Gresham’s Law of Plastic

By Sean Vanatta

In a 1991 article in the American Economic Review, Lawrence Ausubel posed a question: Why had competition failed in the credit card market? Credit card interest rates had surged in the early 1980s following Fed Chairman Paul Volcker’s dramatic bit to purge inflation, but as market interest rates moderated later in the decade, credit card interest rates and annual fees stayed high. Although 4,000 firms nominally competed in a market with few barriers to entry, Ausubel found that “the bank credit card market…behaved widely at variance with the predictions of a competitive model.”

In recent decades, this variance has continued. In its annual examination of the credit card market, the Federal Reserve has consistently found that “credit card earnings have almost always been higher than returns on all bank activities.” Supernormal profits are the norm. And while Ausubel observed a market that, if not competitive, was at least fragmented, the card industry has only become more concentrated, with the planned Capital One/Discover merger the most obvious example.

Reconstruction of graph in Lawrence M. Ausubel, “The Failure of Competition in the Credit Card Market,” American Economic Review 81, no. 1 (1991): 54. Credit card interest rates are from Federal Reserve Bulletin, “Terms of Consumer Installment Credit (Table 1.56),” FRASER. Cost of funds is one-year Treasury bill yield plus .75 percent, from Federal Reserve Bulletin, “Interest Rates (Table 1.35),” FRASER.

Plastic Capitalism

In my new book, Plastic Capitalism: Banks, Credit Cards, and the End of Financial Control, out this month from Yale University Press, I take up Ausubel’s core question and examine it over a longer horizon. In it, I argue that today’s card market today is ruled by Gresham’s Law of Plastic: The largest card issuers, charging the highest prices and using high revenues to aggressively market cards, have crowded out lower-cost, less risky alternatives. Bad plastic money has driven out the good.

The book is at once a history of the bank card industry and of the political and legal processes through which bankers, consumers, and other stakeholders built the credit card market from the 1950s through the 1980s.

This political history highlights a very different set of possibilities than the world of high credit prices we live in today. Before 1980, states rigorously regulated credit card prices through interest rate caps, known as usury laws.

These laws were not some hoary hold-over for an earlier, faith-based prohibition of lending at interest, as the name implies. Rather, they grew from a New Deal commitment to make credit inexpensive and safe for affluent consumers. Consumers wanted low-cost, convenient credit, not long-term expensive debt, and they used price control regulation to discourage lenders from trapping borrowers. During the 1960s and 1970s, consumer groups campaigned to extend state-level price controls to credit cards, which as a novel product had fallen under existing price control rules.

Consumer and labor groups pursued price controls recognizing that they would exclude economically-disadvantaged borrowers. They expected high wages, not expensive credit, to be the fuel for U.S. consumerism.

State regulation of credit card interest made sense within the prevailing system of regulatory federalism. Although credit card networks—BankAmericard (Visa) and Master Charge (Mastercard)—reached across the country, before the 1980s, banks could not build branches across state lines. Bank credit card markets were fundamentally local. Bankers signed up merchants and enrolled consumers in markets defined by federalism, and bankers and their customers participated in the same state-level political negotiations over the price of credit.

Two major changes disrupted this status quo. First, in the mid-1970s, New York’s Citibank mailed millions of pre-approved Visa applications to BankAmericard holders across the country. Citibankers believed that once the card networks had become established, cardholders associated credit with the network, not the bank issuing the card. In 1976, the BankAmericard network announced that it would change its name to Visa, and Citibank capitalized on consumer confusion to gain 4 million new cardholders. Citibank nationalized competition for cardholders, even as price regulation remained the purview of individual states.

Citi’s gambit was aggressive and ill-timed. Just as Citibank poured its resources and reputation into building a nationwide consumer base, its costs of funds went through the roof. In 1979, Jimmy Carter appointed Paul Volcker as Chair of the Federal Reserve Board of Governors, and Volcker proceeded to shock the nation’s money markets. Citi’s cost of funds surged, and New York’s strict credit card interest limits bit hard. By early 1980, the bank was losing millions.

The bank’s lawyers found a solution: a loophole in the Bank Holding Company Act of 1956 allowed Citi to acquire a bank in another state if the legislature invited the bank to do so. After a hurried courtship, South Dakota, a state that recently repealed its interest caps, obliged. On the back of the Supreme Court’s 1978 Marquette decision, Citi exported the high rates and annual fees allowed in South Dakota to cardholders across the country. Where under New York law Citi had charged between 12 and 18 percent, depending on the consumer’s outstanding balance, after its relocation, the bank raised its rates to 19.8 percent and attached a $20 annual fee (which was not allowed in New York).

It was at this point when the Gresham’s logic took over. The nation’s largest card issuing banks moved or threatened to move, and states rolled back interest rate limits. Even as market rates declined, card prices stayed high—and have stayed high.

Reforming Credit Card Markets

In February 2024, the Consumer Financial Protection Bureau reported that “Large Banks Charge Higher Credit Card Interest Rates than Small Banks,” specifically highlighting Capital One on a list of firms charging more than 30 percent interest to cardholders. Three days later, Capital One announced it’s plans to merge with Discover, which would move it from the third-largest to the largest card issuer.

What should policymakers do? The obvious choice would be to block the Capital One merger. In the current political and regulatory environment, that is the most realistic move.

(In a different policy environment, we might hesitate. If card networks compete, there might be good reason to encourage Capital One to transform Discover into a viable alternative to Visa, MasterCard, and American Express. It is just not obvious that card networks do compete.)

Blocking the merger, though, leaves us at the status quo, which is not a great place to be, especially for the millions of households struggling with high-interest credit card debt.

Often, when markets appear to fail to meet their function of price discovery, regulators reach for disclosure. If only consumers had more information, the logic goes, they would make informed choices, competition would do its job, prices would come down, and we would all be better off. Recently in this vein, the CFPB has announced a new comparison shopping tool to promote competition.

Disclosure, however, has been at the heart of federal credit regulation since the 1968 Truth-in-Lending Act, with less than exemplary results. And policymakers have often sought to promote comparison shopping in card markets as an alternative to taking substantive policy action. In 1986, then Representative Chuck Schumer complained in a Washington Post op-ed that “there is no…competition in the credit card industry,” and his office published periodic lists of low-coast card issuers. Certainly, the CFPB can reach further now than Schumer’s list. But it’s not clear that this approach will do more than make the most informed consumers better informed.

Rather, Congress should do to credit card interest rates what the CFPB has done to late fees: cap them. Ausubel calculated a “competitive rate” of just 13.65 (in relation to a then prevailing 7.52 percent one-year T-bill). Ausubel did not suggest an ultimate ceiling that lawmakers should pursue, only that they should reexamine the assumption that competitive markets—rather than laws—would bring interest rates down. Over the years, many lawmakers have introduced national usury limits, including Senator Josh Hawley’s recently introduced 18 percent rate cap in September 2023 (when T-bill yields were around 5.53 percent).

We can debate the finer points—my preference would be a cap that flexes in relation to some agreed market interest rate up to a fixed cap. We should do so with clear eyes on the consequences: Any rate cap will mean that fewer people have access to credit, and that will carry social and political consequences. Yet it is also true that for too long household borrowing has been a substitute for substantive polices that address income inequality and other welfare issues. Pulling off the Band-Aid will hurt and hopeful redirect political energy toward solving these deeper problems with public money, rather than private debt.

Sean Vanatta is a senior fellow at WIFPR.