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. Businesses with low margin, or which exist in very fraud-plagued industries because of the dynamics of the things they are selling, generally tend to have more friction associated with transactions. And so, they are more inclined to either deny transactions which are close to the margins or to subject them to other forms of secondary screening that users will perceive in the moment as being annoying. I'm like, 'I am who I say I am. You know I am who I say I am because I have a credit card and driver's license. Why aren't you letting me buy the thing?' Well, the bad guy also has [?a legal?] credit card and a driver's license. And so, occasionally that is not dispositive on the inquiry.
32:43	Russ Roberts: So, just a couple of things here. I want to make sure I understood that correctly. So, let's say a thief has stolen my credit card, goes into Best Buy and buys a color television, and charges it with my credit card. And, there may be a policy that Best Buy has that the person has to show identification. In my experience, it's rarely the case anymore. They just take the card. And by the way, here in Israel, I never sign anything. There's no piece of paper as there is typically still in America where you have to physically sign your name. In Israel, at least in my experience, you just tap your phone and you're done. Phone obviously has special features that make it a little different than a random piece of plastic, but put those to the side. My point is a thief buys a color TV on my credit card. I get the bill, I say, 'This isn't me.' Who pays for that TV? Patrick McKenzie: So, it will ultimately be the retailer paying for it in almost all cases. Russ Roberts: That's the chargeback you talked about? Patrick McKenzie: A chargeback. So, the way the interaction will work from your perspective is you call your bank; you say, 'I don't remember this transaction.' A relatively non-senior employee of your bank will ask you a few questions about it, like, 'Well, do you remember going into that store? Is it possible someone else in your household could have used that?' And, they'll go through a bunch of things which are designed to essentially talk to many customers who are mistaken about the facts, which happens quite frequently, from filing a chargeback. But ultimately, you are the customer of the bank. And Best Buy is not. And so, the person who the bank has the most incentive to keep happy is you. And so, if you are persistent about saying, 'No, really, that was not me,' it's very highly likely that the bank will say, 'Okay. We agree it wasn't you.' And, if the bank agrees with that, then in 99-point--well, okay? 99.9 is not quite accurate. That is the end of the inquiry in many cases. The bank will push some buttons on the rails as it were, which will immediately claw back money from the credit card processor of the merchant. And, that credit card processor will immediately claw back money from the merchant themselves. And, the credit card processor will also typically tell the merchant, 'A customer has via their bank opened a dispute with you. You can present evidence to the bank.' And then, again, your bank will make a determination based on the evidence presented to them, whether they uphold the dispute or not. And, in the case where the store wins the dispute, they get their money back, less some fee for the services of the bank and being an intermediary. But, a thing that businesses will catch about incessantly is that even when they go through and they submit their evidence, they do not often win disputes. They feel, subjectively speaking, they should have won. Or there are some businesses which say, 'Well, I was not a party to the fraud. Someone came in, they looked reasonable, they presented a credit card. Shouldn't the bank keep that for me?' And there are configurations of the world in which that is a decision we could have made. But we do not live in that configuration of the world. If you are Best Buy, you are certainly sophisticated enough to understand the deal you have struck. For smaller businesses, I understand that many smaller businesses are relatively less sophisticated with regards to those things. I might be surprised the first time it happened or viscerally emotionally funded[?offended?] when it happens. I say this to someone who has paid a fair share of chargebacks myself, sometimes for legitimate reasons and sometimes not. But, that is the nature of the risk transfer. The banks buy certain forms of risk and they decline to bear other forms of risk. Russ Roberts: So, this is an application of what I think of as the Coase Theorem, which is basically property rights. The assignment of property rights sets in motion a set of incentives. And if you change the property rights, you're going to have different incentives on the parties. So, at this particular allocation--which is not imposed, I don't know, but [?] you'll tell me if it's negotiated rather than imposed by regulations. But, with this particular configuration, the--Best Buy has the incentive to avoid the fraud and the bank issuer of the credit card less so. And I find that fascinating, just simply because almost every retailer that I have interacted with in person--online is a little bit trickier obviously, but I'm talking about in-person transactions where I swipe the card--I never got much of a hard time in recent years proving who I am. So, is there an inherent level of lawfulness and trust that's driving this in a country like the United States? Is it different in other countries? I'm surprised that there's a full chargeback. And of course, by the way--we didn't mention this--but if every week I call my credit card company and say, 'I didn't buy that television. I didn't eat at that restaurant. I didn't take that trip to Tahiti,' eventually I'm sure they have systems for people who have too many claims like that. So, you can repeat-- Patrick McKenzie: One-- Russ Roberts: Go ahead. Patrick McKenzie: I apologize for interrupting you. One aspirationally hopes that banks will clamp down on abuse of use of chargebacks, and that's aspirational in some senses. The words 'high-trust society' comes up quite frequently, often in the context of saying the United States is no longer a high-trust society. I think people who make that claim fail to understand how different the spectrum looks over the entire world. But, indicatively, Japan is an extraordinarily high-trust society. The loss rates both in terms of fraudulent transactions and non-payment of legitimate credit card bills in Japan are so low compared to the United States that people assume when they see the numbers that there must be a math error. But, the United States is broadly a trusting society. That is partly why it works--fractally--within the United States. Well, that's why everything works--that we do have such trust in each other, largely deserved. And that is one reason why you are not constantly asked to prove your identity every time you try to buy a cup of coffee. Physical control of the plastic or physical control of the phone is good enough in most cases. And, there will be some fraud losses and they come out in the wash. This does not apply in every industry, in every geography, in every similar. And in places where it does not apply--something like doing the sea trade back during the age of piracy, or I suppose we are still living in the age of piracy in certain parts of the world, and it is impossible to navigate certain straits at the moment--but be that as it may, there are places in the world where chargeback rates are astoundingly higher than they are in the United States. And, where it is the assessment of people in the financial industry who see the numbers that a large portion of those chargebacks are what the industry calls 'friendly fraud'--where the cardholder did indeed authorize the transaction but would prefer to get the good or service and also get their money back; and has used the financial industry as a weapon against the person selling the good or service to defraud them of that good or service, essentially. And, that friendly fraud happens in the United States as well; but it happens to a much greater degree in some other geographies to an extent where it makes it difficult for some transactions to clear at all or the market for some transactions to clear rather than the transactions clearing in the specialized credit-card industry sense of that term.
41:30	Russ Roberts: So, I found out about you from thread you had on X that we'll post where you're reacting to an article in The Atlantic. The author of the article is Annie Lowrey. I'm going to try to do justice to her claim. It's a little bit complicated, as is your reaction to it, so I'll try to read this slowly and try to make sure people understand what's being claimed here. So, the article claimed that: Poor consumers who use credit cards for gas and groceries, what we would call necessities, those people often end up carrying a balance on their credit card with a high interest rate. And, those low income customers are subsidizing rich consumers who are buying business class airline tickets, who never incur interest charges, because they pay off their balance every month. Now, I would just say in passing, before I continue, that we talk about consumers as if they're A or B--rich or poor; carry a balance/don't carry balance. I just want to mention when I was younger, I carried a lot of balances. And when I'm older, I'm carrying fewer. So, I have been both in my life. But, Annie Lowrey's concern was that poorer customers who use credit cards or even who pay cash are subsidizing richer customers. And, part of the reason she would say that--customers also use cash or debit cards, which we haven't talked about but are different. And, when you're a customer in a store, the price of the items are the same for everybody. Now, there are exceptions to that historically and probably I'm sure in different geographies where you would pay a difference whether you charged it or didn't or whether you paid cash. And, in real life, there are plenty of people who give you a discount for cash because they don't have to pay the intercharge, and they can sometimes not report it as income. So, there's a lot of reasons for why a business might like cash. But, the point is that in many, many stores there's just a price. So, if you're paying cash or using a debit card to buy that item, because the intercharge fee is general, you're going to be effectively subsidizing the users of credit cards because that intercharge fee is embedded in the price of all the goods in the store to help cover the costs of giving consumers the convenience of plastic, even if they're not the particular using that plastic on any one transaction. So, the claim of the article was: 'Credit card transactions punish the poor, help the rich.' And then, just to sort of, to make it even worse: The richer folks who are using the credit cards, as opposed to cash or debit cards, they often get rewards for their use of the card. They pick up points for air travel, or they might get some rebate at the end of a time period. So, they're actually getting a discount that is funded effectively by poor people. And, this is the way you framed it--quote--not the way you believe it, but the way you framed the: 'There's a general feeling in some quarters that the payments industry functions as a tax on everyone. And, that the incidence of this tax must be highest on the poor because they're least likely to have a rewards card.' Patrick McKenzie: This thesis is fundamentally untrue. Very important to say that outright. The claim that the credit card rewards are funded by interest payments is just straightforwardly inaccurate. The issuers manage portfolios for each of their credit card products. And, on a portfolio basis, there might be some users who very optimally take advantage of complicated reward schemes to get more in rewards out than businesses are charged an interchange for processing those users custom. But, over a portfolio for a particular product, it would be a very poor job indeed by the program manager for the card to require subsidization from other users elsewhere in the bank. And so, as a general statement, no, this is just straightforwardly false. The more sophisticated version of the critique is that, as you mentioned, there are people who use cash or debit cards that don't pay rewards or certain forms of credit cards or other payment methods that don't pay rewards. And there are some people who get non-zero rewards out of the system. And so, given that they all pay the same prices in the checkout line, isn't there intrinsically some incidence that is happening that is transferring money from pocket A to pocket B? I broadly believe there is not. And, serious people have looked into this question seriously and attempted to find evidence in favor of that narrative of redistribution happening. For example, there is a great paper out from Sumit Argawal, et al, at the Federal Reserve Board: "Who Pays for your Reward's Redistribution in the Credit Card Market?" Like many social sciences, certain parts of the economics- and policy-sphere would like to find certain answers to the questions that it seeks versus other answers. Some answers would end up in the filing drawer. Despite the title of this paper, which was cited to me by many people who said, 'Haven't you read the updated research and economics? It proves that there is redistribution.' The redistribution that they find is not the redistribution that is alleged in the Atlantic article. Which they very clearly wanted to find. That's a bit of editorializing by me of the authors, but I think it is very editorializing. What they actually found was a redistribution from less savvy consumers to more savvy consumers. Which they say tends to benefit better-off consumers. But there are better-off, less-savvy consumers who are also being redistributed to: less, better off, more savvy consumers. And, that by the way, ties into something which you mentioned earlier, that someone's socioeconomic status and their interaction with the financial industry is not static over the course of their life. A different paper by partially the same authors, which I describe as the Rosetta Stone for credit cards, finds that credit cards are most lucrative in two portions of the FICO [Fair Isaac Corporation] spectrum: the lowest end of the FICO spectrum where people are paying lots of interest rate on high resolving balances; but also counterintuitively the highest end of the FICO spectrum where they revolve almost no balances and get lavish credit card rewards, but are getting even more lavish interchange income from the bank. In the middle--in the 650, 720, etc. FICO levels--the customer's profitability to the bank actually dips negative. And that's because, unlike the two extremes of the FICO spectrum, the middle levels of FICO are not exactly an attractive state for most users. You will tend to be in them for a while and age out. And so, you might be an early career professional, perhaps a grad student, and you have relatively good credit habits but do not have much credit history. And so, you're in that 650 to 720 thing where a lot of banks are saying, 'An expectation. You might not have all that much income right now. You might not be that lucrative of customer right now. But, you certainly seem like someone that we would like to recruit for our bank and keep for a very long time,' with the expectation that they make more money from you as you gain more income, as you get more wealth, as you age and age into life circumstances where your consumption tends to go up. And so, cross-subsidization of people isn't impossible in the financial industry. It happens and is acknowledged in many places. This particular cross-subsidization that was alleged in the Atlantic article does not happen. Flat out. Interestingly, by the way, people like to say that all customers pay the same amount of money at the checkout for the same things, but that just straightforwardly isn't true. That is well known by people who work in retail. For example, perhaps less central to the experience of people who read The Atlantic, but there are many people typically in lower socioeconomic strata who historically spent a lot of time couponing. And so, there is one price for Kellogg's cereal at a particular store on any particular day, unless you are willing to spend a lot of time with the newspaper on Friday patiently clipping coupons that would give you 25 cents off of a certain box of cereal if you presented the coupon in the checkout line. And, that allows retailers and Kellogg's to perform some price discrimination on the various customers of Wheaties. People who think that earning $10 an hour implicitly is a good use of their time will spend a lot of time couponing and get discounted Wheaties. And people who think that spending their Sunday afternoon clipping coupons is not a good use of their time will pay the list price for Wheaties or whatever the price it says on the shelf is. And, we don't often describe that as a subsidization of certain consumers by other consumers based on who is more willing to do couponing. But, if you were to describe that in that fashion, I suppose that tracks the economic truth. But, in the same fashion that if you're willing to spend a lot of time on couponing, Wheaties cost less for you, if you are willing to use certain card products versus other card products, Wheaties does cost less for you. That's true.
51:56	Russ Roberts: But, to get to the central question, there's a store: The store has decided to accept credit cards. And, credit card users, that has certain advantages in attracting customers. It also leads to some challenges and costs. And, the interchange fee is one example of that. There's also fraud that we talked about, the chargeback problem. So, prices are higher than they otherwise would be in a world without fraud and where it didn't cost anything to offer a credit card. So, I assume that stores that offer that convenience, in a certain sense--and it's a tricky sense, there's a direct way to think about it and what we might call a meta-way to think about it--but users, customers pay a privilege--excuse me, customers pay a fee for the privilege of being able to use a credit card. Not have to carry cash, not have to borrow money through a different kind of system, etc. People who don't have access to credit cards, who choose to shop in that store--they don't have to. There could be other stores that don't take credit cards that have different prices. They may be convenient/inconvenient for different types of users and customers. But, I assume it's a true statement that if you have a rewards card and you buy one item, the person who buys that one item with cash is paying a little bit more than they otherwise would for the privilege of shopping in that store. And, you could debate whether that's a cross-subsidy or a redistribution. It doesn't strike me as a proper use of the phrase, but I think that part is a true statement. Or do you want to challenge that? Because in your Twitter thread--your X thread--you had something to say about the volume of transactions, which I think you alluded to in a little phrase a minute ago. So, what have you got? Patrick McKenzie: I think there's an empirical question there, and it is not as obvious to me empirically that stores pass through payment costs to customers. The portion of business that various groups of customers represent is not, for most businesses, equal pro rata across the population. And so, broadly speaking, better-off users who broadly speaking are in more premium credit card products that have higher interchange costs associated with them and also tend to give those users monetary rewards, spend more of the total spent at stores. They represent more of the total purchasing power in the economy. And so, to the extent that they are driving up payments costs for the stores, well, they're driving up payments costs for the stores that are paid by users who are themselves. I think if you sketch out the math there, even toy economic models don't work in such a way that there could be enough money coming out of the lower socioeconomic strata to subsidize the consumption of the much more consuming higher socioeconomic strata. And, I think there is a-- Russ Roberts: Well, the only thing I would say to clarify that for listeners who might be a little bit struggling with it: I deliberately said, 'One item.' So, if I go into Best Buy and I buy three color TVs--three TVs: They're all color now; I don't know why I called it color TVs. I would say that that dates me. It doesn't. I don't really remember. I've never used the phrase 'black-and-white TV' very much even when I was younger. But, if you go into a store and you've just bought a house and you're going to have multiple televisions in the house, so you buy a bunch of color televisions and you buy a bunch of other products--a fancy coffee maker and a printer for your computer, maybe a couple of laptops and so on--and, you're going to pay prices for those goods that has, possibly, in them some piece of the interchange fee. But, they're going to make money on you, both the Best Buy and the credit card company that issued you the card that you used when you paid for those things. Because the magnitude--I want to make sure I'm understanding you--the magnitude of those transactions relative to someone who comes into that store and buys a disc draw[?]--a thumb drive, a 32-gigabyte thumb drive that's now practically a very, very small amount of money--that person also pays a little bit of a premium. And, that person paid cash. And so, the price of the thumb drive--the richer person might have bought 10 of them--now I am dating myself because people don't hardly use them anymore--but, that person's going to pay cash. And, the poor person buys one, the richer person buys 10. And of course, they pay a lot of money for those 10; and the fee is in there and they're helping cover the cost to the store in a much larger amount than the poor person. So, if everybody bought one thing once per time period and paid the same price, I think the critique has perhaps a little bit of a validity--the Atlantic critique. But it requires you to ignore any possibility, again, of competition from other stores and opportunities to coupon. Although couponing I'm a little bit skeptical of. I'm not sure that Kellogg is doing a lot of price discrimination. They could just be trying to encourage people to buy their product with the thrill of that slight discount; and it's a form of advertising. But my point is, is that at least as I understood your point, it's the volume of transactions of people who are not being subsidized at a loss. They get a little bit back because they have a rewards card, but not like they're taking it out of the hide of poor people who have/pay cash. Patrick McKenzie: Two things to respond to. So, I definitely agree that part of the thrill of couponing or the economic impetus to do it on Kellogg's perspective is not simply to engage in price discrimination, but it's to give people a moment on Sunday where they think with the anticipation about buying their box of Wheaties this week. And so they will consume more Wheaties at the margin than other companies that don't provide the fun game with the Sunday newspaper. Credit cards also function in very much that fashion. The brands are extremely aware that if we co-brand with an airline, that you will have a little bit of anticipation every time the plastic leaves your wallet. That: I'm earning points for that great vacation, or my honeymoon, or similar. And, therefore, like, I will feel a bit of willingness to spend more money at the margin than I would if I just had plain boring cash, which never does anything fun for me, aside from buying goods and services in the economy. But, yeah: The broader point it was making that--again, Atlantic makes statements that interest rates are subsidizing rewards, which is just straightforwardly untrue. There's no cut of the math that makes that work. But, in a toy world where everyone consumed the same basket of goods and services and you assumed that there was pass-through of all costs of the storage customers on a rateable basis, then it might make sense that if some users are paying 2.2% interchange fees essentially on their basket and getting no rewards, and other users are paying the same 2.2%, but getting 1% rewards, then while they're all paying something, one is paying less on net. And so, there is some sort of redistributed thing in that toy model of the world. In the world we actually live in, the people who are paying interchange but getting some rewards back, consume more of the total basket of goods at the store. And so, it doesn't subsidize them to the point where they are getting something net out of the equation. The interchange also has some other interesting economic consequences. One thing that it does is that it subsidizes down the cost of credit for certain users. And so, in a world where you capped interchange--you can squeeze different parts of the model but the juice has to flow into other parts of the model--in a world where you capped interchange, all sequel[?] interest rates for users that consume credit have to rise. And so, one way to think of interchange is the bank and the town hardware store saying, you know, 'The two of us, we'll come to an agreement that we like subsidizing economic activity in this town. And, the availability of low-cost credit subsidizes economic activity, which is in our mutual interest. And so, we will bear some of the cost of credit on behalf of the consumers in this town. And then, they will spend more, and that will be good for both of us.' And, the limit case of this is the payment method called 'Buy now, pay later,' which charges a much higher--they'd call a different thing, but it's interchange--charges a much higher interchange to accepting businesses than credit cards do. It's closer to 6% versus two point something percent. But, 'Buy now, pay later' says, 'For all users here, you will get the go-to service right now, but pay for it over the course of typically eight weeks. And, you will not pay for the consumer credit at all in the course of that eight weeks. There is no high-fee APR [annual percentage rate] at all. That has been subsidized down to zero for you.' They don't explain that to the customers because the person buying with loss, etc., doesn't care about the detail. But what the 'buy now, pay later'-provider has done is structured some deal where they slice out, say, a percentage point out of that 6% that they charge the merchant. And, they do a warehouse financing agreement with some hedge fund and map it out such that they essentially structure a synthetic 25% APR consumer loan at Exxonelio[?] without ever need to charge the customer for. And so, credit cards that, quote, "don't have rewards" do have a APR that has been bid down a little bit from where it would prevail in a world where interchange did not exist.
1:03:49	Russ Roberts: You know, I said something about Meta. Obviously the existence of credit cards--which are never free--you mentioned the optimal amount of fraud is not zero. It's easy to get to zero fraud: You just don't have credit cards. Or you don't sell things. There's a lot of ways to think about why you don't want zero fraud. It's too expensive to get to zero. So, credit cards are a glorious way to ease economic transactions, to reduce the transaction costs surrounding commerce. And, if they were eliminated, the world be very different. It's hard to even begin to think about that. Things would be more expensive in a different way. And, those birds would fall-- Patrick McKenzie: Can I make an interjection there? Russ Roberts: Sure. Patrick McKenzie: So, you mentioned earlier that fraud imposes a cost on society--which is trivially true--and that society has to pay that cost in some fashion. And, in credit cards, we make it relatively explicit who is paying and how much they are paying. [More to come, 1:05:07]

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.

Businesses with low margin, or which exist in very fraud-plagued industries because of the dynamics of the things they are selling, generally tend to have more friction associated with transactions. And so, they are more inclined to either deny transactions which are close to the margins or to subject them to other forms of secondary screening that users will perceive in the moment as being annoying. I'm like, 'I am who I say I am. You know I am who I say I am because I have a credit card and driver's license. Why aren't you letting me buy the thing?' Well, the bad guy also has [?a legal?] credit card and a driver's license. And so, occasionally that is not dispositive on the inquiry.

32:43

Russ Roberts: So, just a couple of things here. I want to make sure I understood that correctly. So, let's say a thief has stolen my credit card, goes into Best Buy and buys a color television, and charges it with my credit card. And, there may be a policy that Best Buy has that the person has to show identification. In my experience, it's rarely the case anymore. They just take the card.

And by the way, here in Israel, I never sign anything. There's no piece of paper as there is typically still in America where you have to physically sign your name. In Israel, at least in my experience, you just tap your phone and you're done. Phone obviously has special features that make it a little different than a random piece of plastic, but put those to the side. My point is a thief buys a color TV on my credit card. I get the bill, I say, 'This isn't me.' Who pays for that TV?

Patrick McKenzie: So, it will ultimately be the retailer paying for it in almost all cases.

Russ Roberts: That's the chargeback you talked about?

Patrick McKenzie: A chargeback.

So, the way the interaction will work from your perspective is you call your bank; you say, 'I don't remember this transaction.' A relatively non-senior employee of your bank will ask you a few questions about it, like, 'Well, do you remember going into that store? Is it possible someone else in your household could have used that?' And, they'll go through a bunch of things which are designed to essentially talk to many customers who are mistaken about the facts, which happens quite frequently, from filing a chargeback.

But ultimately, you are the customer of the bank. And Best Buy is not. And so, the person who the bank has the most incentive to keep happy is you. And so, if you are persistent about saying, 'No, really, that was not me,' it's very highly likely that the bank will say, 'Okay. We agree it wasn't you.' And, if the bank agrees with that, then in 99-point--well, okay? 99.9 is not quite accurate. That is the end of the inquiry in many cases.

The bank will push some buttons on the rails as it were, which will immediately claw back money from the credit card processor of the merchant. And, that credit card processor will immediately claw back money from the merchant themselves. And, the credit card processor will also typically tell the merchant, 'A customer has via their bank opened a dispute with you. You can present evidence to the bank.' And then, again, your bank will make a determination based on the evidence presented to them, whether they uphold the dispute or not. And, in the case where the store wins the dispute, they get their money back, less some fee for the services of the bank and being an intermediary.

But, a thing that businesses will catch about incessantly is that even when they go through and they submit their evidence, they do not often win disputes. They feel, subjectively speaking, they should have won. Or there are some businesses which say, 'Well, I was not a party to the fraud. Someone came in, they looked reasonable, they presented a credit card. Shouldn't the bank keep that for me?'

And there are configurations of the world in which that is a decision we could have made. But we do not live in that configuration of the world. If you are Best Buy, you are certainly sophisticated enough to understand the deal you have struck. For smaller businesses, I understand that many smaller businesses are relatively less sophisticated with regards to those things. I might be surprised the first time it happened or viscerally emotionally funded[?offended?] when it happens. I say this to someone who has paid a fair share of chargebacks myself, sometimes for legitimate reasons and sometimes not. But, that is the nature of the risk transfer. The banks buy certain forms of risk and they decline to bear other forms of risk.

Russ Roberts: So, this is an application of what I think of as the Coase Theorem, which is basically property rights. The assignment of property rights sets in motion a set of incentives. And if you change the property rights, you're going to have different incentives on the parties.

So, at this particular allocation--which is not imposed, I don't know, but [?] you'll tell me if it's negotiated rather than imposed by regulations. But, with this particular configuration, the--Best Buy has the incentive to avoid the fraud and the bank issuer of the credit card less so.

And I find that fascinating, just simply because almost every retailer that I have interacted with in person--online is a little bit trickier obviously, but I'm talking about in-person transactions where I swipe the card--I never got much of a hard time in recent years proving who I am. So, is there an inherent level of lawfulness and trust that's driving this in a country like the United States? Is it different in other countries? I'm surprised that there's a full chargeback. And of course, by the way--we didn't mention this--but if every week I call my credit card company and say, 'I didn't buy that television. I didn't eat at that restaurant. I didn't take that trip to Tahiti,' eventually I'm sure they have systems for people who have too many claims like that. So, you can repeat--

Patrick McKenzie: One--

Russ Roberts: Go ahead.

Patrick McKenzie: I apologize for interrupting you. One aspirationally hopes that banks will clamp down on abuse of use of chargebacks, and that's aspirational in some senses.

The words 'high-trust society' comes up quite frequently, often in the context of saying the United States is no longer a high-trust society. I think people who make that claim fail to understand how different the spectrum looks over the entire world. But, indicatively, Japan is an extraordinarily high-trust society. The loss rates both in terms of fraudulent transactions and non-payment of legitimate credit card bills in Japan are so low compared to the United States that people assume when they see the numbers that there must be a math error.

But, the United States is broadly a trusting society. That is partly why it works--fractally--within the United States. Well, that's why everything works--that we do have such trust in each other, largely deserved.

And that is one reason why you are not constantly asked to prove your identity every time you try to buy a cup of coffee. Physical control of the plastic or physical control of the phone is good enough in most cases. And, there will be some fraud losses and they come out in the wash.

This does not apply in every industry, in every geography, in every similar. And in places where it does not apply--something like doing the sea trade back during the age of piracy, or I suppose we are still living in the age of piracy in certain parts of the world, and it is impossible to navigate certain straits at the moment--but be that as it may, there are places in the world where chargeback rates are astoundingly higher than they are in the United States. And, where it is the assessment of people in the financial industry who see the numbers that a large portion of those chargebacks are what the industry calls 'friendly fraud'--where the cardholder did indeed authorize the transaction but would prefer to get the good or service and also get their money back; and has used the financial industry as a weapon against the person selling the good or service to defraud them of that good or service, essentially.

And, that friendly fraud happens in the United States as well; but it happens to a much greater degree in some other geographies to an extent where it makes it difficult for some transactions to clear at all or the market for some transactions to clear rather than the transactions clearing in the specialized credit-card industry sense of that term.

41:30

Russ Roberts: So, I found out about you from thread you had on X that we'll post where you're reacting to an article in The Atlantic. The author of the article is Annie Lowrey. I'm going to try to do justice to her claim. It's a little bit complicated, as is your reaction to it, so I'll try to read this slowly and try to make sure people understand what's being claimed here.

So, the article claimed that:

Poor consumers who use credit cards for gas and groceries, what we would call necessities, those people often end up carrying a balance on their credit card with a high interest rate. And, those low income customers are subsidizing rich consumers who are buying business class airline tickets, who never incur interest charges, because they pay off their balance every month.

Now, I would just say in passing, before I continue, that we talk about consumers as if they're A or B--rich or poor; carry a balance/don't carry balance. I just want to mention when I was younger, I carried a lot of balances. And when I'm older, I'm carrying fewer. So, I have been both in my life.

But, Annie Lowrey's concern was that poorer customers who use credit cards or even who pay cash are subsidizing richer customers. And, part of the reason she would say that--customers also use cash or debit cards, which we haven't talked about but are different. And, when you're a customer in a store, the price of the items are the same for everybody.

Now, there are exceptions to that historically and probably I'm sure in different geographies where you would pay a difference whether you charged it or didn't or whether you paid cash. And, in real life, there are plenty of people who give you a discount for cash because they don't have to pay the intercharge, and they can sometimes not report it as income. So, there's a lot of reasons for why a business might like cash.

But, the point is that in many, many stores there's just a price. So, if you're paying cash or using a debit card to buy that item, because the intercharge fee is general, you're going to be effectively subsidizing the users of credit cards because that intercharge fee is embedded in the price of all the goods in the store to help cover the costs of giving consumers the convenience of plastic, even if they're not the particular using that plastic on any one transaction.

So, the claim of the article was: 'Credit card transactions punish the poor, help the rich.' And then, just to sort of, to make it even worse: The richer folks who are using the credit cards, as opposed to cash or debit cards, they often get rewards for their use of the card. They pick up points for air travel, or they might get some rebate at the end of a time period. So, they're actually getting a discount that is funded effectively by poor people.

And, this is the way you framed it--quote--not the way you believe it, but the way you framed the: 'There's a general feeling in some quarters that the payments industry functions as a tax on everyone. And, that the incidence of this tax must be highest on the poor because they're least likely to have a rewards card.'

Patrick McKenzie: This thesis is fundamentally untrue. Very important to say that outright. The claim that the credit card rewards are funded by interest payments is just straightforwardly inaccurate. The issuers manage portfolios for each of their credit card products. And, on a portfolio basis, there might be some users who very optimally take advantage of complicated reward schemes to get more in rewards out than businesses are charged an interchange for processing those users custom.

But, over a portfolio for a particular product, it would be a very poor job indeed by the program manager for the card to require subsidization from other users elsewhere in the bank. And so, as a general statement, no, this is just straightforwardly false.

The more sophisticated version of the critique is that, as you mentioned, there are people who use cash or debit cards that don't pay rewards or certain forms of credit cards or other payment methods that don't pay rewards. And there are some people who get non-zero rewards out of the system.

And so, given that they all pay the same prices in the checkout line, isn't there intrinsically some incidence that is happening that is transferring money from pocket A to pocket B? I broadly believe there is not. And, serious people have looked into this question seriously and attempted to find evidence in favor of that narrative of redistribution happening.

For example, there is a great paper out from Sumit Argawal, et al, at the Federal Reserve Board: "Who Pays for your Reward's Redistribution in the Credit Card Market?" Like many social sciences, certain parts of the economics- and policy-sphere would like to find certain answers to the questions that it seeks versus other answers. Some answers would end up in the filing drawer.

Despite the title of this paper, which was cited to me by many people who said, 'Haven't you read the updated research and economics? It proves that there is redistribution.'

The redistribution that they find is not the redistribution that is alleged in the Atlantic article. Which they very clearly wanted to find. That's a bit of editorializing by me of the authors, but I think it is very editorializing.

What they actually found was a redistribution from less savvy consumers to more savvy consumers. Which they say tends to benefit better-off consumers. But there are better-off, less-savvy consumers who are also being redistributed to: less, better off, more savvy consumers.

And, that by the way, ties into something which you mentioned earlier, that someone's socioeconomic status and their interaction with the financial industry is not static over the course of their life.

A different paper by partially the same authors, which I describe as the Rosetta Stone for credit cards, finds that credit cards are most lucrative in two portions of the FICO [Fair Isaac Corporation] spectrum: the lowest end of the FICO spectrum where people are paying lots of interest rate on high resolving balances; but also counterintuitively the highest end of the FICO spectrum where they revolve almost no balances and get lavish credit card rewards, but are getting even more lavish interchange income from the bank.

In the middle--in the 650, 720, etc. FICO levels--the customer's profitability to the bank actually dips negative. And that's because, unlike the two extremes of the FICO spectrum, the middle levels of FICO are not exactly an attractive state for most users. You will tend to be in them for a while and age out. And so, you might be an early career professional, perhaps a grad student, and you have relatively good credit habits but do not have much credit history. And so, you're in that 650 to 720 thing where a lot of banks are saying, 'An expectation. You might not have all that much income right now. You might not be that lucrative of customer right now. But, you certainly seem like someone that we would like to recruit for our bank and keep for a very long time,' with the expectation that they make more money from you as you gain more income, as you get more wealth, as you age and age into life circumstances where your consumption tends to go up.

And so, cross-subsidization of people isn't impossible in the financial industry. It happens and is acknowledged in many places. This particular cross-subsidization that was alleged in the Atlantic article does not happen. Flat out.

Interestingly, by the way, people like to say that all customers pay the same amount of money at the checkout for the same things, but that just straightforwardly isn't true. That is well known by people who work in retail. For example, perhaps less central to the experience of people who read The Atlantic, but there are many people typically in lower socioeconomic strata who historically spent a lot of time couponing. And so, there is one price for Kellogg's cereal at a particular store on any particular day, unless you are willing to spend a lot of time with the newspaper on Friday patiently clipping coupons that would give you 25 cents off of a certain box of cereal if you presented the coupon in the checkout line. And, that allows retailers and Kellogg's to perform some price discrimination on the various customers of Wheaties.

People who think that earning $10 an hour implicitly is a good use of their time will spend a lot of time couponing and get discounted Wheaties. And people who think that spending their Sunday afternoon clipping coupons is not a good use of their time will pay the list price for Wheaties or whatever the price it says on the shelf is. And, we don't often describe that as a subsidization of certain consumers by other consumers based on who is more willing to do couponing. But, if you were to describe that in that fashion, I suppose that tracks the economic truth. But, in the same fashion that if you're willing to spend a lot of time on couponing, Wheaties cost less for you, if you are willing to use certain card products versus other card products, Wheaties does cost less for you. That's true.

51:56

Russ Roberts: But, to get to the central question, there's a store: The store has decided to accept credit cards. And, credit card users, that has certain advantages in attracting customers. It also leads to some challenges and costs. And, the interchange fee is one example of that. There's also fraud that we talked about, the chargeback problem.

So, prices are higher than they otherwise would be in a world without fraud and where it didn't cost anything to offer a credit card. So, I assume that stores that offer that convenience, in a certain sense--and it's a tricky sense, there's a direct way to think about it and what we might call a meta-way to think about it--but users, customers pay a privilege--excuse me, customers pay a fee for the privilege of being able to use a credit card. Not have to carry cash, not have to borrow money through a different kind of system, etc.

People who don't have access to credit cards, who choose to shop in that store--they don't have to. There could be other stores that don't take credit cards that have different prices. They may be convenient/inconvenient for different types of users and customers. But, I assume it's a true statement that if you have a rewards card and you buy one item, the person who buys that one item with cash is paying a little bit more than they otherwise would for the privilege of shopping in that store. And, you could debate whether that's a cross-subsidy or a redistribution. It doesn't strike me as a proper use of the phrase, but I think that part is a true statement.

Or do you want to challenge that? Because in your Twitter thread--your X thread--you had something to say about the volume of transactions, which I think you alluded to in a little phrase a minute ago. So, what have you got?

Patrick McKenzie: I think there's an empirical question there, and it is not as obvious to me empirically that stores pass through payment costs to customers.

The portion of business that various groups of customers represent is not, for most businesses, equal pro rata across the population. And so, broadly speaking, better-off users who broadly speaking are in more premium credit card products that have higher interchange costs associated with them and also tend to give those users monetary rewards, spend more of the total spent at stores. They represent more of the total purchasing power in the economy.

And so, to the extent that they are driving up payments costs for the stores, well, they're driving up payments costs for the stores that are paid by users who are themselves.

I think if you sketch out the math there, even toy economic models don't work in such a way that there could be enough money coming out of the lower socioeconomic strata to subsidize the consumption of the much more consuming higher socioeconomic strata. And, I think there is a--

Russ Roberts: Well, the only thing I would say to clarify that for listeners who might be a little bit struggling with it: I deliberately said, 'One item.' So, if I go into Best Buy and I buy three color TVs--three TVs: They're all color now; I don't know why I called it color TVs. I would say that that dates me. It doesn't. I don't really remember. I've never used the phrase 'black-and-white TV' very much even when I was younger. But, if you go into a store and you've just bought a house and you're going to have multiple televisions in the house, so you buy a bunch of color televisions and you buy a bunch of other products--a fancy coffee maker and a printer for your computer, maybe a couple of laptops and so on--and, you're going to pay prices for those goods that has, possibly, in them some piece of the interchange fee. But, they're going to make money on you, both the Best Buy and the credit card company that issued you the card that you used when you paid for those things.

Because the magnitude--I want to make sure I'm understanding you--the magnitude of those transactions relative to someone who comes into that store and buys a disc draw[?]--a thumb drive, a 32-gigabyte thumb drive that's now practically a very, very small amount of money--that person also pays a little bit of a premium. And, that person paid cash. And so, the price of the thumb drive--the richer person might have bought 10 of them--now I am dating myself because people don't hardly use them anymore--but, that person's going to pay cash. And, the poor person buys one, the richer person buys 10. And of course, they pay a lot of money for those 10; and the fee is in there and they're helping cover the cost to the store in a much larger amount than the poor person.

So, if everybody bought one thing once per time period and paid the same price, I think the critique has perhaps a little bit of a validity--the Atlantic critique. But it requires you to ignore any possibility, again, of competition from other stores and opportunities to coupon. Although couponing I'm a little bit skeptical of. I'm not sure that Kellogg is doing a lot of price discrimination. They could just be trying to encourage people to buy their product with the thrill of that slight discount; and it's a form of advertising. But my point is, is that at least as I understood your point, it's the volume of transactions of people who are not being subsidized at a loss. They get a little bit back because they have a rewards card, but not like they're taking it out of the hide of poor people who have/pay cash.

Patrick McKenzie: Two things to respond to. So, I definitely agree that part of the thrill of couponing or the economic impetus to do it on Kellogg's perspective is not simply to engage in price discrimination, but it's to give people a moment on Sunday where they think with the anticipation about buying their box of Wheaties this week. And so they will consume more Wheaties at the margin than other companies that don't provide the fun game with the Sunday newspaper.

Credit cards also function in very much that fashion. The brands are extremely aware that if we co-brand with an airline, that you will have a little bit of anticipation every time the plastic leaves your wallet. That: I'm earning points for that great vacation, or my honeymoon, or similar. And, therefore, like, I will feel a bit of willingness to spend more money at the margin than I would if I just had plain boring cash, which never does anything fun for me, aside from buying goods and services in the economy.

But, yeah: The broader point it was making that--again, Atlantic makes statements that interest rates are subsidizing rewards, which is just straightforwardly untrue. There's no cut of the math that makes that work.

But, in a toy world where everyone consumed the same basket of goods and services and you assumed that there was pass-through of all costs of the storage customers on a rateable basis, then it might make sense that if some users are paying 2.2% interchange fees essentially on their basket and getting no rewards, and other users are paying the same 2.2%, but getting 1% rewards, then while they're all paying something, one is paying less on net. And so, there is some sort of redistributed thing in that toy model of the world.

In the world we actually live in, the people who are paying interchange but getting some rewards back, consume more of the total basket of goods at the store. And so, it doesn't subsidize them to the point where they are getting something net out of the equation.

The interchange also has some other interesting economic consequences. One thing that it does is that it subsidizes down the cost of credit for certain users. And so, in a world where you capped interchange--you can squeeze different parts of the model but the juice has to flow into other parts of the model--in a world where you capped interchange, all sequel[?] interest rates for users that consume credit have to rise.

And so, one way to think of interchange is the bank and the town hardware store saying, you know, 'The two of us, we'll come to an agreement that we like subsidizing economic activity in this town. And, the availability of low-cost credit subsidizes economic activity, which is in our mutual interest. And so, we will bear some of the cost of credit on behalf of the consumers in this town. And then, they will spend more, and that will be good for both of us.'

And, the limit case of this is the payment method called 'Buy now, pay later,' which charges a much higher--they'd call a different thing, but it's interchange--charges a much higher interchange to accepting businesses than credit cards do. It's closer to 6% versus two point something percent. But, 'Buy now, pay later' says, 'For all users here, you will get the go-to service right now, but pay for it over the course of typically eight weeks. And, you will not pay for the consumer credit at all in the course of that eight weeks. There is no high-fee APR [annual percentage rate] at all. That has been subsidized down to zero for you.'

They don't explain that to the customers because the person buying with loss, etc., doesn't care about the detail. But what the 'buy now, pay later'-provider has done is structured some deal where they slice out, say, a percentage point out of that 6% that they charge the merchant. And, they do a warehouse financing agreement with some hedge fund and map it out such that they essentially structure a synthetic 25% APR consumer loan at Exxonelio[?] without ever need to charge the customer for.

And so, credit cards that, quote, "don't have rewards" do have a APR that has been bid down a little bit from where it would prevail in a world where interchange did not exist.

1:03:49

Russ Roberts: You know, I said something about Meta. Obviously the existence of credit cards--which are never free--you mentioned the optimal amount of fraud is not zero. It's easy to get to zero fraud: You just don't have credit cards. Or you don't sell things. There's a lot of ways to think about why you don't want zero fraud. It's too expensive to get to zero.

So, credit cards are a glorious way to ease economic transactions, to reduce the transaction costs surrounding commerce. And, if they were eliminated, the world be very different. It's hard to even begin to think about that. Things would be more expensive in a different way. And, those birds would fall--

Patrick McKenzie: Can I make an interjection there?

Russ Roberts: Sure.

Patrick McKenzie: So, you mentioned earlier that fraud imposes a cost on society--which is trivially true--and that society has to pay that cost in some fashion. And, in credit cards, we make it relatively explicit who is paying and how much they are paying. [More to come, 1:05:07]

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

READER COMMENTS

Rob

May 19 2025 at 9:00am

Mark

May 19 2025 at 12:25pm

KMC

May 19 2025 at 2:42pm

Ian

May 19 2025 at 9:12pm

Mark

May 20 2025 at 9:56am

Gregg Tavares

May 19 2025 at 9:41pm

DG

May 20 2025 at 11:57am

Elijah Broadbent

May 20 2025 at 3:15pm

M T

May 21 2025 at 3:21pm

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

READER COMMENTS

Rob

May 19 2025 at 9:00am

Mark

May 19 2025 at 12:25pm

KMC

May 19 2025 at 2:42pm

Ian

May 19 2025 at 9:12pm

Mark

May 20 2025 at 9:56am

Gregg Tavares

May 19 2025 at 9:41pm

DG

May 20 2025 at 11:57am

Elijah Broadbent

May 20 2025 at 3:15pm

M T

May 21 2025 at 3:21pm

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