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Todd J. Zywicki is a George Mason University Foundation Professor of Law at the Scalia Law School at George Mason University and a former Director of the Office of Policy Planning at the FTC.

I was saddened to read of the passing of my dear friend Fred McChesney. An amazing scholar and an even more amazing friend and perhaps the greatest storyteller I’ve ever met. He is largely responsible for me going into law & economics and eventually the academic profession.

When I was deciding whether to pursue my Masters Degree in Economics at Clemson, Roger Meiners connected me with Fred. Fred was by then at Emory and already an established titan of law & economics. Fred had never taught at Clemson, but knew many of the Clemson professors through the Manne law & economics network. I cold-called him at Roger’s suggestion and much to my delight and (now) surprise, we must’ve talked for 30 minutes as he told me all about Clemson and law & economics. That seeming digression changed my life, leading me to UVA as an Olin Fellow and eventually to GMU. If Henry Manne is my intellectual grandfather then Fred McChesney and the crew at Clemson who passed that tradition on to me are my intellectual fathers.

My initial conversation with Fred embodies the spirit of the man — he was already an academic star with an immensely high opportunity cost. And here I was asking him for advice about seeking an MA at a completely different school. Yet rather than brush me off or rush through a hurried conversation, he was eminently patient and helpful. Only when I later became a professor did I realize how rare it was to find a man of his humility and friendliness in the academic profession. Every encounter with Freed from then on had the same spirit.

As for Fred’s intellectual influence on me, that is hard to overstate. Several years ago I published a co-authored book on “Public Choice Concepts and Applications in Law.” The book, of course, discusses Fred’s profound work on “rent-extraction,” one of the most important refinements of public choice theory since its origins. Even better, many years later, when I became Executive Director of the Law & Economics Center, I had the opportunity to organize Law Professor Workshops on Public Choice, at which Fred was one of our star speakers. The professors in attendance invariably left informed — and amused — by Fred’s lectures. As did I!

I always looked forward with anticipation to my meetings with Fred — I’m going to miss him greatly.

In my first post I argued that consumers as a group would likely be made worse off as a result of artificially imposed reductions in interchange fees.  This post considers a second line of attack—that even if consumers overall would be made no better off (or even worse off) as a result of regulating interchange fees, Congress should intervene in the name of “fairness” to regulate interchange fees.  This “fairness” argument, however, is a red herring, especially when advanced by merchants purporting to speak for consumers.  Indeed, the sincerity of the merchants’ concern is belied by their own behavior.

Merchants claim the current interchange price (typically about 1.75% of the price of the transaction) is “unfair” to those customers who pay by cash or check (and thus don’t incur interchange fees) because cash customers are essentially forced to subsidize credit users who pay the same retail price but incur this additional cost.  Note first that whether a reduction in interchange fees would be passed through to consumers is a question of market dynamics.  There is no evidence that Australia’s cap on interchange fees resulted in lower retail prices for consumers.  Even if retail prices did fall there is no evidence that any retail price reductions offset higher credit prices to consumers or would benefit consumers equally.  While capping interchange fees might eliminate the purported unfairness by making credit purchasers worse off, it is questionable whether it would actually make cash customers better off.

But merchant critics of credit cards on “fairness” grounds are playing with a stacked deck: cash and checks are both subsidized payment mechanisms.  The government prints and replaces worn currency and the Federal Reserve clears checks at par. By contrast, credit card issuers bear the cost of maintaining their payment network.  If merchants were serious about accurately allocating the costs of the payment network then they would insist that the government eliminate these subsidies from the system.  And this doesn’t even count the deadweight costs to the economy of cash, such as the time consumers spend making ATM transactions or the cost of paying guards to drive around pieces of paper in armored cars.  Studies find that consumers who write checks take twice as long at the check-out line as those who use payment cards—forcibly imposing an external cost on everyone in line behind the check-writer.  Should check-writers be required to compensate the rest of us for our wasted time standing in line?

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

Moreover, federal law expressly permits merchants to give cash discounts (some do).  That most merchants choose to accept credit cards and charge one price for cash and credit reflects a simple business decision, just like offering free parking (thereby subsidizing those who drive versus those who walk or take the bus), manned check-out lines (subsidized by those who use self-check out), or free returns on merchandise or money-back guarantees (subsidized by those who don’t return products).  Starbucks customers who drink their coffee black subsidize those who use cream and sugar.  Movie-goers who attend primetime shows subsidize those who attend matinees. Consumers who pay full price subsidize those who buy the same product on sale a few days later.  In a free economy we allow the scope of these cross-consumer “subsidies” to be set by free contracts, not governmental mandates.

The insincerity of the merchants’ fairness concerns is illustrated by their own behavior.  Traditionally, many retailers operated their own in-house credit operations.  This included large department stores, but also many grocers, tailors, furniture, appliance, and hardware stores that offered credit to customers on open-book or installment credit.  Many an older lawyer has related to me the memorable experience of opening his first charge account at Brooks Brothers (or the local equivalent) when buying his first suit.  Maintaining these credit operations were quite expensive—the retailer had to bear the operational costs (employees, billing operations, underwriting, customer service), the risks of non-payment and fraud, and the time-cost of money of the delay in receiving payments from the billing cycle and grace period.  Despite this high cost, however, many merchants made a business decision to maintain credit operations because of consumer demand.

Today, many merchants (especially smaller one) have essentially outsourced their credit operations by terminating their in-house programs and accepting credit cards instead, a much less costly system.  Credit cards eliminate the operational cost and non-payment risk associated with maintaining an in-house credit operation.  Credit card issuers bear the cost of the delay in payment over the billing cycle and grace period.  Outsourcing credit also allows small businesses to compete on equal footing with larger businesses that could afford the cost and risk of in-house credit operations.  Some major retailers, however, continue to run their own proprietary credit operations, accepting the higher cost and risk in exchange for the benefits of retaining in-house control.

Why is this history significant?  Because during these decades when merchants operated their own credit operations (and where they continue to do so) they consistently charged the same retail prices for cash and credit consumers despite the higher costs of credit customers than cash customers.  Target’s proprietary credit operation, for example, has been battered by double-digit default rates on its credit portfolio—yet Target charges the same price for cash and credit consumers.  Some merchants even offer “twelve months same as cash” and other promotions that subsidize credit purchasers.  In a similar vein, empirical studies have found that during the 1970s when state usury laws limited the ability of lenders to charge market rates of interest on consumer credit, retailers responded by increasing the price of goods typically sold on credit (such as appliances), thereby burying the price of the credit in a higher price of the goods for all purchasers.

Thus, the merchants’ claim today that the interchange fee forces an unfair subsidy between cash and credit purchasers is a red herring: merchants were (and are) more than happy to force charge the same price for cash and credit—so long as the merchants were capturing all the benefits.  The difference today has nothing to do with fairness, but that the merchants don’t get to keep all the profits.  And that they want the benefits of credit cards (making the issuers bear the cost and risk) without the costs.  Indeed, given that the merchants have outsourced their credit operations to credit cards precisely because they are less expensive, the size of this subsidy is probably smaller today than it was when merchants ran their own operations.  And even this ignores the various costs associated with accepting and handling cash and checks that credit users implicitly pay as subsidies for those types of payment.

Merchants have made a business decision to accept credit cards because it is cheaper and less-risky than running their own in-house credit operations.  As such, the cost of accepting credit cards is a cost of business, just like rent, utilities, and employee salaries.  Let’s get the real issue clear then—the argument over interchange has nothing to do with fairness or benefits to consumers.  Merchants are speaking for themselves, not consumers, when they demand to pay lower interchange fees.  The merchants own behavior demonstrates the point.  Congress needs to stay out of this issue.

Todd J. Zywicki is Foundation Professor of Law at George Mason University School of Law.

Although the mechanisms vary, legislation pending before Congress on interchange has a basic central purpose—to reduce interchange fees, either indirectly or directly.  If adopted, these efforts will likely succeed in their intended goal of reducing interchange fees.  But they will also likely have substantial unintended consequences that will prove harmful to consumers and competition and will roll-back the innovation in the credit card market over the past two decades.

Credit cards produce three basic revenue streams for issuers: finance charges (interest on revolving credit), merchant fees, and other fees on cardholders.  The ratio among these three streams has remained largely constant for almost two decades.  About 70 percent of issuer revenues come from interest paid by cardholders on revolving balances.  About 20 percent of revenues are generated by interchange fees.  And about 10 percent come from various other fees assessed on cardholders: two decades ago the bulk of this revenue was generated by annual fees, today it is predominantly from behavior-based fees such as over-the-limit fees, late fees, and other similar charges tied to a borrower’s actual behavior.  The precise ratios among these three streams varies slightly over time: in recent years, for example, greater use of home equity loans as a source of consumer credit led to a reduction in revolving balances and interest payments and an increase in risk-based fees.  At the same time, transactional use of credit cards has risen rapidly, fueled primarily by consumer use of rewards cards, leading to a growth in interchange fee revenue.

So what would happen if retailers get their way and interchange fees were cut by artificial governmental intervention?  The mathematics of the situation is inescapable: card issuers would have to increase the revenue generated from consumers from either interest payments or higher penalty fees or reduce the quality of credit cards, such as by reducing customer support or ancillary card benefits. In fact, this is exactly what happened when Australian regulators imposed price caps on interchange fees in 2003: annual fees increased an average of 22% on standard credit cards and annual fees for rewards cards increased by 47%-77%, costing consumers hundreds of millions of dollars in higher annual fees.  Card issuers also reduced the generosity of their reward programs by 23 percent.

The credit card system is essentially a closed system: a forced reduction in one stream of revenues generates efforts to substitute other revenue streams.  In a competitive market, the losses from one revenue stream have to be made up for somewhere else.  Americans have been recently reminded of this lesson, as Congress’s imposition of new limits on certain terms of credit card pricing through the Credit CARD Act over the summer has led to increased interest rates and higher annual fees to offset those restrictions.  Because it is more difficult to price risk accurately, issuers have reduced their risk exposure by reducing credit lines and closing accounts.  Congress may wail because its legislation failed to repeal the laws of supply and demand, but just as a minimum wage law increases unemployment or rent control creates housing shortages, regulation of some credit terms leads to predictable substitutions for unregulated terms.  Direct or indirect price caps on interchange fees would have similar negative consequences.

But while this type of substitution is bad enough for consumers there is an even more important systemic problem. The most important pro-consumer innovation in payment systems of the past two decades has been the general disappearance of annual fees on credit cards (except for rewards cards where the annual fee defrays the cost of program administration).  The elimination of annual fees has made it possible for consumers to carry and use multiple cards simultaneously.  According to Experian, consumers today have over five credit cards (including retail accounts) on average and over half the population has two credit cards or more. The consequences for consumer choice and competition have been profound—card issuers compete for consumers’ business literally every time they open their wallet to make a purchase.  Consumers can and do easily shift balances among different cards depending on which provides the best deal at any given time (according to a survey by ComScore, two-thirds of consumers say that they would consider switching their primary credit card if a better feature were offered).  Consumers can also stack credit lines when necessary.

An annual fee is essentially a tax on holding cards.  Policies that produced a return of annual fees would strangle this process of competition by making it more expensive for consumers to hold multiple cards, increasing switch costs and dampening competition.

Access to multiple cards (and their credit lines) is particularly important for the three-quarters of independent small businesses that rely on personal credit cards in their business and count on infrequently-used reserve lines of credit to exploit rapidly-developing business opportunities.  These reserve lines are especially important today as credit lines have been slashed. Forcing small businesses to pay an annual fee just to maintain access to these reserve credit lines would deter many of them from doing so, stifling entrepreneurship and an economic recovery.

Perverse consequences would likely follow on the issuers’ side of the market as well.  Issuers will find it more burdensome to retain customers who pay their bill every month (the lowest-risk group of customers), creating incentives to pursue customers who revolve and the riskiest class of customers who pay behavior-based fees.  This substitution will lead to a less-diversified revenue stream (more dependent on non-interchange revenue), making credit card operations riskier and more dependent on the swings in the business cycle.  Credit unions and community banks rely especially heavily on interchange revenue as they tend to cater to lower-risk customers that are less prone to revolve balances and pay penalty fees.  Reducing revenue from interchange fees would force these issuers to either abandon the credit card market or to pursue a riskier customer base.  It is hard to see why Congress would want to adopt policies that punish the most conservative financial institutions, encourage the very risk-seeking behavior that helped to spawn the financial crisis, and encourage a less-diversified and more risky customer base.  Yet squeezing interchange fees would do exactly that.

There is no free lunch.  In a competitive market, a reduction of the stream of revenues from interchange fees will have to be made up somewhere else.  Not only is this term repricing likely to be inefficient by replacing voluntary contract terms with governmentally-created prices but they will likely dampen competition and innovation, thereby harming consumers in the long run.