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.

Usha Rodrigues and Mike Stegemoller have penned an interesting article, “Placebo Ethics,” assessing the effect of one of SOX’s disclosure provisions: The required immediate disclosure of waivers from a company’s code of ethics, found in Section 406 of the law.  The article is concrete, informative, empirical and well-written.

The article’s abstract summarizes the heart of the paper:

Out of 200 randomly selected firms, we found only one waiver over 4 years disclosed pursuant to Section 406. However, by exploiting an overlap in disclosure regulations [between SOX 406 and Item 404 of Regulation S-K requiring disclosure of related-party transactions in year-end proxy statements], we were able to cross check our sample companies’ waiver disclosure. We find 30 instances where companies appear to be violating the law, and another 74 where companies evade illegality by watering down their codes to an arguably impermissible degree – their codes of ethics do not forbid the same Enron-style conflicts of interest that led to the adoption of Section 406 in the first place. Finally we study all waivers filed by all public companies with the SEC in the four years following SOX’s passage – and find only 36 total. Event studies reveal that the market generally does not react to these transactions, suggesting that companies only use waivers to disclose innocuous, immaterial information.

There’s a lot of interesting stuff here, including the conclusions that 15% of the sample firms are apparently violating the law and that the waivers that are disclosed are viewed by the market as irrelevant.  It is also interesting that 37% of the sample “evade illegality by watering down their codes to an arguably impermissible degree.”  It is this latter claim on which I want to focus.

I talked a bit about this issue in my Hydraulic Theory of Disclosure article.  In the article I said this about the waiver disclosure requirement:

The implicit assumption is that disclosure to shareholders will deter inappropriate waivers, inducing better compliance with the underlying code of ethics.  But that assumption must be animated by a further assumption that some conduct will be relatively static—that codes of ethics will not themselves be re-written and relaxed in response to the rule. In fact, however, the more likely outcome is that codes of ethics will be (and have been) re-written in order to minimize the need for waivers, in the event actually stemming rather than improving the flow of information . . . .  In other words, disclosed waivers are (privately) costly, and it may be less (privately) costly to amend codes of ethics than to seek and publicize waivers. Underlying behavior of the sort requiring waivers may not change, or it may even deteriorate. And either way less of it will be disclosed.

Rodrigues’ and Stegemoller’s (R&S’s) concluision seems to be 1) that immediate disclosure of related-party transactions would be a good thing, 2) that SOX 406 intended this but was poorly-executed to achieve the result, and 3) that companies’ failure to disclose waivers of their codes of ethics for related-party transactions is a violation of SOX 406, even where the code does not explicitly prohibit such transactions.

While the abstract quoted above is somewhat circumspect about the illegality of these “in spirit” violations of SOX 406, the article itself is a bit more hard-nosed:

It may be that, by omitting related-party transactions from their codes of ethics, companies are in violation of Section 406(c)(1), because prohibiting related-party transactions is “reasonably necessary” to promote “ethical handling of actual or apparent conflicts of interest between personal and professional relationships.” At the very least, these codes violate the intention, or “spirit” of Section 406’s disclosure requirements. As discussed in Part III, Section 406’s waiver provision was specifically enacted to address Enron’s related-party transactions with its CFO, Andy Fastow. Yet the majority of our sample companies do not forbid related-party transactions in their codes.

Instead, companies tend to have generic “conflicts of interest” provisions. And even when the provisions address related-party transactions, they use “weasel wording” that makes it hard to find an actual violation.

As R&S note, most ethics codes do not prohibit related-party transactions outright, so neither waivers of these codes, nor, therefore, disclosure of waivers, is required.  While seemingly proving my prediction that the effect of SOX 406 would be watered-down codes of ethics and, thus, less disclosure of information (assuming the watering down came in response to SOX 406), R&S focus instead on the illegality point, with which I have some trouble.

Basically, R&S argue that ethics codes that do not prohibit related party transactions are, in fact, impermissible under SOX, but I find their reasoning to be a stretch, and certainly there is no case law or SEC ruling (that I know of or that they cite) supporting the claim.  The R&S argument goes, in essence: a) a firm has an ethics code, waivers of which must be disclosed immediately; b) the code “should” prohibit related-party transactions but it does not on its face; c) there is a related-party transaction; d) there is no disclosure of a waiver; e) 406 is violated because the code of ethics “should” have prohibited this transaction, thus it “should” have required a waiver, and thus the absence of disclosure of a waiver is a violation of 406.  This seems like a pretty big stretch to me.  It might be that firms are interpreting 406 liberally, but it’s a long way from that to saying they are breaking the law.  Rather, I would say that failure to disclose waivers in this case is not an example of a firm flouting its obligation under SOX, it is instead an example of the predictable (and predicted) hydraulic effect of imperfect regulation.

This would still count as a failure of SOX 406, in my book (whether that’s a bad thing or not is another matter), but not because of non-enforcement, as R&S suggest, but rather because of the perverse incentive created by SOX 406 that induces firms to enact less-restrictive ethics codes.

In the end, I see the article as a vindication of my prediction.  My point was to suggest that SOX 406 would have the opposite effect of the one it intended–less internal prohibition (or policing) by firms of “unethical” conduct and less disclosure of such conduct.  I hasten to note that this study doesn’t say anything about whether SOX had anything to do with the watered-down ethics codes; for all I know they were already watered down (and thus the accuracy of my prediction is unconfirmed by the article).  But that would have been the thing to look at, it seems to me:  The role of SOX in inducing firms to engage in disfavored conduct to avoid new disclosure obligations that they would not otherwise have engaged in.

Despite this critique, I think the article is the best sort of empirical legal scholarship.  My conclusion might diverge from R&S’s (I would not suggest, as they do, a rule simply requiring disclosure of all related-party transactions over a certain size), but the evidence they uncover is important and their presentation of it is straightforward, well-written and informative.

I’m sure it’s an honor just to be nominated.

A recent opinion from Judge Posner cites our very own Josh Wright (Joshua D. Wright & Todd J. Zywicki, “Three Problematic Truths About the Consumer Financial Protection Agency Act of 2009,” Lombard Street, Sept. 14, 2009, available here) (by the way, the essay has drawn a few comments, my favorite of which is definitely the one titled, “are you stupid or scumbags[?]“).

The opinion is vaguely interesting touching as it does on the propriety of short-term, high-interest loans, but the holding rests on an analysis of the commerce clause so is pretty well beyond my ken.

At issue is an Indiana statute that purports to apply Indiana’s restrictive usury laws to consumer contracts executed outside the state, but with creditors that have advertised or solicited sales within Indiana.  The Indiana usury statute at issue constrains consumer loan interest to terms under which “the ceiling is the lower of 21 percent of the entire unpaid balance, or 36 percent on the first $300 of unpaid principal, 21 percent on the next $700, and 15 percent on the remainder,” with an exception for payday loans.  Such terms would preclude payday loans if they weren’t excepted under the statute and does preclude car title loans of the sort at issue in the case.  The court rules that the restriction on out-of-state transactions is impermissible under the constitution and strikes down the Indiana law.

The interesting part (to me) of the case, and the part where Josh (and Todd) are cited, is where Posner discusses the law and economics and related scholarship of car title and payday loans.  He doesn’t really come down on one side or another in this debate except to aver that Indiana has a colorable interest in protecting its citizens from “predatory lending,” if it so chooses.  It seems to me that he gives too much credit to the behavioral-economics-based arguments on the “predatory lending is, well, predatory” side of the debate, but he really doesn’t wade into the debate.  Nevertheless, Josh and Todd get their mention (Todd actually gets a couple of mentions) in this section, and kudos to them (and to FinReg21, where their essay appears) for drawing Posner’s attention.

Russ Roberts’ brilliant and eagerly-awaited Keynes vs. Hayek rap video is here.  It’s the best economics pop music since Merle Hazzard.  Here are the lyrics:

We’ve been going back and forth for a century
[Keynes] I want to steer markets,
[Hayek] I want them set free
There’s a boom and bust cycle and good reason to fear it
[Hayek] Blame low interest rates.
[Keynes] No… it’s the animal spirits

[Keynes Sings:]

John Maynard Keynes, wrote the book on modern macro
The man you need when the economy’s off track, [whoa]
Depression, recession now your question’s in session
Have a seat and I’ll school you in one simple lesson

BOOM, 1929 the big crash
We didn’t bounce back—economy’s in the trash
Persistent unemployment, the result of sticky wages
Waiting for recovery? Seriously? That’s outrageous!

I had a real plan any fool can understand
The advice, real simple—boost aggregate demand!
C, I, G, all together gets to Y
Make sure the total’s growing, watch the economy fly

We’ve been going back and forth for a century
[Keynes] I want to steer markets,
[Hayek] I want them set free
There’s a boom and bust cycle and good reason to fear it
[Hayek] Blame low interest rates.
[Keynes] No… it’s the animal spirits

You see it’s all about spending, hear the register cha-ching
Circular flow, the dough is everything
So if that flow is getting low, doesn’t matter the reason
We need more government spending, now it’s stimulus season

So forget about saving, get it straight out of your head
Like I said, in the long run—we’re all dead
Savings is destruction, that’s the paradox of thrift
Don’t keep money in your pocket, or that growth will never lift…

because…

Business is driven by the animal spirits
The bull and the bear, and there’s reason to fear its
Effects on capital investment, income and growth
That’s why the state should fill the gap with stimulus both…

The monetary and the fiscal, they’re equally correct
Public works, digging ditches, war has the same effect
Even a broken window helps the glass man have some wealth
The multiplier driving higher the economy’s health

And if the Central Bank’s interest rate policy tanks
A liquidity trap, that new money’s stuck in the banks!
Deficits could be the cure, you been looking for
Let the spending soar, now that you know the score

My General Theory’s made quite an impression
[a revolution] I transformed the econ profession
You know me, modesty, still I’m taking a bow
Say it loud, say it proud, we’re all Keynesians now

We’ve been goin’ back n forth for a century
[Keynes] I want to steer markets,
[Hayek] I want them set free
There’s a boom and bust cycle and good reason to fear it
[Keynes] I made my case, Freddie H
Listen up , Can you hear it?

Hayek sings:

I’ll begin in broad strokes, just like my friend Keynes
His theory conceals the mechanics of change,
That simple equation, too much aggregation
Ignores human action and motivation

And yet it continues as a justification
For bailouts and payoffs by pols with machinations
You provide them with cover to sell us a free lunch
Then all that we’re left with is debt, and a bunch

If you’re living high on that cheap credit hog
Don’t look for cure from the hair of the dog
Real savings come first if you want to invest
The market coordinates time with interest

Your focus on spending is pushing on thread
In the long run, my friend, it’s your theory that’s dead
So sorry there, buddy, if that sounds like invective
Prepared to get schooled in my Austrian perspective

We’ve been going back and forth for a century
[Keynes] I want to steer markets,
[Hayek] I want them set free
There’s a boom and bust cycle and good reason to fear it
[Hayek] Blame low interest rates.
[Keynes] No… it’s the animal spirits

The place you should study isn’t the bust
It’s the boom that should make you feel leery, that’s the thrust
Of my theory, the capital structure is key.
Malinvestments wreck the economy

The boom gets started with an expansion of credit
The Fed sets rates low, are you starting to get it?
That new money is confused for real loanable funds
But it’s just inflation that’s driving the ones

Who invest in new projects like housing construction
The boom plants the seeds for its future destruction
The savings aren’t real, consumption’s up too
And the grasping for resources reveals there’s too few

So the boom turns to bust as the interest rates rise
With the costs of production, price signals were lies
The boom was a binge that’s a matter of fact
Now its devalued capital that makes up the slack.

Whether it’s the late twenties or two thousand and five
Booming bad investments, seems like they’d thrive
You must save to invest, don’t use the printing press
Or a bust will surely follow, an economy depressed

Your so-called “stimulus” will make things even worse
It’s just more of the same, more incentives perversed
And that credit crunch ain’t a liquidity trap
Just a broke banking system, I’m done, that’s a wrap.

We’ve been goin’ back n forth for a century
[Keynes] I want to steer markets,
[Hayek] I want them set free
There’s a boom and bust cycle and good reason to fear it
[Hayek] Blame low interest rates.
[Keynes] No it’s the animal spirits

Simon Johnson is at it again, advocating the use of antitrust to break up the banks because they are, you know, big, and antitrust is about busting up big companies, right?

As Josh suggested back in July, the idea is gaining momentum, it seems.  The Financial Times is also pushing the idea.  What’s remarkable about both the FT’s and Simon Johnson’s “analysis” is that it is actually largely devoid of modern antitrust analysis.  It reflects the outdated, non-economic (dare I say anti-economic?) logic of the structure-conduct-performance paradigm of the 1960s.  Here, for example, is the FT:

The issue is not just market share in deposits, which attracts public attention. Many corners of the financial services market with a lower profile are highly concentrated and highly profitable.

Concentrated markets can still be competitive and high profits are not in themselves proof of anti-competitive behaviour. Market concentration is high in many industries – including new areas of the economy such as web search.

Anti-trust investigation would focus only on areas where critics allege anti-competitive behaviour, for example, the puzzle of why investment banks charge standard rates to raise equity capital for businesses. But even where there is no suspicion of collusion, regulators could examine market structures and practices that create barriers to entry.

Or, the administration could simply float the idea of a wide-ranging push on competition in banking and use it to gain leverage over big banks on issues such as regulatory reform and whether or not they pass on the cost of the financial levy to their customers.

So, yes, there is a nod (”concentrated markets can still be competitive . . .”) toward recognition that Demsetz does, indeed, exist and he did write Industry Structure, Market Rivalry, and Public Policy in 1973.  But the thrust is pure SCP.

Here’s Johnson:

There are definite elements of oligopoly in wholesale markets, underwriting new issues, and mergers and acquisitions both in the United States and around the world. This is part of the explanation for very high profits in banks — particularly big banks — over the past decade.

The question becomes: Is there evidence that our leading banks have used their pricing power or other aspects of their market muscle to keep out competition or otherwise distort behavior in very profitable arenas, like over-the-counter derivatives?

I don’t even know what that means:  “pricing power or other aspects of their market muscle to keep out competition?” Huh? It’s just hand waving.  And my favorite part:

We may also need new theories of antitrust.

Sure. Why not? Here “new” seems to mean “old,” but by all means we should launch antitrust investigations with the intention of developing new theories of antitrust that can justify the a priori policy conclusion that banks are violating the antitrust laws.  That’s some sound policy advice from the IMF’s former chief economist.

His “analysis” has not changed, as far as I can tell, since the last time he advocated bank busting, so I can hardly do better than repeat what Josh said back in July:

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?

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.

I’m delighted to report that the Liberty Fund has produced a three-volume collection of my dad’s oeuvre.  Fred McChesney edits, Jon Macey writes a new biography and Henry Butler, Steve Bainbridge and Jon Macey write introductions.  The collection can be ordered here.

Here’s the description:

As the founder of the Center for Law and Economics at George Mason University and dean emeritus of the George Mason School of Law, Henry G. Manne is one of the founding scholars of law and economics as a discipline. This three-volume collection includes articles, reviews, and books from more than four decades, featuring Wall Street in Transition, which redefined the commonly held view of the corporate firm.

Volume 1, The Economics of Corporations and Corporate Law, includes Manne’s seminal writings on corporate law and his landmark blend of economics and law that is today accepted as a standard discipline, showing how Manne developed a comprehensive theory of the modern corporation that has provided a framework for legal, economic, and financial analysis of the corporate firm.

Volume 2, Insider Trading, uses Manne’s ground-breaking Insider Trading and the Stock Market as a framework for many of Manne’s innovative contributions to the field, as well as a fresh context for understanding the complex world of corporate law and securities regulation.

Volume 3, Liberty and Freedom in the Economic Ordering of Society, includes selections exploring Manne’s thoughts on corporate social responsibility, on the regulation of capital markets and securities offerings, especially as examined in Wall Street in Transition, on the role of the modern university, and on the relationship among law, regulation, and the free market.

Manne’s most auspicious work in corporate law began with the two pieces from the Columbia Law Review that appear in volume 1, says general editor Fred S. McChesney. Editor Henry Butler adds: “Henry Manne was an innovator challenging the very foundations of the current learning.” “The ‘Higher Criticism’ of the Modern Corporation” was Manne’s first attempt at refuting the all too common notion that corporations were merely devices that allowed managers to plunder shareholders. Manne saw that such a view of corporations was inconsistent with the basic economic assumption that individuals either understand or soon will understand the costs and benefits of their own situations and that they respond according to rational self-interest.

My dad tells me the sample copies have arrived at his house, and I expect my review copy any day now.  But I can already tell you that the content is excellent.  Now-under-cited-but-essential-nonetheless corporate law classics like Some Theoretical Aspects of Share Voting and Our Two Corporation Systems: Law and Economics (two of his best, IMHO) should get some new life.  Among his non-corporations works, the classic and fun Parable of the Parking Lots (showing a humorous side of Henry that unfortunately rarely comes through in the innumerable joke emails he passes along to those of us lucky enough to be on “the list”) and the truly-excellent The Political Economy of Modern Universities (an updating of which forms a large part of a long-unfinished manuscript by my dad and me) are standouts.  And the content in the third volume from Wall Street in Transition has particular relevance today, and we would all do well to re-learn the lessons of those important contributions.

The full table of contents is below the fold.  Get it while it’s hot! (more…)

The lesson from Jones, see my post below, is that law untamed can be very costly, and with little benefit. This is, of course, not a new idea. In a critical essay of “Southey’s Colloquies on Society,” Lord Thomas Macaulay wrote eloquently about the cost of law and government:

“Our rulers will best promote the improvement of the nation by strictly confining themselves to their own legitimate duties, by leaving capital to find its most lucrative course, commodities their fair price, industry and intelligence their natural reward, idleness and folly their natural punishment, by maintaining peace, by defending property, by diminishing the price of law, and by observing strict economy in every department of the state. Let the Government do this: the People will assuredly do the rest.”

This short passage was intended as a rebuttal to the source of prosperity claimed by Mr. Southey — “the omniscient and omnipotent State.”

Thus our arguments today about the size and scope of government, way bigger battles than the rule in Jones but of similar foundation, are centuries old. Those on the Right believe, as Aaron Director said, that “extensions of government activity should be viewed under a presumption of error,” while those on the Left believe the opposite — that extensions of private activity should be thought of as presumptively bad. See the debate about health care, climate change, retirement security, and on and on. As a matter of sloganeering, one can see this in the treatment of “profits.” To the Left, profits (or the profit motive) are bad.They are signs of power, abuse, advantage taking, and excess. To the Right, profits are a sign that the market is working. Profits are evidence of consumer preferences and help the market allocate resources in the economy. Profits by computer companies tell us that we as a society should spend more money on computers and less on other things. We cannot resolve the debate here but to say that the issue is simply one of government power.

The battle rages at the level of politics, with the forces attempting to constrain government failing miserably. Government spending as a percentage of the size of the economy has grown from less than 10 percent in 1900 to over 45 percent today. See useful charts and graphs here. It is, of course, possible that spending could be higher and government power more excessive if we did not have strong voices arguing in the tradition of Macaulay and Director, but the efficient role of government imagined by Macaulay and prescribed in our Constitution seems quaint. The fight must go on, but politicians of both parties in this country can’t seem to help themselves when in power. Of course, we shouldn’t blame them anymore than any individual who simply responds to the incentives of the rules of the game they are playing. To change behavior, we must rewrite the rules.

Which is why the battle raging at the local level of law, as in Jones, is so important. Finding the efficient role for law in ordering our affairs — what Macaulay called “diminishing the price of law” — is a battle that still can be won. This is just a variant of a slogan of the environmental movement: Think Globally, Act Locally. Those who believe that liberty and free markets are the best mechanism of prosperity can win battles and skirmishes about what the right rules should be for government and law, and hopefully achieve a larger victory in an uncoordinated manner that would make Hayek proud.

What is the proper role for judges in deciding how much investment advisers to mutual funds should be compensated? This is the question the Supreme Court will answer in Jones v. Harris Associates, argued last month. At first, the question seems silly: courts don’t get a say in how much I get paid or how much (beyond the minimum wage) I pay our nanny, so why would they have any say here.

The difference between my pay and that of investment advisors is that there is a statute – section 36(b) of the Investment Company Act of 1940 – that obligates investment advisors under a “fiduciary duty with respect to the receipt of compensation for services.” The justification for the statute was a belief that the corporate structure of mutual funds, where the investment advisor appoints the board of the fund, which in turn is supposed to negotiate with the advisor over its compensation, is insufficient to generate the arm’s length bargaining that I have with our nanny or the University has with me. It is as if I appointed the Trustees of the University, and then they had as their first job deciding how much to pay me.

Unfortunately, the statute’s command is ambiguous – what does having a fiduciary duty mean for the proper judicial role? The prevailing view, until last year, was set forth in a 1982 case from the Second Circuit. The so-called “Gartenberg test” required courts to weigh numerous factors to determine whether the pay of investment advisors was reasonable. Lawyers, of course, love this test. All work-a-day lawyers, regardless of side, love multi-factor tests because they generate uncertainty and therefore fees. Not surprisingly, this generates an agency cost between lawyers and their clients, which may explain in part why no lawyers in the Supreme Court litigation argued to affirm the Seventh-Circuit opinion, which rejected the Gartenberg test.

As I show in a new paper, the Gartenberg standard has generated several hundred cases over the past two decades, costing several billion dollars. Shockingly, plaintiffs have never won once. They are 0 for 150 in cases resulting in reported decisions. Nevertheless, tens of cases are filed each year in an attempt to extract money (up to the costs of defending the litigation) from advisers. This might not be an inefficient result if the litigation is serving a deterrence function, but I show in the paper that the statute’s limit on the damages that can be paid in this litigation and the size of fees relative to the costs of litigation make this an impossibility. There is, in short, absolutely no economic justification for Gartenberg and private litigation about fees.

Perhaps based on this kind of economic analysis, Judge Easterbrook rejected Gartenberg, holding that a fiduciary duty means being transparent and playing no tricks, something not sufficiently alleged by plaintiffs in Jones. This is the approach state courts, for example, in Delaware, take when enforcing the fiduciary duty of corporate managers with respect to the pay they receive. Courts don’t balance factors to determine whether Jeffrey Immelt is paid too much, they look only at the pay-setting process and for unremedied conflicts of interest. This seems like the most sensible reading of the statute, but the simple economic analysis I do in the paper shows that there is another reason for the Court to reject Gartenberg.

A final observation is another reason why no parties before the Court defended Judge Easterbrook’s opinion. As noted above, agency costs is one explanation. Another is fear of change. Although defendants and the mutual fund industry might prefer avoiding the tax imposed on them by Gartenberg, I show that the dollar amounts of the tax are very small relative to the fees advisers earn. Moreover, a decision by the Court affirming Easterbrook might generate a legislative response (note: highly paid Wall Street types aren’t so popular on Capitol Hill these days), and the new statute might be much worse than the prevailing interpretation of section 36(b). In short, better Gartenberg than Barney Frank. The Court therefore did not hear the full story when the parties argued the case. The plaintiffs lawyers had their say, the defense lawyers and the industry had their say, but investors, the ones who ultimately pay the tax or what amounts to a useless wealth transfer to lawyers, did not.

Today’s Wall Street Journal reports that Senators Cantwell and McCain are preparing legislation to reinstate Glass-Steagall-type restrictions to create a “firewall” between commercial and investment banks. Apparently Rep. Hinchey is preparing a similar assault in the House.

The purpose behind the proposal, according to Ms. Cantwell, is so that “banks will stop diverting resources to Wall Street speculation and get back to more business lending to main street.” Mr McCain wants to “ensure that never again we stick the American taxpayer with another $700 billion or even larger tab to bail out the financial industry.”

Perhaps instead they should spend just $0.25 and buy a clue.

Let’s start with Ms. Cantwell’s concern for the ever-elusive “main street.” Affording the benefit of the doubt, I presume Ms. Cantwell is referring to small business in general, that sector of the economy that is traditionally responsible for the majority of job creation in the US. But to whom do most small businesses sell? Answer: larger businesses. And what does all that speculative money on Wall Street do? Reduce the cost of financing–either directly or indirectly–for (sometimes larger) businesses, which makes them more likely to grow their own businesses and purchase more things from smaller businesses. Not to mention that large businesses also hire people and are more likely to provide them health benefits (an added bonus in our political point count). Imposing restrictions that reduce financing options for large businesses may, in Ms. Cantwell’s world, mean more money to lend small businesses, but in effect it means small businesses have fewer opportunities to sell their wares and therefore have less need of financing.

As for Mr. McCain’s concern about ensuring we don’t have another $700+ billion bail out, there is a much easier solution: Just Don’t.  First, “just don’t” spend another $700 billion of tax dollars to bail out the banks (or the auto industry or … well, you get the point).  And as, if not more, importantly, “just don’t” impose financial market distortions (such as federally-subsidized mortgages to sub-prime borrowers) in order to achieve political and social engineering goals.

The media consensus seems to be Congressional leadership has no interest in the Cantwell-McCain proposal. Let’s hope they get this one right and this proposal dies a quiet death.

Try reading H.R. 4173.  All 1300 pages of it.  The portion of the bill creating the Consumer Financial Protection Agency starts around page 665 for those keeping score at home.