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Saturday, August 10, 2013

How credit cards changed our relationship with money

Plastic people
The first credit card hit Britain 50 years ago and it kick-started a revolution that made money and credit more accessible than ever
Gemma is a child of the plastic generation. She's only ever known finance through the medium of debit and credit cards where access to goods and funds is instant and easy. The 31 year old from Essex has had a lot of flexible friends. But they let her down badly.
"I got offered my first card when I was 18," she explains. "It was an Abbey National Visa Platinum. The credit limit was £4,000. I had reached that within a few months and saw an ad for a Mint card offering a zero per cent balance transfer. I took the offer and for the next few years I balance-transferred so many times that I ran out of companies to use."
Within two years, Gemma had incurred £14,000 of debt. The money went on clothes, holidays, meals, and luxuries.
"I realised I was in financial difficulty when the bills started to come through and I struggled to make the minimum payments. I started to feel ill about it and realised I needed help. I got into that mess because I just didn't get it. I didn't get what money was about, I didn't understand it."
Gemma's story is emblematic of a generation that only knows consumption through the prism of plastic, where the relationship between purchase and funds is disjointed.

This September marks the 50th anniversary of a financial transformation which enabled Gemma's spending spree. Plastic arrived in the UK in the form of the American Express charge card. It kick-started a revolution and made money and credit more accessible than ever. Initially, AmEx was accepted by just 3,000 hotels, restaurants, shops and car-hire companies in the UK and applicants needed an income of £2,000 a year to qualify for one and were charged a £3, 12 shillings annual fee. The maximum payment for any single transaction was £75 and balances were required to be paid in full each month.

Internationally, charge and credit cards were nothing new. They had been around in the US since the 1920s when individual firms began issuing them to customers. Diners Club and American Express cards specifically targeted travelling businessmen and boasted the USP of convenience. The entry-level American Express green card was even printed to look like money, implying instantly available funds.

But as other cards came on to the market – Mastercard, Barclaycard and Access in the UK – they also became status symbols. Depending on credit rating and income, card companies issued different levels of product. In the Eighties, nothing said you'd made it like an AmEx Gold. In contrast, today the minimum requirement for one is an annual household income of £20,000; less than the national average wage.
By 1972, the year Access was launched, another financial milestone tightened the plastic grip on the population's bank accounts. Lloyds introduced the world's first computerised cash machine in Brentwood, Essex. Developed by IBM, it was linked to a central computerised accounting system that recognised transactions by reading magnetic strips on the back of plastic cards. Initially the system was rolled out to 500 locations at a cost of £3.5million.
The plastic movement reached another benchmark just under 25 years ago when Barclays Bank introduced thef UK's first debit card; the Connect card, which was followed a year later by Natwest, RBS and Midland's Switch. Plastic had begun to change the mechanics of how we purchased goods. People used cards to pay for smaller and smaller items. This disjoint between physical money and the act of purchase became even wider 10 years ago with the introduction of chip and pin, which meant that consumers no longer had to sign for their purchases. The nature of personal finance and domestic accounting had changed irrevocably. Money had lost its physical relevance, it had become abstract.
Today it is hard to imagine how any of us could function without plastic. In the UK, there are 47 million debit card holders and 30 million credit and chargecard holders. Globally, around six billion non-biodegradable cards are produced each year.
Our psychological and economic relationship with our cards is complex. While some believe that, like Gemma, they allow us to spend beyond our means too easily and subsequently damage the economy, others argue that they lubricate commerce. The recession has made many more wary of the dangers of spending on plastic with reports that coins and notes are staging an unexpected comeback. Just over half of all purchases in the UK are made with cash and the long-term trend of decreasing annual cash payments stalled last year when Britons handed over £0.2bn more notes and coins than they did in 2011. Nevertheless, in April this year, £43.6bn was still spent on plastic through 883 million purchases.
As UK Card Association chair Melanie Johnson explains: "The card-payments industry has a great story to tell when it comes to its contribution to economic growth. The most prominent contribution made by the industry to GDP is through the role played by online commerce, which accounted for 43 per cent of the UK internet economy as a whole during 2011, bringing in £76 billion, with the card payments industry acting as the great enabler of e-commerce."
Despite the changes plastic has made to the way we conduct transactions, few rigorous studies have been done to ascertain the impact the medium has had on our spending habits. Generally, figures show that plastic encourages consumers to spend more, especially credit cards. When McDonald's started allowing credit card purchases in the US, the average spend rose from $4.50 to $7. This effect is contrary to standard economic theory which says that essentially people make rational financial decisions based on cost and that the medium of payment should not influence this. There are, however, several theories about why we spend more on plastic from the relatively new field of behavioural finance and economic psychology.
One simple idea is that parting with physical money is a more concrete action than inserting a card in a machine. With cash you get instant feedback on how much you have spent and how much you have left. The transaction feels more real. The act of punching in a pin as a promise to pay for something at a later date is, on the other hand, intangible.
Professor Rob Ranyard, an economic psychology specialist at Bolton University, has studied financial decision making. He argues that, according to the denomination effect theory, we all mentally compartmentalise different aspects of our economic worlds into areas such as current assets, future income and current income. We link money that we hold to these different mental accounts. For example, we are more likely to spend smaller denominations on everyday items but link larger notes to savings. The extent to which we spend from these accounts and are influenced by the medium we use to make transactions from them varies according to where we fall on the wonderfully titled spendthrift/tightwad scale; a tool used by behaviourists to analyse a subject's likely spending habits.
As Prof Ranyard explains: "We are inclined to spend from these compartments in different degrees depending on the budget constraints we place on them. Hypothetically it could be that money withdrawn from the hole-in-the-wall is assigned to your everyday expenses and so has a low budget constraint. But one hypothesis is that because the plastic is linked to the bank accounts you have, it has a higher constraint. Which is the opposite to what you might expect, that the plastic makes it easier to spend. Some people organise their finances quite strongly and others don't. People will vary and what the denomination effect has found is that people will be affected by the medium but to different degrees. I would theorise that it is the tightwads that are affected more by the medium than the spendthrifts."
When cards were introduced, there was little in the way of theory to suggest how they would influence spending behaviour. It wasn't until the late Nineties that psychologists and economists started to discover patterns and that financial decision making included many influences, including emotions.
One of the few studies on the subject was published 10 years ago by research consultancy Decision Technology and written by Greg Davies, a visionary financial behaviourist who founded and now heads the Behavioural Finance department at Barclays Bank.
His 2003 paper, The Realities of Spending, looked at models of spending behaviour and how they were influenced by means of payment.
It began: "It has been known for some time that the specific payment mechanism used by consumers has a significant effect on spending behaviour. This seems particularly true of credit cards; customers using credit cards spend more than those paying by cash and cheque in spending situations that are otherwise identical."
The paper identified several theories which could explain why people appear to make irrational decisions when spending with plastic.
For example, psychophysics suggests that people perceive an expense as far larger when it is on its own rather than when it is grouped into a bigger payment; as in the case of credit card bills which accumulate spending over time. Another theory – coupling – refers to the degree which consumption and payment are bound together. The more purchase and payment can be psychologically 'decoupled', the better the overall assessment of the transaction. By this theory, cards work by reducing the pain of payment in a number of ways; credit cards increase the period between purchase and payment and group purchases together, and together with debit cards, they lower the salience and vividness of the payment.
Five years before the financial meltdown, Davies' work warned of overspending and offered solutions to curb people's propensity to rely on credit.
He wrote: "An understanding of the psychology may assist in designing product features that reduce overspending, and thus limit both adverse selection and the risk inherent in offering credit to those with low levels of financial self-control."
His recommendations included designing credit card slips which increase salience by requiring the purchaser to write the amount on them, emphasising the remaining credit at each transaction, sending alerts to customers as they near their credit limit and redesigning statements to group similar items together, therefore increasing coupling. Several have been adopted over the years.
"The advent of the financial crisis has led more people to accept that it is important to understand psychology and emotions. We really cannot understand financial behaviour without some insight into human psychology," he says.
He believes that plastic can be used to help us control our financial decisions.
"A comfortable financial future for most depends on how much you save, spend or put in your pension, and on that level the effect of the payment mechanisms you use does become salient. It does change the psychology of the decision. Everyone is influenced by the medium. People on the spendthrift side of the scale probably want to exert more control over their spending and it could be beneficial to develop ways of increasing coupling for them, such as providing them with a credit card that can only be used if the purchase amount is typed in on every occasion."
The new generation of plastic cards being rolled out in the UK now is the NFC (Near Field Communication) contactless system. These are cards you wave across the front of a reader and which require no PIN number. They even come in smaller, adhesive form so you can stick them to back of your mobile phone. This system, along with software that allows people to pay for purchases directly on their smartphones will decouple purchase and payment even more.
Davies believes, however, that financial service providers can use behavioural finance to mitigate some of the excessive spending this trend towards decoupling may encourage.
"You can start to get at situations where the financial services and products you provide are genuinely tailored to the individuals in a way that enables the individual to make better decisions."
If this brave new world of cards based on personality type and spending habits comes about, plastic may just be the saviour, rather than the sinner.
"This stuff can help people," says Davies. " If you help people make better decisions, they will be better off, and if you do that for a large enough number of people, society will be better off."

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