Onions Forever! A Response to Allan Shampine

Richard Epstein —  8 December 2009

There is nothing like the provocative post from Allan Shampine to move this debate up a notch.  First, I did not say that the debate over interchange fees was Onionesque. I reserved that dubious distinction to the on-the-hand-on-the-other-hand title of the GAO report.  Allan is right that the stakes are huge, which is why this debate is so important.  But he is wrong to think that the GAO adds much to the debate when all it can responsibly say is that any regulation of interchange fees has both costs and benefits, when it is unable to quantify or evaluate either.

My own substantive view starts with the legal version of the Hippocratic Oath—first, do no harm.  That generally counsels against the interference with competitive markets.  But it does not, evidently, have quite the same pop in the complex world of interchange agreements where there are sure to be some pockets of monopoly power.  But even if that were the case, the second order concern remains true.  Is the cure proposed likely to be worse than the disease, which I suspect will be the case if there is no clear path from diagnosis to treatment.

On this issue, the excellent posts by Tom Brown & Tim Muris, Robert Stillman, and Todd Zywicki all make the same point.  As Zywicki properly notes, the credit-card system is a closed loop.  The loss of revenues from one part of it has to be offset by the gains in revenues elsewhere.  It becomes therefore very difficult to construct a telling narrative that justifies the use of high administrative costs to switch these flows in a direction that retailers prefer, but which do little good for others.  As Brown & Muris point out, fully corrected for debit cards, there is no run up in interchange costs, so why worry.  As Bob Stillman points out, if the merchants were prepared to make a dollar-for-dollar pass through of fee reductions, they would have no incentive to lobby so hard for a program from which they received no return.  I think that they have better knowledge of their own business than I do, so that the question of who pays if they get a government break still remains.

Allan is surely right to point out that the 1.7 percent interconnection fee is not chump change.  It is larger than the 0.5 percent reduction in sales taxes that is being mooted in Chicago.  A fair comparison would ask about the change in effective rates that regulation could impose.  But even if we put that aside, the structural differences between interchange fees and the sales tax really matters.  The sales tax takes wealth out of the productive cycle of credit (indeed all) sales.  The one unambiguous effect is that Chicago purchasers now have an incentive to shop in the suburbs for their large weekly household purchases, and even for smaller transactions like gasoline.  Governing a long and thin city has important tax consequences because it puts a lot of people close to city lines, and also to Indiana.  Cutting down the fees brings business back.

There of course no taxes involved in this dispute, just lots of dollars.  But the flip side of the tax issue does arise with subsidies for various payment systems.  Here one of the great achievements of credit cards is that it does not have the public subsidy that is found both for checks, and for cash, when, last I looked, no one had to pay a cent to acquire a shiny new $20 bill.  The government assumes the printing costs, and guards against counterfeit transactions, a rough analogy to credit fraud.  If this industry can continue to expand its share of the market, hands off looks to be the better solution, if only because there are more players who can divide the substantial fixed costs in running this system.

Conclusion: even if you cancel your Onion subscription, don’t buy into the regulation of interchange fees until the GAO can supply a better narrative than it has already done.

2 responses to Onions Forever! A Response to Allan Shampine


    A number of commenters and posters have argued now that a credit card network is a closed system, and that decreases in fees in one place must, by definition, be offset by increases in fees in another place. The experience in Australia has been cited to support this claim – an experience which Bob Stillman, among others, has studied. While Todd Zywicki and others point out, correctly, that research by the Reserve Bank of Australia has indicated that cardholder fees rose and rewards programs became less generous, it is important to point out that Bob did not say that the network was a closed system.

    That is, Bob found, as his post here states, that the reduction in interchange fees was not fully offset by increases in other fees. Total fees flowing into the network were lower – so bank profits fell. Put another way, the total fees paid by cardholders and merchants to the banks were lower after interchange fees were reduced even though volumes did not decline.

    Other researchers have found similar results. Intuitively, if banks could raise the same amount of money without interchange fees, it is hard to see why all of this debate would be necessary.

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