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Credit card rewards paid for much of our trip to Hawaii recently. Maybe I should feel guilty about that.

Recent research indicates that credit cards contribute to inflation and may impose unfair costs on people who don't use plastic. Everybody pays more, in other words, so that some of us can snorkel at Molokini.

The idea that credit cards may cause inflation is not really new, but it gets quite an academic airing in a paper by John Geanakoplos of Yale University and Pradeep K. Dubey of New York state's Stony Brook University. (If you like theorems, you can geek out to your heart's content by downloading the paper here.)

Boiled down to its essence, the paper argues that:

  • Credit cards increase the money supply, because consumers can spend more than the cash they have on hand.
  • More money chasing the same amount of goods leads to inflation as merchants raise prices in the face of higher demand.
  • Can we stuff the cat back in the bag? No. Credit cards are clearly here to stay, and trying to offset the inflation they create by reducing the money supply elsewhere would cause bigger problems, the researchers conclude, including slower economic growth.

    Image: Liz Pulliam Weston

    Liz Pulliam Weston

Which, as we all know, we don't really need right now.

The biggest issue

It may be easiest to do something about interchange fees, which merchants pay in order to accept credit cards.

Retailers complain that rising "swipe" fees are leading to higher prices for consumers. A November 2009 report [[linknew=November 2009 report http://www.gao.gov/products/GAO-10-45]] from the U.S. Government Accountability Office confirmed that the fees are increasing costs for merchants and that consumers may be paying higher prices as a result.

The GAO report found that not only had the fees generally risen but that the fee structure had gotten way more complex. MasterCard, for example, had just four interchange fee categories in 1991, ranging from 1.3% to 2.08%; 18 years later, it had 243 categories in a range from 0.9% to 3.25%. Retailers say the proliferation of categories at different rates makes it tough to keep track of how much they're being charged.

 
A cut of every purchase
 VisaMasterCard
Number of interchange rate categories in 199144
Number of interchange rate categories in 200960243
Range of interchange rates in 19911.25% to 1.91%1.3% to 2.08%
Range of interchange rates in 20090.95% to 2.95%0.90% to 3.25%
Percentage of rates that increased43%45%
Percentage of rates that stayed the same45%45%
Percentage of rates that decreased12%10%
Source: U.S. Government Accountability Office

Bear in mind that retailers' profit margins are only a fraction of purchase prices. While a 1% rise in fees sounds infinitesimal, it can represent a substantial portion of the profit on some goods.

Merchants don't pay the fees directly, by the way. Banks that issue credit cards take a cut of the transactions they process and so, to a lesser extent, do banks that serve the merchants.

The GAO has a nice little graphic depicting how this works. A customer charges a $100 purchase to her card. The merchant submits the transaction to the credit card network, which passes it along to the bank that issued the customer's credit card. That issuing bank takes a $1.70 interchange fee for itself out of the $100 and submits a $98.30 payment to the merchant's bank. The merchant's bank takes a 50-cent processing fee for itself, and forwards the remaining $97.80 to the merchant.

Your rewards come right off the top

The fees range from about 1% to about 3%, with merchants paying more if:

  • A rewards or business credit card is used.
  • The card isn't physically present (as in online transactions).
  • The merchant's volume of transactions is low (a mom-and-pop outfit pays a higher percentage than, say, Wal-Mart).
  • The card number is manually typed into a card terminal, rather than swiped.
  • They aren't getting a special deal. Outlets that haven't traditionally accepted credit cards, such as utilities, may get a lower rate as an incentive to start saying yes to plastic.

Merchants get lots of benefits from accepting cards, of course, including increased sales, faster processing (payment comes in one to two days instead of the five days a check typically takes to clear) and lower labor costs (credit card transactions are typically faster to process than other payment types and sometimes allow for easier self-service, such as at gas stations).

But retailers say the rising cost of accepting cards is offsetting the benefits.

"For example, staff from one large retail chain told us that for a $100 transaction, a credit card payment generally cost the company about 14 times as much to accept as cash," the GAO report said. "Other merchants reported that transaction costs for credit cards were two to four times more than their transaction costs for cash."

Rewards cards are a particular concern. People who use rewards cards tend to spend more than those who use standard cards or other payment methods, the GAO said, and retailers question whether those increased sales are worth the higher interchange fees the rewards cards command.

"Staff from (large retail chains) all expressed concerns that the increasing use of rewards cards was increasing merchants' costs without providing commensurate benefits," the report said.

A raw deal for retailers?

Retailers say they have little wiggle room to negotiate these charges because their merchant agreements with the credit card networks tie their hands. Under those agreements, they must accept all types of plastic if they accept one. (If they accept credit cards, they must accept debit, and vice versa. Plus they can't discriminate against high-cost rewards or business cards.) They can't impose surcharges for credit cards or steer customers to cheaper payment methods.

Other countries have dealt with rising interchange fees by changing the agreements the card networks have with banks and merchants. Among them:

  • Limiting or capping interchange fees.
  • Allowing merchants to impose a surcharge for accepting cards.
  • Allowing retailers to accept only debit or credit cards instead of requiring them to take both.
  • Letting merchants steer customers to lower-cost payment methods.

Congress has begun to tackle at least some of these concerns. The Dodd-Frank financial reform measure that became law in July 2010 gives the Federal Reserve increased regulatory authority over debit-card swipe fees and aims to limit anticompetitive practices in handling card transactions.

The legislation could also be the beginning of the end for truly great credit card rewards. Anything that lowers revenue from interchange fees could result in such cutbacks. From the consumer's side, using rewards cards might become harder to justify if you lose a discount that could offset the value of the rewards.

Of course, we all know there is no such thing as a free lunch, and the deals that come close don't last forever.

Here's one example. For a few years, many people used a credit card arbitrage scheme to make easy profits. They used fee-free, 0% balance-transfer offers to write themselves checks that they then deposited in savings accounts earning 3% to 5%. One message-board poster claimed to have borrowed a whopping $250,000 that way, which generated interest income of more than $1,000 a month.

Those deals are long gone. You're lucky to get much above 1% on a savings account now, and card issuers have raised fees and rates on balance-transfer offers.

The same thing may well happen with rewards credit cards. A good thing may have become too good to last. So if you have rewards cards, use those rewards while you still have them.

Liz Weston is the Web's most-read personal-finance writer. She is the author of several books, most recently "The 10 Commandments of Money: Survive and Thrive in the New Economy" (find it on Bing). Weston's award-winning columns appear every Monday and Thursday, exclusively on MSN Money. Join the conversation and send in your financial questions on Liz Weston's Facebook fan page.