credit cards · economic principles · policy

The Credit Card Debt Puzzle: A Lesson in Cognitive Biases

Exploration of the liquid hand-to-mouth concept leads to another economic conundrum: the credit card debt puzzle. The puzzle refers to a situation in which a consumer simultaneously holds interest bearing credit cards debt and liquid assets. Economists have mused for years over why people engage in this obviously irrational behavior. Why not just use your liquid assets to pay down this expensive credit card debt? Many explanations have been proffered, and none of them seem to be fully satisfactory.

 A recent paper uses  a longitudinal data say, the 1979 National Longitudinal Survey of Youth, to study individuals over time. It then examines their behavior and whether or not they enter this puzzle groups based on their financial literacy, risk preferences, discount rates and general demographics.  While acknowledging that many different things can contribute to engaging in this seemingly irrational behavior, there are a few general takeaways:

  • Individuals in the puzzle group have higher discount rates. In other words, they are impatient.
  • Individuals in the puzzle group have slightly lower financial literacy scores. They also have higher debt, overall.
  • Many people in the puzzle group do this on purpose as a precautionary behavior; they’re worried about losing credit in the future so they hold cash just in case. Similarly, puzzle group members have higher uncertainty about their future credit status.
  • Puzzle group members are more likely to have average levels of risk aversion, as opposed to being at either extreme of the spectrum (very risk averse or not risk averse at all).

So, the puzzle group is heterogeneous, but there are some trends. For simplicity, I’m going to call out two distinct types of puzzle groupers:

  1. People who know what they’re doing, know it’s expensive, but do it anyway because it aligns with their risk tolerance to keep some money in the bank despite paying high interest on revolving debts.
  2. People who struggle with patience and self-control when it comes to their spending and perhaps don’t understand the cost of this behavior.

I will focus on the latter group for the remainder of this post, as providing a solution for the former lies in the realm of repairing the macroeconomy and restoring trust in financial institutions – a topic for another day.  The second group has fallen  victim to a variety of cognitive biases that breed irrational behavior.  The primary perpetrator here is hyperbolic discounting, also known as current-moment bias or present bias. This is obvious and discussed in the literature. Individuals in the puzzle group are present biased because they’d rather have liquidity now than save money in the future by having lower interest payments. Also at work is the neglecting probability bias; people feel the need to be prepared for a catastrophic event that would require them to immediately use liquid assets even though such an event likely has very low probability.  Loss aversion/sunk costs, endowment effect, post-purchase rationalization…the list goes on and on.

My point is basically just to say that there are clearly cognitive biases at work.  Yet economic models generally fail to account for them.  Like I wrote about when discussing the liquid hand-to-mouth, the most current versions of the personal consumption/savings models assume that consumers are rational consumption smoothers. This is clearly not the case. While I am still an advocate of improving financial literacy, the data demonstrates that this would not solve the problem. Even people who are well educated and understand what they’re doing engage in puzzle behavior because of their risk appetites. So, we either have to get people to think that having low liquidity is less risky or have better understanding of what makes people think this way so that we can predict it.

The credit card debt puzzle is just one example of an individual phenomena that has large effects on the macroeconomy. It’s a major failing of the discipline at present to not be able to account for the irrational behavior of individuals. If we want to be able to advise on effective fiscal and monetary policy, we have to understand how people think and how they actually make decisions about money.



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