Steven Pearlstein
Columnist February 5, 2011

Credit card companies are amazing. Not only do they now offer cards with no annual fees and low teaser rates, they even give you a a rebate for 1 percent of everything you buy. Get an American Express card through Fidelity and you can get 2 percent of your purchases rebated to your investment account. Discover offers 5 percent on selected categories of purchases - groceries, gasoline, travel, clothing - depending on the month and the season. Can 7 percent be far behind?

Of course, you may be wondering, as I did, where the credit card companies come up with all the money for these rewards and rebates, which are now a feature on half of all credit cards in active use. At first blush, the money appears to be coming from retail merchants, who are paying ever-escalating fees for the privilege of swiping your credit card through their registers. But according to a wide range of government and private economists, ultimately it's you, the consumer, who is paying for those rebates, as merchants raise their prices to cover those additional costs. When all is said and done, all that's really happening is that the credit card companies are taking money out of your left pocket, setting aside a hefty fee for themselves and putting what's left back in your right pocket.

Steven Pearlstein is a business and economics columnist who writes about local, national and international topics. View Archive

Only it's worse than that. Because while everyone pays the higher retail prices necessary to cover the "swipe fees," only those with rich rewards cards actually get the kickback. In effect, they are subsidized by those who pay those higher retail prices with cash, debit cards or standard-issue credit cards.

To understand how we got to this point, you need to understand the unique economics of the credit card business.

Credit cards are a "network" business, one in which everyone benefits when there are more customers using the same network. Cardholders prefer cards that are accepted by more merchants, and merchants prefer to take the cards that have the largest number of cardholders. So once one card company begins to get a lead, it's difficult for the others to catch up or enter the fray. The result is that, in most network industries, all the business winds up in the hands of very few companies, at least until some new disruptive technology comes along. Certainly that's the case with credit cards. Visa, Mastercard and American Express now account for more than 90 percent of the market. And with that much concentration comes the power to charge higher prices than would be possible in a market with many competitors.

The other unusual characteristic of credit cards is that it is what economists call a "two-sided market," where firms compete both for merchants and cardholders. In the industry's early years, more of the revenue came from cardholders as companies competed to get more retailers into their networks. Keeping merchant fees low was an essential part of that strategy, and card companies made up for that by charging card holders annual fees and high interest rates on unpaid balances.

Over time, however, the competitive dynamic changed. Once consumers began using credit cards to make a majority of their big purchases, merchants realized that they simply couldn't stay in business if they didn't accept all the major credit cards. At that point, the credit card companies had the upper hand, allowing them to push through fee increases with relatively little drop-off in merchant participation.

Card companies now face a competitive landscape where the price sensitivity of their merchant customers is so low, and the price sensitivity of their cardholders is so high, that the winning strategy is to push merchant fees ever higher and use the money to offer ever more lavish rewards and cash rebates to win new cardholders and get them to use their cards to make more of their purchases.

What makes this strategy so effective is that the costs are largely hidden. Although the merchant fees eventually translate into higher retail prices, consumers can't really see that. What they can see, on the other hand, is that those wonderful card companies are giving them a 5 percent kickback every time they go to the supermarket.

The credit card companies, you won't be surprised to learn, dismiss this analysis, claiming that rewards programs are a win for consumers, a win for merchants and a win for their shareholders. How can that be? Because, the argument goes, credit cards have brought so much efficiency to retail operations that they have actually lowered retail prices, not raised them. The credit card companies have figured out a way to spin straw into gold!

This argument is not as fanciful as it might sound. The widespread use of credit cards by consumers and retailers probably has made the payments process less costly and more efficient, particularly once those clunky mechanical systems were replaced with easy swipes of the card. But those efficiencies were pretty much realized a decade ago, when most retailers adopted the latest technology. It's hard to see how there could have been enough additional efficiencies since then to justify the big jump in typical merchant fees since 2005. The Government Accountability Office found that not only have fees for transactions with standard cards increased about 25 percent but also that there has been a significant jump in merchant revenue as a result of the extra half-percentage point that card companies impose for purchases made with premium rewards cards.

In an effort to deal with this perverse competitive dynamic, the Justice Department brought an antitrust suit against Visa, Mastercard and American Express in October. In settling the suit, Visa and Mastercard agreed to change their contracts so that merchants can inform customers of the transaction fees and use discounts or gentle persuasion to encourage them to use cash or cards that have lower fees. The intent is to bring some price competition back into the market for merchant participation. At most retailers, however, the new rules won't go into effect until a similar agreement is either negotiated with American Express or imposed by a federal court.

Certainly this is a good first step. It would have been better if Justice had also insisted that merchants be given the option of adding surcharges for credit card purchases or the right to refuse to accept higher-fee cards altogether. Both are prohibited under credit card contracts.

In the end, there is only so much under existing antitrust law that the Justice Department can do. Given the hammerlock that Visa, Mastercard and American Express have on the market, the only sure way to prevent them from charging excessive fees and earning monopoly-like profits is through direct regulation. Congress recently mandated just that for debit-card fees, which the Federal Reserve now proposes to cut by more than 80 percent. It was only political push back from the banks and credit card companies that prevented similar regulation of credit cards.

There are two other reasons for the public to be concerned about the arms race in premium awards card.

The first is that the current kickback arrangement is highly regressive. A study by the Federal Reserve Bank of Boston found that households with annual incomes of less than $20,000 pay an extra $21 a year in higher retail prices as a result of merchants' credit card fees, while households with incomes of $150,000 benefit by $750. The reason is simple: Poorer people tend to do more of their business in cash and don't qualify for many high-reward cards.

The other is debt. One common rationale that the industry gives for high-reward cards is that they help to "lift" merchant sales by getting customers to spend more than they otherwise would. While that might be true for an individual merchant, it can't be true for all merchants unless it increases overall household income (unlikely) or induces consumers to save less and take on more debt. And, indeed, that's exactly what appears to have happened during the recent credit bubble - a bubble, we should remember, that led to a financial crisis, a prolonged recession and, ironically, tens of billions of dollars in bad debt write-offs by credit card issuers.

That hardly seems like the kind of social and economic benefit that the credit card industry wants to brag about.

pearlstein@washpost.com