The WSJ implies that the answer is yes in an interesting article describing the Obama administration’s changing views on behavioral economics and regulation.  The theme of the article is that the Obama administration has eschewed the “soft paternalism” based “nudge” approach endorsed by the behavioral economics crowd and that received so much attention in the blogs — especially as it related to Cass Sunstein’s appointment to OIRA, the Consumer Financial Protection Agency and a few other issues — in favor of harder paternalism and “shoves” including recent proposals for “regulating health-insurance rate increases, separating commercial banking from investing on behalf of their own bottom lines, and prohibiting commercial banks from owning or investing in private-equity firms or hedge funds.”  The article also points to a proposal for new regulations (that I had not heard of prior), that “would require retirement counselors to base their advice on computer models that have been certified as independent” as a precondition that must be satisfied before advisers can push funds with which they are affiliated.

A few observations.

First, is anybody really shocked to see behavioral economics-based proposals give way to harder forms of paternalism?  Though I take Rizzo and Whitman to be focusing on a different slope towards old paternalism, the idea that the behavioral economics nudge approaches reveal policy preferences consistent with hard paternalism is one that has been discussed frequently in this context.  Perhaps the surprising thing is how quickly the shift has occurred?

Second, given the buzz around behavioral economics in antitrust, and especially the misguided notion that the financial crisis has taught us that the baseline assumption for antitrust analysis should that firms are irrational, I was pleased to see Peter Orszag recognizing that “Institutional decision-making is much closer to a rational economics than individual decision-making, no question.”

Third, and cutting to the chase a little bit, its unclear to me that the Administration was ever really interested in behavioral economics as an intellectual guiding force as a “new” approach to regulation.  For example, little attention has been paid to areas where behavioral economics implies less regulation.  Regulators of all sorts want intellectual support for what they are doing.  That is not a criticism.  But was there really ever anything there?  Has anybody seen anything that has come out of OIRA with the signature of behavioral economics?  On this score, TOTM readers may recall that, since early on, I have expressed skepticism about claims that the Obama administration had made any real commitments to behavioral economics:

The second issue is that I’m not convinced that Obama’s policies have much to do with a behavioral economics-based platform. Leonhardt raises Obama’s savings plan (opt-out 401(k)’s), broad based tax cuts for the middle class, and opposition to a health care “mandate” as examples of policies informed by behavioral economics. I understand the the connection between the 401k default policy and behavioral economics. But the second two examples don’t strike me as have much do with with the insights of behavioral economics per se. The link between tax cuts and the lessons of behavioral economics, in this context, is tenuous at best. And as Ezra Klein notes while taking the position that he doesn’t see much behavioral economics in Obama’s positions either, one might suspect that a health care mandate would be more in line with the teachings of behavioral economics rather than Obama’s plan.

Fourth, and finally, I can’t help but note that some agreement on what counts as a behavioral economics-informed policy choice might be helpful in order to make progress.  I’ve been fairly critical of those, especially in the law review literature, who invoke the terms like irrationality and endowment effect willy-nilly, wave their hands around quickly while saying something about market failure (usually this section of the paper also has the term “orthodox neoclassical theory” in it somewhere), and move on to discuss regulatory proposals on the assumption that they will be costless.   But if we are going to be keeping a scorecard here, we should at least agree on what counts as a nudge.  The WSJ shares an example that it says is consistent with what is left of the Administration’s commitment to behavioral economics:

Landlords, for instance, have no incentive to replace a 40-year-old refrigerator if the tenants are paying the utility bills. So the Department of Housing and Urban Development, the Small Business Administration and the Energy Department are looking for ways to give property owners more incentives to save energy, possibly through loan discounts or guarantees offered through mortgage brokers. In October, Mr. Biden unveiled a pilot Property Assessed Clean Energy financing program to try it out.

Wait.  So, the landlord has less than optimal incentives to make investments in refrigerators when the tenant plays the bills because he doesn’t internalize the benefits of the investments.  I hate to be a stickler, but I’m pretty sure standard economics can do this one.   Transacting parties reach agreements to economize on agency costs and incentive conflicts.   The fact that the landlord’s private decision process is different when he owns the refrigerator than when he doesn’t imply irrationality!  Nor is any regulatory shove to get individuals to act closer to the what the regulators think is “optimal” decision-making based on behavioral economics simply by invoking the term.

But if the WSJ is right, maybe this debate about behavioral economics is old news anyway.  Shove is the new nudge and all that.

Over at the International Center for Law and Economics website we’ve posted a link to a pdf e-book version of the collected content (including both posts and comments) from our recent “Interchange Fees and the Law and Economics of Credit Cards” symposium.  Head on over and download a copy if you’re interested in a dead tree version of the symposium.

Jim Van Dyke (who contributed to our interchange symposium) has an interesting post up today recounting a brief glimpse of life without payment cards:

What would a day without payment cards be like? I had a glimpse into that just this morning, when my usual Bay Area morning routine of using my prepaid card to get a cup of Peet’s coffee and then check email and news was changed up by the coffee shop’s downed Internet connection. I was the store’s first customer for their 5:30 am opening, and the two young clerks were visibly nervous because they couldn’t take my merchant’s prepaid card and credit cards had to be processed with an old-school “knuckle-buster” device. From my usual seat in the corner I watched as the barista duo struggled to keep up with even the slightest trickle of customers, and the line of customers quickly backed up until the work crew doubled to four as sleepy-eyed and bed-headed backup workers arrived on the scene following emergency calls for their help. If we eliminated prepaid and credit cards, everything would change for merchants and retail customers. I’ve all but eliminated checks from my daily existence, but until I heard the now-unfamiliar sound of change jingling in my pocket I hadn’t realized how infrequently I use cash.

Now, there may be valid, empirical arguments that for some transactions cash is more efficient (see this post and comments for a brief discussion and for the key academic references).  And, of course, in the situation Jim describes, with time and regularity the burden of cash transactions would surely be reduced (the Second Law of Demand).  But the merchant-driven campaign against payment cards, in full recognition of the reality that making payment cards more expensive for consumers will lead to an increase in the use of cash and checks, is problematic.  For many, in fact, the move to cash is a feature, not a bug.  Suze Orman is (indignantly) leading a “Back to Cash Movement.”  Merchant advocacy groups tout cash and checks as a cheaper choice–for consumers–than credit cards.

But costs like the ones described by Jim in his post are not well-accounted for, as Todd Zywicki discussed in detail in his second interchange symposium post here.  Presumably the merchants who are advocating for greater use of cash in an effort to avoid interchange fees believe that the costs of cash born by merchants are less than interchange fees.  I’m not sure they are right given the costs to retailers of dealing with cash (from theft to accounting to transportation to security to employee time, etc., etc.), but let’s grant that revealed preference carries the debate (assuming the “back to cash” advocates really speak for all retailers . . . which is doubtful).  But what about the costs to consumers and taxpayers?  What about the costs of going to the ATM, maintaining precautionary checking account balances, budgeting without monthly statements, not having a float or access to consumer credit?  What about the huge and growing cost of not being able to engage in online commerce?  And what about the costs of increased tax evasion and enforcement, printing cash, protecting it, and transporting it?  Merchants are extremely critical of the cross-subsidy from cash customers to credit card customers they purport to see in the imposition of credit card interchange fees that raise retail prices for all consumers.  But what about the subsidy ofrom people with high time costs to those with low time costs when the costs of processing cash are imposed on all customers who have to wait in longer lines?

These costs may not be dispositive, but merchants and their advocates pretend like they don’t exist, and without knowing anything systematic about the magnitude or incidence of these (and many other) costs blithely advocate yet another round of government micromanagement of important parts of the economy.

Meanwhile, in the UK, banks are actually moving to eradicate paper checks completely:

There are many more efficient ways of making payments than by paper in the 21st century, and the time is ripe for the economy as a whole to reap the benefits of its replacement.

Gretchen Morgenson doesn’t want poor people to have access to consumer credit. At least, that’s what I think she’s saying in her rambling NYT column this week.

Congress and federal regulators have recently taken a number of actions that will make it tougher for riskier customers to access consumer credit. First there was the Credit Card Accountability Responsibility and Disclosure Act, which precludes issuers from charging fees for services like telephone payments, requires a number of disclosures and advanced warnings, and makes it harder for issuers to raise interest rates and charge over-limit fees. Then there are the new Fed regulations set to go into effect next month. Those rules, which implement the Credit Card Act, preclude credit card issuers from raising interest rates for the ensuing twelve months after an account is opened, and then only on new charges, not on existing balances. By limiting an issuer’s ability to reprice credit based on changes in a customer’s risk profile, the Credit Card Act and Fed rules will make it harder for risky consumers to access consumer credit.

But all these things aren’t enough for Ms. Morgenson. She’s upset that issuers catering to higher-risk consumers are finding other sources of revenue:

An example is Alliance Data Systems, a big issuer of private-label credit cards like those that specialty stores offer. It has decided to levy a $1 monthly surcharge to customers who choose to receive account statements by mail. Proof, yet again, that if you close the door, they will come in through the window. And if you close the window, they blow through the door.

Ms. Morgenson sees Alliance’s $1 charge for assembling, printing, and mailing a paper bill (as opposed to posting the bill on the Internet) as inconsistent with the thrust of the new Fed regulations and the Credit Card Act, and she calls on regulators to “pursue companies flouting the spirit or the letter of the new rules.” Never mind that the small and seemingly justified charge is consistent with the actual terms (as opposed to the amorphous “spirit”) of the new regulations. Never mind also that those new rules have effectively forced Alliance to impose this slight charge if it wants to continue servicing high-risk consumers without raising interest rates. Indeed, Ms. Morgenson recognizes that Alliance caters to riskier customers and is generally compensated via penalty fees rather than higher interest rates:

William Ryan, an analyst at Portales Partners in New York, said the $1 statement fee wasn’t a surprise, given Alliance’s business model. “A disproportionate part of Alliance Data Systems’ yield comes from penalty fees,” he said, “so by default they would be more proportionately impacted by the Credit Card Act than an American Express that caters to higher-end customers.”

Ms. Morgenson thus seems to acknowledge that if the law is enforced as she’d prefer an issuer like Alliance must either charge higher interest rates or up-front service fees, cater exclusively to higher-end customers (a la American Express), or shut down. (She might say that Alliance could also just reduce its revenues, but doing so would probably drive its capital elsewhere.) All these options would make it harder for poorer and riskier consumers to access consumer credit.

But that doesn’t bother Ms. Morgenson. She admits that she prefers a paternalistic “nanny state” to “the pirate state that brought this economy to its knees.” I wonder if the high-risk consumers she’s trying to protect share her views?

Economist, co-author, and sometimes TOTM guest David Evans (UCL, University of Chicago School of Law) has an excellent note on “Why Now is Not the Right Time To Revamp Consumer Protection,” based on remarks made at the New York Federal Reserve Board-New York University Conference on Regulating Consumer Financial Products yesterday in New York.  Evans makes some of the points we discuss in our joint work criticizing the intellectual basis for the Consumer Financial Protection Agency, but also offers a concise and powerful case against “revamping” consumer protection too hastily, or without attention to the institutional details or the economic evidence.  Geoff’s post the other day on credit card regulation, for example, points out precisely the types of harmful errors that can be made on “behalf” of consumers when invoking the behavioral economics literature without analyzing it (or the related empirical evidence) closely. Evans makes six essential points — and I’m excerpting here — but I suggest readers check out the whole thing:

First, the Treasury Department proposed a sweeping overhaul of consumer protection for financial services for the wrong reasons. It is widely reported that the Administration pushed consumer financial protection legislation because they thought it would be the “locomotive that would drive financial reform.” The idea is that the folks back home couldn’t get why their representatives would be working on obscure things like clearing houses for credit default swaps. But they could connect with plain old consumer protection. Hey, who wouldn’t want to be protected? Since we’re not in DC perhaps I won’t be laughed out of the room for saying this is pretty cynical.

Second, Treasury wrapped consumer protection in the flag of the financial crisis. Yet there is no credible evidence that failures in the current system were a significant factor in causing the financial crisis. Many of the consumer protection problems that people point to are mainly the result of our collective delusion—the madness of the crowds—that housing prices would go up forever. There are numerous accounts of the causes of the financial crisis from varying ideological perspectives. Not one of them that I know of blames the financial crisis on failed consumer protection.

Third, instead of being the locomotive for financial reform, consumer protection has deflected attention from problems that really were at the heart of the financial crisis. Remarkably, the Administration proposed no significant reforms of Fannie and Freddie. The Administration came forward with nothing on dealing with the credit rating agencies. There’s widespread support among economists for introducing competition into that business… .

Fourth, the Treasury Department and Congress have proposed this sweeping overhaul of the lending industry at just about the worst possible time. A massive credit crunch is holding back the economy. New businesses that drive most of the job growth in the economy can’t get loans. Small businesses have had their credit lines slashed. Consumers who need to borrow money can’t. Now is the time to focus on policies to encourage lending. It is not the time to impose a new layer of regulations and costs that will make it more expensive and legally risky for financial institutions to lend money to people and businesses who want to borrow it….

Fifth, instead of dealing with financial reform and getting ourselves out of the economic crisis it looks like a lot of energy is going to be spent on the CFPA bill. So let’s talk about the merits of the proposals. The CFPA is the brainchild of several law professors including Professor Warren who spoke at lunchtime. If you look at the articles that they have written you will see that the proposed CFPA is based on three propositions …. .

Here’s my sixth and final point. If we are going to have a single consumer financial protection agency I would give it to the Federal Trade Commission. They are a well run government agency, have significant expertise in consumer protection, and have first-rate economists….

On the reliance on behavioral law and economics providing the intellectual foundation for the CFPA, Evans notes:

I’m a fan of behavioral economics. However, much of the work that proponents of the CFPA rely on is based on studies that find that consumers are shortsighted in a particular technical sense known as hyperbolic discounting. Recent work has found that those studies confused shortsightedness with risk aversion. People act in ways that seem impulsive and shortsighted mainly, it seems, because bird in hand is better than two in bush. As a result I don’t believe we have a sound basis at least at this time for moving from regulations that are based on market failures in the provision of information (the intellectual basis for the current system) to market failures based on people making systematically stupid or shortsighted decisions (the intellectual basis for the new regime). The behavioral economics field has produced a rich and interesting theoretical and empirical literature. One should exercise caution, however, in unleashing these “new products” on the American consumer before they are more fully tested and vetted.

And consider the following fun anecdotal account of precisely the problems with authorizing (or requiring) a federal agency to design credit card products on the assumption that regulators are better situated than consumers to make these decisions:

Professor Warren’s lunchtime discussion of her venture into developing a new credit card deserves some mention here. As I understood it she and her colleagues had developed a “clean card”—one that did not have any fees besides an annual fee an APR—and at least got some banks excited about considering it. They soon learned that banks couldn’t introduce the card profitably. She also mentioned that Citi had introduced a more “consumer friendly” card and gotten a lot of great PR out of it. They eventually pulled it from the market because few consumers wanted it. So Professor Warren sees a problem. Banks can’t make money from a “good card” (I think that her explanation is that one bank can’t unless others also offer it) and consumers won’t take a “good card” (I think the story her goes back to our mental deficiencies). So regulation is needed. I find this very worrisome. I don’t believe that even extremely smart and well-intentioned people such as Professor Warren should be put in the position of telling—or prodding—businesses to offer products they don’t want to offer to consumers who don’t want to take them. The CFPA Act put forward by the Administration was set up to do just that.

If you are looking for a short and concise statement of the case against the consumer protection revolution, this is it.

Our friend and University of Chicago law professor, Omri Ben-Shahar, fresh off a run participating in our credit card interchange fee symposium, has penned a guest post following up on our ongoing discussion of annual fees:

There is no annual fee for shopping at Wal-Mart, but there is an annual fee for shopping at Sam’s Club. Is there a consumer protection problem here?

Some people think that credit card issuers are acting badly by not charging annual fees, thus luring consumers into services that involve back end costs. By this logic, should retail stores like Wal-Mart be condemned for NOT charging annual membership fees, luring customers in, and making profit at check out lines? In fact, some stores probably charge a “negative” fee.  High-end retailers (Whole Foods, Neiman Marcus) provide a pleasant shopping experience and free samples. Low-end retailers distribute discount cards. They all charge these negative “membership fees” because they surely make up for it at the cashier. Should these retail techniques be regulated to protect consumers?

I find it puzzling why some retailers and service providers charge annual membership fees and others don’t. Why, for example, do wholesale clubs like Costco and Sam’s Club charge memberships while retail department stores do not? I am sure there is much to be learned from finding the answer to this puzzle, but I don’t think it has anything to do with consumer protection. Consumers are doing quite well in either format, and if there are problems of deception they are independent of the annual fee dimension.

Adam Levitin has a blog post up responding to Todd Zywicki’s recent WSJ editorial on credit card interchange fees.  As most readers know, this is a topic of significant interest around here, and Josh blogged about Todd’s op-ed just yesterday.  I’m on vacation so I’ll be brief, but I thought Adam’s post was so wrong it necessitated my getting off the beach for a reply.  Adam writes:

Todd is right that consumers are happy to see annual fees go away, but the disappearance of annual fees wasn’t a freebie for consumers.  It came about as part of a shift in the credit card business model whereby upfront fees were replaced with backend fees that have lesser salience to consumers when the consumers decide which cards to carry and use.  This was a move that was made to increase revenue for card issuers (or put another way, to siphon off more consumer surplus); it was not a charitable act.  The disappearance of annual fees is an important innovation, but I think it is a stretch to call it a pro-consumer innovation, when it is viewed contextually.

The disappearance of annual fees was a step in the democratization of credit (or put another way, the decline in underwriting standards).  Whether this was a good thing is unclear.  It certainly increased consumer’s borrowing ability and choices, and might have led to a substitution from secured installment credit to unsecured revolving credit.  But greater ability to borrow and more borrowing choices are not necessarily good.  They are only good to the extent that a consumer is capable of repaying the increased credit line and making informed choices among credit options.  Both of those are questionable for many consumers.

Adam’s incessant claims that consumers are idiots, fooled time and again by rapacious capitalists, is tiresome.  The behavioral econ/behavioral law and econ literature just doesn’t support these strong claims.  Yes, there are some interesting theories.  No, there is no empirical proof, and there are plenty of counter-explanations.  There are some experiments that support these claims.  And they have been called in to question (sorry I can’t take the time to link right now, but we’ve discussed the behavioral literature quite a bit on this blog).  Todd’s competition story is the Occam’s Razor argument here and unsupported claims to the contrary should be scoffed at.

The “contextual” reality is that the “backend” fees that have replaced annual fees are born by a small fraction of cardholders and are avoidable, as opposed to unavoidable annual fees born by all cardholders.  These backend fees have likewise been falling in magnitude and incidence over recent years.  And meanwhile, they act to make borrowing more expensive for the helpless people Adam and other self-appointed consumer advocates claim to want to protect from themselves and less expensive for those who don’t “need” Adam’s protection (scare quotes because I’d say no one “needs” Adam’s help).  On Adam’s own terms this should be a feature, not a bug, and it is arguably more efficient, lowering consumer credit costs for everyone.

Adam’s view that these backend fees make credit seem cheap to profligate spenders in a way that annual fees do not is absurd.  Maybe the first time, but I’d have to say that fees imposed directly when repayment is not forthcoming, for example, and showing up on a statement at the very moment they are incurred should have much more “salience” than annual fees imposed once a year with no relationship in time or magnitude to any behavior on the part of consumers.  Meanwhile, there is a whole industry of protectors warning consumers of the dangers of over-extending, and very few daytime talk shows warning of the perils of annual fees.  I’d wager the behavioral fee is much more “salient” than the annual fee.

This is the problem with the behavioral literature on which Adam relies: It is a set of non-rigorous, just-so stories that can be tortured to support any a priori policy view. The bottom line is that credit card markets have seen falling fees, increasing benefits (rental car insurance, airline miles, purchase protection, etc., etc.) and structural changes that respond to consumer preferences.  The just-so story that would turn this into a story of corporations preying on ignorant consumers is insulting and unsupported.

My colleague (and TOTM Credit Card Symposium participant — posts here and here) Todd Zywicki has an excellent op-ed in the Wall Street Journal today on Congressional legislation aimed at regulating interchange fees.  Here’s an excerpt detailing the predictable economic consequences of the legislation:

What would happen if the Merchants Payments Coalition gets its way and politicians squeeze interchange fees? Credit cards are essentially a closed economic system: A reduction in interchange fees will have to be offset by increased revenues elsewhere or a reduction in costs. For example, issuers could try to increase the revenue generated from consumers through higher interest payments, higher penalty fees, or reinstating annual fees.

Card issuers might also reduce the quantity and quality of credit cards by restricting credit availability and cutting back on product innovation or ancillary card benefits. This is exactly what happened when Australian regulators imposed price controls on interchange fees in 2003: Annual fees increased an average of 22% on standard credit cards and annual fees for rewards cards increased by 47%-77%. Card issuers also reduced the generosity of their reward programs by 23%. Innovation, especially in terms of improved security and identity-theft protection, was stalled. Card issuers also increased their efforts to attract higher-risk customers who generate interest and penalty fees to offset lower interchange revenues from lower-risk transactional users.

Todd also exposes the weak “cross-subsidy” objection to interchange (see, e.g., here):

Merchants also contend that the current regime forces cash purchasers to subsidize credit card users through higher prices. But federal law expressly permits merchants to give cash discounts (and some do). Moreover, cross-subsidies are ubiquitous in the economy. Newspaper advertisers subsidize readers, and Starbucks’ customers who drink their coffee black subsidize those who use cream and sugar. Consumers who pay full price subsidize those who buy the same product on sale, and free parking benefits drivers but not bus riders.

There is no free lunch for interchange fees or anywhere else. But if groups like the Merchants Payments Coalition have their way, consumers may soon find their lunch more expensive if they pay with a credit card.

Readers interested in this topic can check out the posts from our credit card symposium conveniently collected here.

Thanks to all of our participants and readers for the blog symposium–both the posts and the comments were engaging and thoughtful, and I hope these entries will be helpful in the ongoing debate over credit cards and interchange fees.

A concluding point or two:

Credit card networks are incredibly complex, and no one fully understands the full consequences of tinkering with these markets.  The best empirical evidence we have is difficult to interpret, and the broad interactions among the parts of the credit card system, between cards and other payment systems, and in the macro-economy more generally are simply unknown:  Richard’s do no harm principle seems like the strongest conclusion in this debate.

At worst, theory and empirical evidence suggest that lowering interchange fees does nothing to help consumers, and in fact harms them by raising annual fees and thus again by limiting competition among cards at the point of sale.  Perhaps there is some policy reason why we would want to help merchants at the expense of consumers, but the issue, often framed as merchants and consumers against banks and card networks, really seems to be merchants against consumers.  At best, we have no idea what the full social implications of capping interchange fees would be–but there is still a conflict between merchant and consumer interests, and we should be wary.

As I read the comments and posts in this debate, essentially all of us agree that, at minimum, there is a potential for consumer harm from government intervention in these markets.  Certainly all of us engaged in this discussion–even those with a more “pro-regulatory” bent–are far more circumspect about the prospects for positive social welfare effects and effects on consumers in particular than are the proponents of regulation.  I do wish our system limited the political salience of regulatory initiatives unsupported by evidence–the burden should be on the proponents of intervention to demonstrate affirmatively that regulation will likely have net positive effect.  Here, this is simply not the case.

As is so often the case, Richard has the last word:

The clear upshot is that it is difficult through informed speculation to identify all the collateral consequences of running a credit card system, both positive and negative.  The only sure piece of data that we have is that credit transactions have done far better than cash and checks, even if they are losing ground to the next generation of payment systems that rely on cell phones and other technologies that are untied to the now ubiquitous magnetic strip.  These dynamic changes could easily force down interchange prices without the need for administrative proceedings.

The hard institutional question therefore is why concentrate major reforms on the interchange fees when all these other components must be added into the mix.  On this question, priors really matter. And after reading the assembled posts, my own view is that technological innovation is a far more important driver of improvements than partial fine-tuning of the current system, whatever its flaws.

In one sense, therefore, we, the members of this blog-fest, may well be part of the problem.  By putting one part of a complex payment industry under a microscope we divert resources from cost reduction measures that have unambiguously positive effects.  How large a cost is this?  Frankly, no one knows.  But given the risks of error in implementation, the best response still seems to be, play for the next big breakthrough, and in the short run, leave well enough alone.

Thanks once again to all of our great participants, and to our readers.  The full set of posts and comments from the symposium are available by clicking on the “credit card symposium” link on the right side of the TOTM page.

I have now had a chance to review the excellent posts on the second day, all of which have a common flavor.  They expand the universe of relative considerations that need to be taken into account to decide whether imposing caps on interchange fees enhances or reduces overall social welfare.  The narrow perspective on this issue, which is difficult enough, is to master the dynamics of two-sided markets to figure out where the fixed costs of running the overall system should be allocated.

That model assumes that the credit card business operates in isolation from all other payment systems present and future.  Its effort is to run an efficient allocation of costs in the face of the famous marginal cost controversy that dates back to the 1940s.  Unless there is some outside subsidy all relevant players cannot be allowed to pay only marginal cost.  Yet to put in the subsidy is to create a tax distortion in some unrelated market whose welfare consequences are virtually impossible to track, given the difficulty that arises in discovery of the incidence of the tax as it works its way through the economy.  We are therefore necessarily in the world of second-best even on the simplest possible analysis.

Unfortunately, that simple analysis leaves a lot out of the equation.  One key issue is the competition that credit cards have with noncredit card systems, each of which may have built in distortions of their own.  We know that the United States has to print and police the use of cash. We also know that it can disappear from company coffers into the hands of dishonest employees.  It can be lost.  It can be stolen.  It can get waterlogged.  It can be deposited in the wrong account by accident.  Credit cards reduce these costs, and they do so arguably in a more efficient form than the use of checks, which of course clear at par, which means that the cost of interchange is borne by general tax revenues, with the usual set of static distortions. It also creates dynamic distortions because the want of price signals between the players makes it harder to introduce innovation into that space on such critical matters as error control, even if it would result in higher level of reliability in transactions.

In addition, it is also important to consider the other benefits that can arise with the use of credit card payments, one of which is the ability to key in all relevant data from a transaction at once.  Quite simply it may well be easier to link in inventory control, for example,  with a credit card system than it is with a cash or checking system. And it may speed up the rate of transactions so as to reduce the length of queues that are so important in many retail operations.

The clear upshot is that it is difficult through informed speculation to identify all the collateral consequences of running a credit card system, both positive and negative.  The only sure piece of data that we have is that credit transactions have done far better than cash and checks, even if they are losing ground to the next generation of payment systems that rely on cell phones and other technologies that are untied to the now ubiquitous magnetic strip.  These dynamic changes could easily force down interchange prices without the need for administrative proceedings.

The hard institutional question therefore is why concentrate major reforms on the interchange fees when all these other components must be added into the mix.  On this question, priors really matter. And after reading the assembled posts, my own view is that technological innovation is a far more important driver of improvements than partial fine-tuning of the current system, whatever its flaws.

In one sense, therefore, we, the members of this blog-fest, may well be part of the problem.  By putting one part of a complex payment industry under a microscope we divert resources from cost reduction measures that have unambiguously positive effects.  How large a cost is this?  Frankly, no one knows.  But given the risks of error in implementation, the best response still seems to be, play for the next big breakthrough, and in the short run, leave well enough alone.

In my first post I discussed the potential for interchange legislation from a consumer protection perspective, that is, would the combination of disclosure requirements coupled with a reduction of interchange fees be likely to improve consumer welfare.   I concluded that from the consumer protection perspective, the case for interchange legislation was weak.  I noted that a highly likely consequence of a direct or indirect reduction in interchange would result in an increase in the cost of credit to consumers (higher finance charges, other fees, annual fees) or a reduction of consumer benefits (loyalty and rewards programs).  The significant risk of a reduction of consumer access to credit, especially given the tenuous state of the economic recovery and the critical role of consumer spending in generating economic expansion and jobs, imposes a significant risk of consumer and social losses without strong evidence of offsetting consumer protection value.  However, consumer protection is not the only possible defense of such legislation.  This post will focus on defense of interchange legislation from a competition policy perspective.

As the commentators in this symposium suggest, as does the long and storied antitrust history of Visa and MasterCard, the more conventional story is that interchange fees are the product of a market power and the lack of competition between payment card systems.   Much of the discussion here has followed that general framework and focuses on the “cross-subsidy” question and the role of interchange legislation in increasing efficiency by reducing “usage” externalities.   The essence of this argument is that interchange fees should be regulated or eliminated in order to avoid cross-subsidization of payment card users by those using cash or checks (but see Ron Mann’s post here, focusing on the subsidy running from high interchange credit products to low interchange debit transactions).  So far, the symposium contributors have been largely skeptical of this defense.  For example, my colleague Todd Zywicki notes;

So it may be theoretically possible to imagine that credit cards are overused as a transaction medium.  On the other hand, it may also be possible that consumers underuse electronic payments because they don’t consider the social benefits of electronic payments, such as increasing efficiency, tax compliance, reduced risk of theft (and the police force and judicial system that accompany that)—in which case, it is possible that credit cards should be subsidized, not taxed.  Finally, it seems at least as plausible (probably more so) that consumers overuse cash and checks because those payment systems are subsidized by the government or that some of their costs are externalized, thus consumers don’t pay their full price.

Tom Brown and Tim Muris argue that the objection to cross-subsidies is overdone, emphasizing the ubiquity of such cross-subsidies and noting that the shift toward electronic payments render this objection largely moot:

At the outset, we note that discount fees, unlike interchange, are a feature of virtually all private payment instruments.  Thus, if there is something to the notion that discount fees tax other forms of payment, then the criticism applies as much to American Express and Discover as it does to MasterCard and Visa.  In our view, however, although this criticism is oft repeated, repetition obscures a number of problems.

First, cross-subsidies are ubiquitous in any complex economy.  Consumers receive free refills on drinks in restaurants, free parking at shopping malls, goods below cost in supermarkets (via loss leaders), relatively inexpensive newspapers because advertisers pay most of the costs, and many similar benefits.  To bring buyers and sellers together through such intermediaries as newspapers, supermarkets, and credit cards, one side frequently receives inducements to participate.  These inducements help maximize the joint value of the ultimate transaction for the parties.  Rather than an inefficient “subsidy,” these inducements are the lubricant necessary to make the economic machine work at its best.

I agree with these commentators that the cross-subsidy “problem” does not warrant a regulatory fix.  But I have a slightly different, and more antitrust-centric perspective.  Brown and Muris note the ubiquity of cross-subsidies in restaurants, supermarkets, and shopping malls.  These are just examples.  Cross-subsidization would occur not only in these settings, and in settings where firms do not plausibly have market power, but would also occur in closed-loop systems that do not use interchange fees, suggesting that this criticism has more to do with the necessity of balancing in two-sided markets rather than interchange per se.  But the important point from an antitrust perspective is that cross-subsidization is a normal and healthy part of the competitive process that generates substantial benefits for consumers.  The normal competitive process frequently does not result in customers being charged for all of the costs associated with their purchases.  Consumers face such cross-subsidies every time they go to Starbucks for their caffeine fix or an all you can eat buffet.  Some consumers are very sensitive to which products are allocated to the eye level shelf space in the grocery store, while others will purchase their favorite product regardless of where it is put on the shelf.   The very idea of promotion is to target what amount to effective discounts at marginal consumers rather than the infra-marginal ones.  See generally, Benjamin Klein, Kevin Murphy, Andres Lerner and Lacey Plache, Competition in Two Sided Markets: The Antitrust Economics of Payment Card Interchange Fees, 73 Antitrust L.J. 571 (2005).

Understanding the nature of promotion, and therefore cross-subsidization, as a part of the normal competitive process offers a new perspective on the potential for interchange legislation as an antitrust remedy.  Competition in highly competitive markets, such as grocery retail, results in supermarkets competing by offering various promotional services to marginal consumers.  Sometimes this competition results in free parking that some consumers use but others pay for, sometimes it results in dimensions of non-price competition (like offering a deli or keeping the store clean) that some consumers value more than others.  Competition between supermarkets to shift sales from these marginal consumers generate largely inter-retailer effects, but that cannot be said to be “inefficient” in any meaningful way.  This form of competition is essential to the competitive process.  Consider the interchange legislation in this light.  Do we, in response to supermarket competition resulting in “usage externalities” call for legislation that would allow the supermarkets to collude?  Of course not.  From a competition perspective, the very idea of replicating the collusive outcome for merchants and allowing a coordinated reduction in competition on the grounds that it would reduce cross-subsidies or costs wouldn’t make economic sense.  But notice that collusion between supermarkets to refuse to offer free parking, clean stores, or other promotional services would surely reduce the costs to the retailers in the same way that interchange would result in a reduction of costs to the merchants.

One possible explanation of our tolerance of these arguments is a failure to understand that, like in the case of supermarkets, competition between merchants on the acceptance of payment cards is a normal part of the competitive process.  But there is another possible and more plausible argument: countervailing power.  In other words, one could argue that legislation to allow collective monopsony conduct is appropriate to offset monopoly power (see, e.g., Steve Salop’s recent guest post here at TOTM on this issue in a different context).  Whether or not this justification is persuasive depends on the degree to which payment system market power explains interchange fees.  As it turns out, there is not compelling evidence that this is the case.  For example, consider that regulation reducing the interchange fees for open loop systems (and reducing their ability to balance both sides of the market) results in a shift of total credit purchase volume toward closed loop systems.  The loss in share that MC and Visa experienced in reaction to the Australian regulation suggests that interchange levels were not supra-competitive before the regulation.  Further, as Klein et al (2005) suggest, the time series evidence also casts doubt over the claim that market power explains interchange fee levels since fees were falling from 1977 to 91 while the importance of the payment systems was growing, and that fees remained lower in 2005 than they were in 1971.  In short, interchange fee levels appear to be a poor proxy for market power, and there does not appear to be convincing empirical evidence that market power explains changes in interchange fees.

In the absence of such evidence of a compelling problem, the regulatory “fix” of replicating the collusive outcome for merchants and interfere with the normal competitive process appears to be sure to shift rents between sides of the market, but more importantly, to impose a significant risk of doing more harm than good for the consumers it is purportedly designed to protect.

Most of the discussion related to pricing at the point of sale has emphasized the “cross-subsidy” between those that pay with cash and checks and those that pay with credit cards.  This discussion misses the core of the problem in a market where the use of cash and checks is rapidly declining; the central problem is the differential pricing of different card products.  The reaction of the card networks to their “loss” in the debit-card and American Express litigation was to create two new product lines (Visa Signature and World MasterCard) that have unusually high interchange fees, 1-2% higher than typical Visa and MasterCard products.  The rationale for these products from the network’s perspective is two-fold.  First, the increased interchange revenues compensate for lowered interchange revenues on debit-card transactions.  Second, issuers collect higher interchange revenues and thus would not shift their business out of Visa and MasterCard and toward American Express.

The problem from the merchant’s perspective is that these cards differ in no substantial way from the conventional credit products, except that they cost more.  The same customers that formerly used a typical Visa or MasterCard product now use a high-interchange product.  Although those customers often have multiple cards in their wallet from which to choose, they are likely to choose the high-interchange product because it brings them more rewards.  Merchants that do not believe the products motivate increased spending in their stores have no practical response except to refuse all Visa, or all MasterCard products.  Thus, the networks face no price pressure, because the only competitive pressure they face is to keep issuers from moving to other networks.

If the best way to identify prices is to let the market set them, perhaps the best reform is the simplest: allow merchants to discriminate among the products of the various networks, to surcharge or decline products priced at a level that is unattractive to the individual merchant.  Wal-Mart and Walgreen’s might immediately decline to accept Visa Signature and World MasterCard at their current price.  Their customers, predictably, would make identical purchases but simply pull a different card from their wallet.  Macy’s and Bloomingdale’s probably would continue to accept the high-cost products, worried that customers might spend less or go elsewhere if they can’t use their high-rewards cards.  Visa and MasterCard could judge for themselves whether it would be appropriate to decrease, or increase, the interchange fees for those cards.  The outcome, though, would be price levels determined by the attractiveness of the particular products to particular merchants.

Will reduction in interchange fees help or hurt consumers? Two posts yesterday made the conjecture that a reduction in one category of fees would only increase other fees, and that the overall sum of fees will not change. This is the fee-neutrality claim. Todd Zywicki writes:

The mathematics of the situation is inescapable: card issuers would have to increase the revenue generated from consumers from either interest payments or higher penalty fees.

And Josh Wright agrees:

It would be unwise from a consumer protection policy standpoint to assume that [reduction in interchange fees] represent the free lunch legislators have been looking for after all these years – or that those fees will not simply be reinstated in other guises elsewhere.

As a logical claim, I tend to agree with this “neutrality” conjecture. Indeed, the Australian experience can be explained in a way that is consistent with this dynamic, as Joshua Gans noted:

The interchange fee reduction causes merchant fees to fall but issuer fees to rise (or loyalty schemes to be curtailed) but otherwise does not impact on the consumer’s choice of payment instrument.

The question, though, is what are the implications of fee neutrality. Zywicki and Wright conclude, I believe, that in light of fee neutrality, it is pointless to try to help consumers by capping one component of the overall fee. It will not help, and might introduce an inefficiency.

My claim in this post is that the normative implications are not necessarily as Zywicki and Wright suggest. Fee neutrality, as I understand, applies only to the average cost of using credit cards. That is, consumers who use credit cards end up paying on average the same economic cost, regardless of the division of fees.  But when we consider other measures of consumer welfare, the neutrality claim no longer holds.

First, consumers who use credit cards as payment device and not for borrowing would benefit from the fee substitution. For them, the lower product prices when interchange fees decline are not offset by higher finance charges, because they don’t pay finance charges. So even if the neutrality proposition is correct on average, limits on fees have a distributive effect. This effect could also change the relative uses consumers make. Buying things becomes cheaper, borrowing becomes more expensive, and so we can predict some shift in primary conduct, which, again, violates the neutrality conjecture.

Second, even if for a given consumer the increase in finance and other charges exactly offsets the reduction in interchange fees, it is plausible to expect that a reduction in fees would lead to a reduction in prices of products and change the consumer’s purchasing decisions. Imagine that the interchange fee were to drop, in a hypothetical economy, from 5% to 0.5%. Do we think that product prices will drop accordingly? In response to a comment I posted yesterday, suggesting that such a price decline would occur, Todd Zywicki correctly responds that not all the saving will be rolled over to consumers. It depends on cross-elasticities of demand and supply. But at least in competitive markets, where prices equal marginal cost, the bulk of the savings in interchange fees would be enjoyed by consumers. It may be that nominal prices would display some stickiness, but it’s hard to imagine that in the long run consumers will be deprived of this benefit. One has to have very little faith in markets to imagine that the cost reduction will be enjoyed in its entirety by merchants, through higher profits.

If caps on interchange fees cause a non-trivial effect on prices, this regulation has the potential to reach far beyond the credit card market. It now affects primary decisions regarding the composition of consumption.

It is true that some of the increased demand due to lower prices is offset by the higher cost of credit. To buy these cheaper products with borrowed money would be just as costly, according to the neutrality claim. But it is important to unbundle the overall price into its two pure costs—the cost of the product and the cost of the credit. The potential efficiency of fee limits is in achieving an unbundled price, where the product component and the price component are priced separately.

Geoffrey A. Manne is Executive Director of the International Center for Law & Economics and a Lecturer in Law at Lewis & Clark Law School.

I take to heart Jim’s claim that fraud is too-little discussed in this realm given its cost, and thus I’ll try my hand at it.

Every discussion of the industrial organization of credit card networks owes a debt to Bill Baxter.  Baxter, a law professor and former Assistant Attorney General in the Antitrust Division of the DOJ, was one of the first (maybe the first?) scholars to discuss the economics of two-sided markets, in a paper, as it happens, on the economics of interchange fees in credit card networks.

In simple terms, the essence of Baxter’s analysis is that the role of the interchange fee in credit card networks is to balance and maximize demand for credit card transactions on both the consumer side and the merchant side–optimizing the system by drawing in as many consumers on the one side and merchants on the other as possible while still matching up demand for credit transactions on each side (thus maximizing network benefits).  The lever of the interchange fee allows the system to re-allocate some of the costs that are otherwise born by only one side of the market in order to effect this optimization.  One of these costs is the cost of fraud–and the interchange fee is, it seems to me, an essential lever for re-allocating the costs of fraud within the credit card system to where they can best be born.

Fraud costs are an important, if oft-neglected, component of payment systems’ functioning.  Every payment system by its nature includes the risk of fraud, and every payment system, by design or by default, imposes the risk of fraud on one or more parties in the system.  For example, a merchant that accepts cash in exchange for goods bears the risk that the cash will be counterfeit.  The cost of counterfeit currency to merchants is substantial.  (Although, speaking of cross-subsidies, the cost to merchants likely captures barely a fraction of the full cost of counterfeit currency—a cost born mostly by the government (and passed on to taxpayers) in policing and deterring counterfeiting).  The cash system, essentially by default, imposes the residual fraud costs on the merchant.  Checks present an even greater fraud problem than cash and, again, the costs are allocated essentially by default: A merchant that accepts a fraudulent check will bear the cost of the fraud.

In principle, the fraud costs of checks or cash could be allocated differently.  The government could offer some sort of guarantee, or the issuing bank could agree to bear the cost.  But in part because the government requires banks to clear checks at par—has, in other words, fixed the interchange fee at zero for checks—there is little opportunity for the system’s lever to operate to reallocate these costs, ensuring that the costs lie where they fall, and that redistribution is made only in the parts of the system governed by explicit contracts (thus, for example, depending on a host of factors, some of this cost may be redistributed from merchants to merchants’ banks via reductions in various fees in the agreement between merchant and bank).

In contrast, the flexible interchange fee in the credit card system allows fraud costs to be allocated differently throughout the system, presumably ensuring not that the costs lie where they fall, but rather that they are born by the party best positioned to bear the costs.  In the case of credit cards, assuming the merchant complies with the network’s rules for seeking authorization of payment, the issuing bank, in fact, guarantees the payment (and thus bears the risk of non-payment).  As Bill Baxter noted, “[t]his shifting of risk under the [credit card] system obviously increases [the issuing] bank’s cost, enhances [the merchant’s] demand for the system, and increases the amount of discount [the merchant] is willing to pay to [the acquiring] bank.”  It is this re-allocation of costs, facilitated by the interchange fee, that helps to optimize the system.