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The Economics and Regulation of Payment Card Interchange Fees: Paper and Conference

Posted by Geoffrey Manne on June 8, 2010

Two related items from ICLE:

As regular readers know, interchange fees are a frequent topic of conversation around the blog.  Taking the conversation from the ether to the real world, ICLE has funded a white paper and is putting on a conference next week on the topic.  The conference, in fact, grows out of the successful online symposium we held here at Truth on the Market a few months ago.  An e-book/pdf version of the posts and comments from that sympoisum can be downloaded here, by the way.  A few of the participants from the symposium will be participating in the conference, as well (more below).

The paper, by Todd Zywicki (ICLE Senior Fellow and Foundation Professor of Law at George Mason University School of Law), is entitled, “The Economics of Payment Card Interchange Fees and the Limits of Regulation.”

The timing of the paper’s release couldn’t be more fortuitous, as Congress reconvenes next week and begins to confer over the language of the Durbin Amendment to the “Restoring American Financial Stability Act of 2010.”  The Durbin Amendment would impose price controls on debit card interchange fees and would restrict the use by credit and debit card networks of certain network rules.  As Todd described it recently in a Washington Times op-ed:

Late in the Senate’s proceedings on the financial regulatory reform bill, the Senate adopted – with no hearings and minimal debate – a controversial provision proposed by Sen. Richard Durbin, Illinois Democrat, that imposes price controls on interchange fees for debit and prepaid cards. The amendment also allows merchants to override several rules of payment card networks that currently protect consumers from abusive practicesby merchants. While big-box merchants and convenience stores are declaring this a victory against the financial services industry, if the amendment survives in conference committee, consumers and small banks will be the real losers.

The paper, although focused most heavily on credit card interchange fees (and the attendant complexity of credit card markets more generally) has important implications for the debate over the Durbin Amendment.  As the paper’s abstract explains:

Fresh off of the most substantial national liquidity crisis of the last generation and the enactment of sweeping credit card regulation in the form of the Credit CARD Act, Congress continues to deliberate, with a continuing drumbeat of support from lobbyists, a set of new regulations for credit card companies. These proposals, offered in the name of consumer protection, seek to constrain the setting of “interchange fees”—transaction charges integral to payment card systems—through a range of proposed political interventions. This article identifies both the theoretical and actual failings of such regulation. Payment cards are a secure, inexpensive, welfare-increasing payment mechanism largely unlike any other in history. Rather than increasing consumer welfare in any meaningful sense, interchange fee legislation represents an attempt by some merchants to shift costs away from their businesses and onto card issuing banks and cardholders. In particular, bank-issued credit cards offer a dramatic improvement in the efficiency and availability of consumer credit by shifting credit risk from merchants onto banks in exchange for the cost of the interchange fee—currently averaging less than 2% of purchase value. Merchants’ efforts to cabin these fees would harm not only consumers but also the merchants themselves as commerce would depend more heavily on less-efficient paper-based payment systems. The consequence of interchange fee legislation, as Australia’s experiment with such regulation demonstrates, would be reduced access to credit, higher interest rates for consumers, and the return of the much-loathed annual fee for credit cards. Interchange fee regulation threatens to constrain credit for consumers and small businesses as the American economy begins to convalesce from a serious “credit crunch,” and should be accordingly rejected.

The paper presents a detailed analysis of the economics of payment card networks and the implications for the various participants in those networks–from consumers to banks to merchants, among others–of political intervention into the setting of the interchange fee.

Please click on the link to download the paper:

Todd J. Zywicki, “The Economics of Payment Card Interchange Fees and the Limits of Regulation.”

Coinciding with the release of the paper, ICLE, in conjunction with George Mason University’s Mercatus Center, will be hosting a conference in Washington, DC, next week on the interchange fee debate.  For more information on the conference and to register, please click here.  The conference, to be held on June 9th from 8:30 am to 1:00 pm at the Willard InterContinental Hotel, will cover both the politics and regulation of interchange fees, as well as the underlying economics of card networks and the place of the interchange fee in those networks.

Conference Speakers include:

Thomas Brown, O’Melveny & Myers LLP

Sujit Chakravorti, Federal Reserve Bank of Chicago

Thomas Durkin, Former Senior Economist, Federal Reserve Board

Mike Konczal, Roosevelt Institute

Geoffrey Manne, International Center for Law and Economics

Megan McArdle, Atlantic Monthly

Tim Muris, former Chairman, Federal Trade Commission

Felix Salmon, Reuters

Steven Semeraro, Thomas Jefferson University

Fred Smith, Competitive Enterprise Institute

Joshua Wright, George Mason University Law School and ICLE

Todd Zywicki, George Mason University Law School, Mercatus and ICLE

We hope to see you there

Posted in announcements, business, consumer protection, credit cards, economics, financial regulation, interchange and credit cards symposium, international center for law & economics, law and economics, markets, personal finance, regulation, scholarship | Comments Off

A Follow Up on the Cato Unbound Conversation on New Paternalism

Posted by Josh Wright on April 25, 2010

Two weeks ago I highlighted the promising looking Cato Unbound forum on the new paternalism kicked off by Glen Whitman, with follow up posts and responses from the King (or co-King along with Cass Sunstein) of Nudge, Richard Thaler, along with Jonathan Klick and Shane Frederick.  I was really excited about the forum, because I have research interests in this area and consider myself a “skeptic” of the new paternalism generally (hey, the Weekly Standard says “prominent skeptic,” but even I don’t go that far).  So — now that the exchange is over — I find myself, well, better off for having read it but disappointed.  I’m going to blog about the disappointing part.  Don’t get me wrong, it started off really well.  Glen came out swinging, Thaler responds (there no slopes, paternalism is inevitable, and by the way, a really odd choice of example for the lack of evidence in favor of slopes: prohibition), Klick and Frederick chime in.

It was the conversation following the initial postings that left me disappointed.  Whitman started off with a post responding to Thaler that pointed out that Thaler ignores a number of his key points.  The most interesting of these points, or at least the one most in need of a serious and thoughtful response, was about the role of opt-out in the new paternalism.  If new paternalism involves simple “choice architecture” that nudges individuals to make choices that are welfare-improving from their own preferences, one must ask the question about what happens when the individuals don’t respond to the nudge!  This need not require a slope mechanism.  For example, one can introduce a “plain vanilla” requirement that requires those selling credit products to consumers to offer a certain, regulator-approved version and disclose risks of selecting non-approved products.  Of course, these non-vanilla products are very much welfare improving for some individuals.  So the real question is how costly it will be for consumers to opt-out from the nudge.  Or if the costs imposed on lenders to satisfy the “nudge” requirement are in fact to costly as to remove the new products from the market or make them relatively more expensive, thus dampening their beneficial effects.

Here’s Whitman raising the opt-out issue:

Whenever they are challenged, the new paternalists place heavy emphasis on the inevitability argument. Don’t fall for it! It is not inevitable that the state must alter longstanding rules of contract law to reflect political judgments about what people “really” want. It is not inevitable that some opt-outs will be subject to onerous conditions. It is not inevitable that certain kinds of contractual terms will be outlawed entirely. It is not inevitable that the state will impose cooling-off periods on certain purchases, or sin taxes on tempting goods. Again, every one of these proposals appears in Thaler’s own work.

Here’s Klick raising the same issue in his second round response:

In some ways, Thaler’s critics are probably projecting the sins of the paternalist paternalists onto him. Thaler’s nudges are generally premised on the assumption that opt-out costs will be trivial. If we have to have a default rule anyway, why not pick the one that makes people best off, and for those with different preferences, they can simply opt out? Under that premise, Thaler is completely reasonable in suggesting that we should not fear when nudges move from private choices to public policies.

As a practical matter, however, most paternalism is not accompanied with these costless opt out provisions in real world public policy. When it is, and large numbers of people do actually opt out, undercutting the policy goals of the paternalists, a common impulse is to foreclose the possibility of opting out. In my previous comment, I painted national Prohibition as following exactly this pattern. Similar stories can be offered regarding more recent smoking bans and a host of other paternalistic interventions. Beyond simply asserting that their suggestions are default rules, leaving people free to make different decisions, perhaps the libertarian paternalists can spend some time discussing how the opt-outs can be preserved in the face of these tendencies.

I’ve searched Thaler’s two responses for an answer to these questions, which strike right at the heart of the new paternalism enterprise, but have found nothing.  Well, that’s not exactly true.  There is an odd debate over whether Thaler 2003 disagrees with Thaler 2010 (Thaler says no, but Thaler 2010 is a better writer).  There is also lots of aggressive tone to go around (“Whitman’s biggest gripes are with the policies that he only imagines that we favor, ones that involve coercion. What part of the term libertarian doesn’t he get?”).   But I did not read anything responsive to the critical point about the costs of opt-outs.

Of course, in many ways the opt-out issue is one about regulatory design.  And, well, its been said by my friend David Zaring that “when you listen to economists” on such matters, “you are listening to amateurs.”   But even if that were true, I’m not sure that is any excuse for economists to stop talking.  But Jonathan Klick makes a better point.  Economists have a, as Jon puts it, “unfortunate tendency of assuming that you can simply implement a policy with all of the important academic nuances intact without worrying about how the policy will interact with other legal and political forces.”  I agree with him that economists that choose to delve into the area of public policy and actual regulation carry the burden of moving beyond the workshop realm of academic musings and even laboratory and field experiment results, and into practical questions of regulatory design.   Thus, it is no defense to say that others are responsible for the analytics behind the design of opt-outs from new paternalism-based regulation.

Posted in credit cards, economics, financial regulation, regulation | Comments Off

Politically-Mandated Credit Card Interchange Fees Won’t Create Jobs (But They Will Hurt Consumers and the Economy)

Posted by Geoffrey Manne on March 20, 2010

by Geoffrey A. Manne, Joshua D. Wright and Todd J. Zywicki

Cross-posted at Business in the Beltway (at Forbes.com) and The Volokh Conspiracy.

In a recent commentary at Forbes.com, former Clinton administration economist Robert Shapiro argues that some 250,000 jobs would be created, and consumers would save $27 billion annually, by reducing the interchange fee charged to merchants for transactions made by consumers using credit and debit cards.  If true, these are some incredible numbers.

But incredible is indeed the correct characterization for his calculations.  Shapiro’s claims, based on a recent study he co-authored, rest on tendentious accounting, questionable assumptions, and—most crucially—a misunderstanding of the economics of interchange fees.  Political price caps on interchange fees won’t help the economy or create jobs—but they will make consumers poorer.

First, Shapiro estimates the employment impact of a redistribution of fees using the same stimulus multiplier that the Obama administration uses to tout the effect of its stimulus package.  But it is completely inappropriate to simply “plug in” the multiplier for government stimulus to calculate the effect of a reduction of interchange fees —unless the interchange fees currently paid to banks somehow simply disappear from the economy, contributing nothing to job creation, lowering the cost of capital, or increasing access to credit.  Even assuming that some portion of the fees are pure profit for card issuers, those profits must be paid out to shareholders or employees, invested, or used to bolster bank balance sheets (which provides capital for lending).  So, unlike the stimulus, this is at best merely a politically-mandated wealth (and employment) redistribution from card issuers to merchants, and any calculation of apparent economic gain must be offset by a similar calculation of loss on the other side.  Having ignored this offset, Shapiro’s conclusions are completely untenable.

But Shapiro also misunderstands the economics of payment card networks and the role of the interchange fee within them.  For example, Shapiro estimates that 70% of merchant savings from reduced interchange fees would be passed on to consumers in the form of lower retail prices.  But that is pure speculation.  In Australia, where regulators imposed price controls on interchange in 2003, fees paid by merchants have fallen but consumers have seen no reduction in the prices that they pay.  And where merchants have been permitted to impose surcharges on credit users, the surcharge can, and often does, substantially exceed the interchange fee cost.  It is not for nothing that merchants have spent millions trying to push interchange fee regulation through Congress.

In addition, Shapiro suggests that interchange fees are excessive in light of the “transaction and processing costs of using credit and debit cards.”  But his estimation of these costs is dramatically off-base.  Not only does he appear to exclude the cost of the delay between the time merchants receive payment (almost immediately) and when consumers pay their bills (at the end of a billing cycle), he ignores what may be the most significant single cost of consumer credit operations (and corresponding benefit to merchants): the cost of credit loss. Read the rest of this entry »

Posted in business, credit cards, economics, financial regulation, law and economics, markets, personal finance, politics | Tagged: , , , , , , | 5 Comments »

Has the Obama Administration Retreated From Behavioral Economics?

Posted by Josh Wright on March 9, 2010

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.

Posted in antitrust, business, credit cards, economics, financial regulation, markets, regulation | 2 Comments »

Interchange Fees Symposium E-Book

Posted by Geoffrey Manne on February 21, 2010

iclelogoOver 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.

Posted in announcements, blogging, credit cards, economics, interchange and credit cards symposium, international center for law & economics, law and economics | Tagged: , , , , | Comments Off

The problem with paper payments

Posted by Geoffrey Manne on January 20, 2010

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.

Posted in business, credit cards, economics, financial regulation, markets, personal finance | 3 Comments »

Gretchen Morgenson Calls for Greater Protection (?) of High-Risk Consumers of Credit

Posted by Thom Lambert on January 18, 2010

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?

Posted in business, contracts, credit cards, financial regulation, regulation | 1 Comment »

David Evans Makes the Case Against Revamping Consumer Protection

Posted by Josh Wright on January 7, 2010

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.

Posted in blogging, credit cards, federal trade commission | Comments Off

The faulty logic of "protecting" consumers from the absence of annual fees

Posted by Omri Ben-Shahar on January 7, 2010

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.

Posted in business, credit cards, financial regulation, law and economics, personal finance | Comments Off

Credit card annual fees and the self-appointed consumer protectors

Posted by Geoffrey Manne on January 6, 2010

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.

Posted in credit cards, financial regulation, law and economics, markets, personal finance | 8 Comments »

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