organizational substrates, contracts, and system design that allows you to move money from point A to point B.

Number two: Credit cards are both a transactional mechanism for many people, but they are also the largest source of consumer lending in many markets, including the United States. And so, some people will never use a credit card for consumer lending. They just pay off their balance every month. That's about 40% of users. But, for many people, lending is an important part of the offering. And, banks make money in lending in a pretty simple fashion. They get money from depositors and other sort of sources of capital at some rate. They will lend it out at a higher rate; and they make a spread between the two. And out of that, they pay costs for, for example, credit losses, fraud losses, and operating expenses.

So, those are two ways credit cards make money.

The other two are far less important, but I'll mention them for completeness. One is fees. You might be familiar with the annual fee for the credit card and also late payment fees. Late payment fees were very material for certain spectrums of credit card issuance for a very long time. They've been kept by regulation and other action over the last few years and they're far less material now.

And, the fourth one is a sideline to a sideline, but it's money paid for marketing consideration by various businesses. And so, for example, if you have a system within your credit card, mobile application, or website which says, 'Hey, if you spend $40 on this business using this card in the next two months, we will give you $5 back.' There is a player in the middle that has done the business development to convince your bank to put that section on their website and convince the, 1-800-flowers, for example, that 1-800-flowers should spend some of its marketing budget for Mother's Day in giving people credit card rebates. And, both the bank and that player earn some consideration from 1-800-flowers for putting that essential ad into your credit card web application.

But, the two main ways credit cards make money: interchange and net interest income.

4:51

Russ Roberts: So again, just to review: The interchange is the fee paid by the store--typically the vendor, the supplier, the producer--not me. The fee paid by the store for the privilege of using credit cards to facilitate transactions. And, the second is: Some people don't pay their balance. And, when they're late, they have to pay interest on that balance. And, it's typically been fairly high. When it was high, of course, and it was uncapped, I assume it was easier to get a credit card, perhaps. Now if it's capped--and it varies as I understand it by countries and maybe by states in America--it may be a nice thing that you don't pay these very high interest rates, but it means, for some people, they've lost the privilege of being able to borrow money at any rate at all because they can't get the card to start with. Is that true?

Patrick McKenzie: Yeah. There's a rich history of regulation of usury coming down from literally earlier than medieval times. Some of that history is reflected in the laws of the several United States. And, there are different regulations based on country.

But, broadly, across the spectrum of credit behavior and other socioeconomic status, there are some people who will be able to get credit in basically any usury regime. There are some people who will never be able to get credit in any usury regime. And then, there are some people who are on the margins. And, people in finance and particularly in credit cards understand thinking on the margins in a way that economists understand thinking on the margins.

But, this is occasionally a more complicated thing to get broader audiences to understand. But, it's important that we are thinking on the margins. There are some people who are bankable--who can get a credit card issued to them or a checking account issued to them. Checking accounts are also a credit product. That's a digression. They're bankable at some interest rates and they are not bankable at other interest rates. And, they might get pushed from the sort of formal lending markets mediated by banks into what are called alternate financial services, such as, for example, payday loans, which have generally speaking much higher interest rates due to various shenanigans and offer comprehensively worse products, which is why they're, quote-unquote, "alternative."

Or, they might be forced to use non-market mechanisms to access credit. For example, borrowing from friends and family at some sort of social cost, which doesn't conveniently have an APR [Annual Percentage Rate] associated with it. Or, doing activities in their life which essentially borrow from their future self, but which aren't mediated by the financial industry and which frequently have ruinous costs associated with them. So, for example, if you don't pay your electricity bill and you have your electricity turned off, you are in some sense borrowing from your future self--who would like to consume electricity to manage your payments for the month.

So, this is one reason why access to credit is systemically important and an important goal of both the financial system and society. And, the financial system says--self-servingly but true--when you tell us that we are only allowed to charge interest rates up to some certain amount of percent, well, money doesn't come from nothing. And, there are people at the margin that will be affected by that decision. And, many of those people will be very sympathetic to you and their lives will get worse as a result of you putting that cap in there.

And, that is a thing that I wish policymakers and the broader civil society would keep more close to the top of their mind when making decisions like that.

Russ Roberts: One of the reasons we're having this conversation, Patrick, trying to spread the word.

You mentioned APR. That's Annual Percentage Rate. Correct? That's the interest on the unpaid balances. I think one of the reasons the public--a lot of reasons--the public struggles to understand these issues--non-economists or non-finance people do--but there's a certain suspicion that financial intermediaries, credit card companies, banks, and so on, quote, "don't do anything." They don't make anything. And they only have profits. So, a higher interest rate is just obviously merely taking flesh out of the body of the poor borrower. But, we will come back to that.

I would also just--you didn't mention baseball bats, but of course besides friends and family of social costs, there are other types of market transactions that are not formal. They're often called 'black market,' where people borrow from gangsters, crooks, thieves. And, those contracts are often enforced with violence--the threat of violence for sure--but also actual violence in the case of unpaid bills.

10:00

Russ Roberts: Now, so I want to focus for now for a while on 'interchange,' which is an awkward word because it is only used in everyday parlance to mean a junction of a highway. But, interchange, you said, was the fee paid by a merchant for the opportunity to process transactions via a credit card of a particular credit card issuer.

And, one of the greatest things about economics, of course, is that when we use the phrase 'the interchange is paid by the vendor or the merchant,' we understand in economics that's not always literally the case, because the merchant or vendor can sometimes, if not always, pass on some or if not all of those costs to the customer in the form of higher prices. It's certainly not free to the consumer.

So, the consumer is excited--consumer is excited that this merchant accepts a credit card that the consumer carries with them. But, there's a fee associated with it and that interchange. And, how that's divided between consumer and merchant is uncertain. It depends on market forces typically and market competition.

Do you want to say anything about that before we go a little deeper into it?

Patrick McKenzie: Sure. I'll give one clarification. Just for the payment industry nerds out there, that there is quite a bit of complexity in nomenclature in finance. And so, people who work at, for example, Visa, might say, 'Well, okay: Interchange means just one thing.' But, there's also scheme fees which are fees which go to Visa directly. And, there are, we prefer to call it, a merchant discount rate for the thing that you're saying. But I just prefer using the word interchange for simplicity. We don't have to care exactly about how it is divvied up.

Some, I suppose, brief points I'll make.

One: Interchange is not a constant number. So, across the sort of panoply of the United States, you can round it to about, call it about 2.2, 2.3% for credit cards. But, it isn't constant for each credit card product.

And so, one of the things that Visa, MasterCard, and to a far lesser extent, Amex, have done is brought essentially every financial institution and every card-transacting business to the world, to the negotiating table, to hammer out some negotiation of the interchange fee is paid. And, there are massive PDF [Portable Document Format] files which list: If you are in this line of business by what the industry calls an MCC--a Merchant Classification Code--and, you are dealing with this level of Visa Card, this is the interchange you will pay. And, it's typically a percentage of the transaction size plus some fixed fee.

And, off the top of my head, these are by the way, very difficult documents to understand. There was literally a team of Ph.D.-level people at Stripe that was attempting to predict in advance of getting the bills from our merchant processing bank. In advance of getting the bill from the bank, can we predict what the interchange will be for what percentage of transactions? And, it took many years of work from a team of literally Ph.D.-level people before we could predict that at least 99% of the time.

And so, you can Google for these PDF files. Like, just Google "Visa interchange rates 2025". And, you'll get a PDF file; but it's difficult to get a signal of down to the dollars-and-cents level on, like, an individual. Like, 'What did someone pay for when I bought my coffee this morning from that PDF file?'

But, broadly speaking, as you go up in socioeconomic status, your custom becomes more valuable to businesses across the economy. And, those interchange schedules will say, broadly speaking, for any business--whether it's an airline or a supermarket or similar--as you increase in socioeconomic status, you'll get into progressively more, unquote, "exclusive" card products. And, those card products will cause the accepting business to be charged more interchange than if they had used a less exclusive product.

And, the trade that the payments industry made with the rest of the world many years ago was: Well, people who have money are great customers to have. We will identify the people who have money. We will market to them incessantly, and we will put a piece of plastic in their wallet that will cause them to come back to your business more frequently, spend more money when they do, and thereby contribute more to your enterprise. And, you'll pay us for that, in the same way that you pay, you know, the newspaper for advertising your goods and services. But, unlike the newspaper, we only get paid when someone actually comes into the store and spends money on you; and you have perfect visibility into when that happens. Versus, like, you spend $15,000 a month on a spread in a magazine and goodness knows if that generated anything for you at the margin.

Russ Roberts: It's a fantastic example of how market forces--to the extent there are market forces in this business, and there are--but of course they vary by product. And I'm sure time and history and all kinds of things.

I mention it only because there's a limited number of commonly used pieces of plastic. You said Amex--that's American Express. There's Visa, there's MasterCard. Used to be Discover. I don't know what else there is. I have an Apple Card. I don't even know what kind. I think it's a MasterCard.

But, my point is that it's a beautiful example. The credit card company is providing a service that is not transparent to anyone other than the vendor, other than the merchant. Because, you and I as customers, as people going through the world: Yeah, we get an offer for a card: it looks good or it doesn't look good. We take it, we don't take it.

But, what you're explaining is that there's information that's useful and actionable about the kind of people who generally take this card rather than another card, and that changes what they can charge. And, it doesn't necessarily mean they make an enormous greater amount of profit off of those cards with respect to merchants--because they incur other costs: to identify those people. Sometimes as they miss and fail.

16:52

Russ Roberts: I want to actually, though, back up a little bit because you have a wonderful paragraph--and I'll let you talk about it after I read it--that sort of summarizes why a credit card is attractive for the merchant.

In the old days, as you point out in the essay that I'm quoting from--and we'll put a link to this essay and to other essays you've written on the topic--in the old days, stores offered credit and they kept a ledger. Sometimes it was a piece of paper. Eventually it became a computer program that they had. They had a bookkeeper. And they offered credit to their customers because sometimes customers didn't have sufficient cash to make a payment; and they were happy to take care of that as long as they were going to be paid eventually--and paid a little bit more, perhaps, for the opportunity to delay the reception of the payment.

But this is what you wrote--this is the deal that the credit card issuer offers to the merchant. Quote:

"You know, if you had a specialist doing that for you, it would be much more efficient. They'd have computers doing the math, not bookkeepers. They'd have departments doing collections, not clothing salespeople worried about offending customers who they'd need again at Christmas. They'd have access to cheap deposits to fund loans, rather than expensive working capital. They'd be adequately capitalized against losses, rather than having tiny margins backed by almost no equity, like most retailers. They'd diversify against regional and sectoral risk, rather than being all-in on the plant down the road still being open." [Quotation marks and italics in original]

Endquote.

So, just that simple explanation really gives a rich flavor for the power of this innovation. This is effectively an innovation. It's not just, 'Oh, it's convenient.' It is a transformation of the payment experience with a myriad of costs that used to be associated with it for the merchant now being reduced, if the price is right.

Patrick McKenzie: Yep. And, there's a complex bundle of goods that didn't even get it into everything there. Businesses receive their money much faster when getting paid on a credit card versus being paid in other fashions. There isn't a 60-day invoice stance for businesses in the economy that are poorly capitalized. The difference between getting your money two business days after a transaction and getting paid 60 days after a transaction is really quite material. Money is useful. You can pay it to employees, and similar. And, it moves credit risk from the merchant to the issuer, which is a very important part of the transaction.

So, this might not be obvious for people, so I'll just say it explicitly. You probably pay all your bills, but if something ever happens in your life--if you get laid off, if you have a medical catastrophe or similar--you always have the implicit option with a credit card of not paying the credit card; and you'll be assessed a fee, and you'll be sent to collections, and that will be very unpleasant for you.

In that hypothetical world where you don't pay your credit card bill, the bank doesn't call up every company that you've bought a coffee from or bought a TV from and say, 'Well, they welshed on the bill, so I want my money back.' The bank takes the loss. And, they have carefully mapped out to make that a survivable loss given a portfolio of similarly-situated customers in the other lines of the business that the bank runs.

But in the world--and again, we used to live in this world where retailers took the loss if you were less than credit-worthy--that had multiple negative consequences. Widespread economic downturns hurt retailers in multiple ways: one by depressing demand. But two: the combination of depressed demand in the current period plus credit losses for purchases that had already been made in past[?depressed?] periods, tended to kill retailers in downturns. So, moving that risk into the financial sector causes more problems at the margin for the financial sector, but less problems at the margin for people that can't afford teams of Ph.D. economists to do risk-catching[?].

And, the very real factor is that putting retailers on the hook for this sort of thing meant retailers would essentially be underwriting based on social capital and visible attributes of customers and similar. And, not underwriting based on, say, risk-scoring models that were adequately informed by actual data about behavior. And, that resulted in very sharply different experiences from people who are relatively advantaged in the socioeconomic system they find themselves in versus other people.

And so, one of the--I think you could call it a triumph of the financial industry over the course of the last few decades--has been increasing financial inclusion to people who are not central examples of the socioeconomic system they find themselves in.

I don't think we've mentioned, but I was an immigrant in Japan for about 20 years. And, the month I got off the plane, I was explained by--I will name the company, I won't name the financial firm. I got all my computers from Dell back in the day. I got to Japan with a suitcase full of clothes and immediately went to Dell and said, 'Can I please buy a computer? I would love to be able to'--we used Skype back in the day, so--'I would love to be able to Skype my parents. And, I assume you offer computers on credit.' And Dell said, 'We would love to sell you a computer. Talk to the finance people.' And, the finance people in Japan said, 'You're a foreigner who has been in the country for one week. No, absolutely no. Hell no. You have a paycheck? We don't care.'

So, I did not--what was the old commercial? 'You get a Dell?' I did not get a Dell until I was able to convince a Japanese financial institution to take a risk on a lanky foreigner who had only a few weeks of being in the country.

And, you know, the United States broadly is better at that than Japan. And, Japan has gotten much better in the intervening 20 years on that story particularly.

Russ Roberts: How much was that Dell computer 20 something years ago? Do you remember?

Patrick McKenzie: I am a bit of a gamer, so it would have been a little less than 2004-dollars [dollars in the year 2004]. But, you could get a reasonable computer back then for about $1,200, 2004-dollars. And of course, you could get adequate for your Word-processing computers for a few hundred dollars even back in the day.

Russ Roberts: Okay.

23:48

Russ Roberts: I want to talk for a second about the interchange fee of 2.2, 2.3%. And then, you mentioned it in passing--and a fixed charge. I think most of us have experienced at some point in our life, we walk into a store, we have zero cash. And, by the way, I live in Jerusalem, Israel. I don't carry any cash with me, generally. Everyone here takes credit cards.

But, let's say I want to buy a Diet Coke; and they might have a minimum that I have to pay--I have to be buying--to use a credit card. And I assume that's because of that fixed cost. And I'm curious, is that always there? In general, the reason you would do that is that there are costs associated with a transaction of any magnitude and there are costs that vary by the amount of the transaction. You might think, 'Well, I mean what's the variance in the amount of the transaction?' But of course, if you don't pay, it's a bigger loss for a big transaction than if you don't pay for a smaller transaction. So, that would be why you'd want to have a percentage rather than a fixed cost at all. So, do you have anything to say about that? I suspect you do, Patrick.

Patrick McKenzie: Sure. So, the fixed cost is not necessarily fixed at a particular number for all businesses at all times. Again, they do heavy discrimination based on ability to pay based on what industry a business is in. And so, businesses with large margins, generally speaking, the banks negotiate more of that margin to themselves than businesses with very thin margins. The fixed cost does not primarily pay for an underlying cost of the rails that operates on a per transaction basis. It's simply part of the model, let's say.

Credit card transactions are a complicated bundle of goods. Again, we talked about they are a risk transfer, they're a convenience mechanism, they're a marketing mechanism, and similar. There are parts of the bundle that are priced directly and that you can read on a statement. And, there are parts of the bundle that are unpriced because the businesses involved or the industry finds it difficult to charge for them, but which they nonetheless must offer by some combination of customer preference, regulation, contractual agreements between themselves, and similar.

And so, for example, one interesting thing about credit cards is: If you are traveling abroad and you lose your wallet or get your card stolen and you find yourself in a city that you've never lived in with no payment method in your pocket. And you call your bank at 2:00 a.m in the morning, someone will pick up at 2:00 a.m in the morning. And, if you explain the circumstances, let's say, 'Yep, we have a process for this. We will overnight you a credit card.' And, it doesn't matter if you're in the middle of central Japan, your bank is in St. Louis. Nope. 'We can make that happen.' And, often that will be offered just as a courtesy for you. At some places they charge you a ticky-tacky fee like $5 or $20 for expedited shipping, but they'll usually waive it if you ask a [inaudible 00:27:14].

But, what pays for the person to be awake at 2:00 a.m in the morning, even though they can't charge you for a 1-900-number phone call, it's the broader revenues thrown off by the credit card business.

Russ Roberts: So, as one of this aspect of the credit card world we haven't gotten to, but you just kind of hinted at it: I'm on a trip or I'm home--it doesn't matter--and I lose my credit card and a miscreant finds a bad person. In fact, maybe it's not--I didn't lose it: it gets stolen. And, I don't notice for a while and this person tries their darndest to buy things with my credit card.

The risk to me has a ceiling. In my memory in America, in the old days it was something very small, $75. I don't know if that's right, still. But, the point was is that, what of course this means is that I'm not as careful with my credit card as I otherwise would be. I'm not as desperate to find it if I do lose it or it gets stolen.

And, it also means that the credit card company is extremely eager to discover a stolen credit card transaction because they're going to eat that amount, not the store. In the literal sense, the store has transferred that risk as you mentioned, or at least in the explicit sense, to the issuer of the credit card.

So, talk about what's going on there and how banks and credit cards deal with that.

Patrick McKenzie: Sure. So, one: If your credit card ever gets stolen or you get defrauded using credit card networks, I apologize in advance, you are going to undergo some hassle, but your direct out-of-pocket expenses are capped. By regulation in the United States--the most salient regulation is called Regulation E--and there's a $50 cap if you give timely notice--which, there's a very generous definition of timely notice--to your bank.

Banks in the United States virtually universally, as a marketing decision, waive the $50 deductible. So, your actual out-of-pocket costs are highly likely to be zero.

Russ Roberts: Wow.

Patrick McKenzie: And, in the case where you call your bank and say, 'This transaction was not authorized,' your bank is going to do a few things that will cause what the industry calls a chargeback.

And so, in the case where you don't pay your credit card bill, that risk hits your financial institution. In the case where the card is used without your authorization, the bank will do a chargeback which ultimately flows to the card accepting business. And so, in that case, they have not successfully, in most cases, lain off their risk on the credit card ecosystem. They're internalizing that risk.

There are products they can buy from the credit card ecosystem to insure them against that risk. And, like most forms of insurance, there's a cost that is associated with that insurance.

Because banks--they do bear certain forms of fraud risk--identity theft and similar--and they bear non-payment risk, but they don't bear fraudulent usage of credit card risk, there is actually, let's say, less investment by banks with regards to quickly interdicting fraudulent usage of credit cards than you might expect in a world where hypothetically they bore that risk directly. The banks are incentivized to approve more transactions at the margin than otherwise, because approving transactions the salary get paid. And, I have a essay about this whose title I inadvertently snow-cloned[?] from Dan Davies, who is a wonderful English author and economist. The optimal rate of fraud is not non-zero.

Russ Roberts: Correct.

Patrick McKenzie: And, the businesses all over the world get to choose at which margins, what transactions they allow to go through and what transactions that they would stop or where they would impose other costs on the transaction going forward. You need to speak to a sales rep about this. You need to convince their fraud department you are who you say you are. You need to spend time out of your day versus simply typing in your credentials. And, businesses that have very high margins would like to push the friction of marginal transactions in most cases to very close to zero so that they can realize those high margins, even if that pushes fraud up a bit at the margin. [More to come, 32:01]

Inside the Mysterious World of Credit Cards (with Patrick McKenzie)

Megan McArdle on Debt and Self-Restraint

Jason Zweig on Finance and the Devil's Financial Dictionary

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Inside the Mysterious World of Credit Cards (with Patrick McKenzie)

Megan McArdle on Debt and Self-Restraint

Jason Zweig on Finance and the Devil's Financial Dictionary

LEAVE A COMMENT

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