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Today, the International Center for Law & Economics (ICLE) released a study updating our 2014 analysis of the economic effects of the Durbin Amendment to the Dodd-Frank Act.

The new paper, Unreasonable and Disproportionate: How the Durbin Amendment Harms Poorer Americans and Small Businesses, by ICLE scholars, Todd J. Zywicki, Geoffrey A. Manne, and Julian Morris, can be found here; a Fact Sheet highlighting the paper’s key findings is available here.

Introduced as part of the Dodd-Frank Act in 2010, the Durbin Amendment sought to reduce the interchange fees assessed by large banks on debit card transactions. In the words of its primary sponsor, Sen. Richard Durbin, the Amendment aspired to help “every single Main Street business that accepts debit cards keep more of their money, which is a savings they can pass on to their consumers.”

Unfortunately, although the Durbin Amendment did generate benefits for big-box retailers, ICLE’s 2014 analysis found that it had actually harmed many other merchants and imposed substantial net costs on the majority of consumers, especially those from lower-income households.

In the current study, we analyze a welter of new evidence and arguments to assess whether time has ameliorated or exacerbated the Amendment’s effects. Our findings in this report expand upon and reinforce our findings from 2014:

Relative to the period before the Durbin Amendment, almost every segment of the interrelated retail, banking, and consumer finance markets has been made worse off as a result of the Amendment.

Predictably, the removal of billions of dollars in interchange fee revenue has led to the imposition of higher bank fees and reduced services for banking consumers.

In fact, millions of households, regardless of income level, have been adversely affected by the Durbin Amendment through higher overdraft fees, increased minimum balances, reduced access to free checking, higher ATM fees, and lost debit card rewards, among other things.

Nor is there any evidence that merchants have lowered prices for retail consumers; for many small-ticket items, in fact, prices have been driven up.

Contrary to Sen. Durbin’s promises, in other words, increased banking costs have not been offset by lower retail prices.

At the same time, although large merchants continue to reap a Durbin Amendment windfall, there remains no evidence that small merchants have realized any interchange cost savings — indeed, many have suffered cost increases.

And all of these effects fall hardest on the poor. Hundreds of thousands of low-income households have chosen (or been forced) to exit the banking system, with the result that they face higher costs, difficulty obtaining credit, and complications receiving and making payments — all without offset in the form of lower retail prices.

Finally, the 2017 study also details a new trend that was not apparent when we examined the data three years ago: Contrary to our findings then, the two-tier system of interchange fee regulation (which exempts issuing banks with under $10 billion in assets) no longer appears to be protecting smaller banks from the Durbin Amendment’s adverse effects.

This week the House begins consideration of the Amendment’s repeal as part of Rep. Hensarling’s CHOICE Act. Our study makes clear that the Durbin price-control experiment has proven a failure, and that repeal is, indeed, the only responsible option.

Click on the following links to read:

Full Paper

Fact Sheet


[The following is a guest post by Thomas McCarthy on the Supreme Court’s recent Amex v. Italian Colors Restaurant decision. Tom is a partner at Wiley Rein, LLP and a George Mason Law grad. He is/was also counsel for, among others,

So he’s had a busy week….]

The Supreme Court’s recent opinion in American Express Co. v. Italian Colors Restaurant (June 20, 2013) (“Amex”) is a resounding victory for freedom-of-contract principles.  As it has done repeatedly in recent terms (see AT&T Mobility LLC v. Concepcion (2011); Marmet Health Care Center, Inc. v. Brown (2012)), the Supreme Court reaffirmed that the Federal Arbitration Act (FAA) makes arbitration “a matter of contract,” requiring courts to “rigorously enforce arbitration agreements according to their terms.”  Amex at 3.  In so doing, it rejected the theory that class procedures must remain available to claimants in order to ensure that they have sufficient financial incentive to prosecute federal statutory claims of relatively low value.  Consistent with the freedom-of-contract principles enshrined in the FAA, an arbitration agreement must be enforced—even if the manner in which the parties agreed to arbitrate leaves would-be claimants with low-value claims that are not worth pursuing.

In Amex, merchants who accept American Express cards filed a class action against Amex, asserting that Amex violated Section 1 of the Sherman Act by “us[ing] its monopoly power in the market for charge cards to force merchants to accept credit cards at rates approximately 30% higher than the fees for competing credit cards.”  Amex at 1-2.  And, of course, the merchants sought treble damages for the class under Section 4 of the Clayton Act.  Under the terms of their agreement with American Express, the merchants had agreed to resolve all disputes via individual arbitration, that is, without the availability of class procedures.  Consistent with that agreement, American Express moved to compel individual arbitration, but the merchants countered that the costs of expert analysis necessary to prove their antitrust claims would greatly exceed the maximum recovery for any individual plaintiff, thereby precluding them from effectively vindicating their federal statutory rights under the Sherman Act.  The Second Circuit sided with the merchants, holding that the prohibitive costs the merchants would face if they had to arbitrate on an individual basis rendered the class-action waiver in the arbitration agreement unenforceable.

In a 5-3 majority (per Justice Scalia), the Supreme Court reversed.  The Court began by highlighting the Federal Arbitration Act’s freedom-of-contract mandate—that “courts must rigorously enforce arbitration agreements according to their terms, including terms that specify with whom [the parties] choose to arbitrate their disputes, and the rules under which that arbitration will be conducted.”  Amex at 2-3 (internal quotations and citations omitted).  It emphasized that this mandate applies even to federal statutory claims, “unless the FAA’s mandate has been overridden by a contrary congressional command.”  Amex at 3 (internal quotations and citations omitted).  The Court then briefly explained that no contrary congressional command exists in either the federal antitrust laws or Rule 23 of the Federal Rules of Civil Procedure (which allows for class actions in certain circumstances).

Next, the Court turned to the merchants’ principal argument—that the arbitration agreement should not be enforced because enforcing it (including its class waiver provision) would preclude plaintiffs from effectively vindicating their federal statutory rights.  The Court noted that this “effective vindication” exception “originated as dictum” in prior cases and that the Court has only “asserted [its] existence” without ever having applied it in any particular case.  Amex at 6.  The Court added that this exception grew out of a desire to prevent a “prospec­tive waiver of a party’s right to pursue statutory reme­dies,” explaining that it “would certainly cover a provision in an arbitration agreement forbidding the assertion of certain statutory rights.”  The Court added that this exception might “perhaps cover filing and administrative fees attached to arbitration that are so high as to make access to the forum impracticable,” Amex at 6, but emphasized that, whatever the scope of this exception, the fact that the manner of arbitration the parties contracted for might make it “not worth the expense” to pursue a statutory remedy “does not constitute the elimination of the right to pursue that remedy.”  Amex at 7.

The Court closed by noting that its previous decision in AT&T Mobility v. Concepcion “all but resolves this case.”  Amex at 8.  In Concepcion, the Court had invalidated a state law “conditioning enforcement of arbitration on the availability of class procedures because that law ‘interfere[d] with fundamental attributes of arbitration.’”   As the Court explained, Concepcion specifically rejected the argument “that class arbitration was necessary to prosecute claims ‘that might otherwise slip through the legal system’” thus establishing “that the FAA’s command to enforce arbitration agreements trumps any interest in ensuring the prosecution of low value claims.”  Amex at 9 (quoting Concepcion).  The Court made clear that, under the FAA, courts are to hold parties to the deal they struck—arbitration pursuant to the terms of their arbitration agreements, even if that means that certain claims may go unprosecuted.  Responding to a dissent penned by Justice Kagan, who complained that the Court’s decision would lead to “[l]ess arbitration,” contrary to the pro-arbitration policies of the FAA, Amex dissent at 5, the Court doubled down on this point, emphasizing that the FAA “favor[s] the absence of litigation when that is the consequence of a class-action waiver, since its ‘principal purpose’ is the enforcement of arbitration agreements according to their terms.”  Amex at 9 n.5 (emphasis added).

By holding parties to the deal they struck regarding the resolution of their disputes, the Court properly vindicates the FAA’s freedom-of-contract mandates.  And even assuming the dissenters are correct that there will be less arbitration in individual instances, the opposite is true on a macro level.  For where there is certainty in contract enforcement, parties will enter into contracts.  Amex thus should promote arbitration by eliminating uncertainty in contracting and thereby removing a barrier to swift and efficient resolution of disputes.

Many thanks to the Truth on the Market bloggers for having me.  I’ve long enjoyed reading the blog and am delighted to be contributing.  A quick disclaimer up front to apply to all my posts:  The views expressed here are my own and do not express the views of my employer or clients.


Economists have long warned against price regulation in the context of network industries, but until now our tools have been limited to complex theoretical models. Last week, the heavens sent down a natural experiment so powerful that the theoretical models are blushing: In response to a new regulation preventing banks from charging debit-card swipe fees to merchants, Bank of America announced that it would charge its customers $5 a month for debit card purchases. And Chase and Wells Fargo are testing $3 monthly debit-card fees in certain markets. In case you haven’t been following the action, the basic details are here. What in the world does this development have to do with an “open” Internet? A lot, actually.

The D.C. Court of Appeals has been asked to consider several legal challenges to the FCC’s Open Internet Order. Passed in December 2010, the Open Internet Order was the regulatory culmination of an intense lobbying campaign by certain websites and so-called consumer groups to regulate the fees that Internet access providers such as Comcast or Verizon may charge to websites.

Although the challenges to the Open Internet Order largely concern the FCC’s authority to regulate Internet access providers and the proper scope of the regulations—for example, whether they should apply to wireline networks only or to all broadband networks including wireless—here’s to hoping that the rules are also judged according to the FCC’s public-interest standard. Along that dimension, the FCC’s experiment in price regulation clearly fails.

Just as Internet access providers bring together websites and users, banks provide a two-sided platform, bringing together merchants and customers in millions of cashless transactions. Because banking networks cost money to create, banks can’t be expected to provide their services for free. If you tell a bank that it can’t charge one side of a two-sided market—particularly when that one side (the merchant side) is less price sensitive than the other (the customer side)—then expect customer fees to rise. It’s not because banks are evil; it is because the profit-maximizing price charged to customers by a bank depends on the price charged to merchants.

Ignoring this economic lesson of two-sided markets, the Durbin Amendment to the Wall Street Reform and Consumer Protection Act instructed the Federal Reserve Board to cap swipe fees charged by banks to merchants. Prodded by consumer advocates to eliminate the fees entirely, the Fed cut the fees in half, to about 24 cents per transaction from an average of 44 cents per transaction. Paradoxically, the smaller the merchant fee, the larger is the debit fee—this is the “seesaw principle” of two-sided markets in action. Say hello to $5 monthly debit fees.

In a classic case of one regulation spawning another, now there is talk of regulating the banks’ debit-card charges. In response to the new debit fees, some members of Congress asked the Justice Department to investigate the major banks, suggesting that the higher fees resulted from a pricing conspiracy and not from their own bone-headed price regulation.

Months before the new debit fees came into effect, Bob Litan of the Brookings Institution predicted in a paper that “consumers and small business would face higher retail banking fees and lose valuable services as banks rationally seek to make up as much as they can for the debit interchange revenues they will lose under the [Federal Reserve] Board’s proposal.” As noted by Todd Zywicki in the Wall Street Journal, Litan’s prediction proved prescient.

Although both the Durbin Amendment and the FCC’s Open Internet Order are price regulations, there are important differences. Unlike the Fed’s rulemaking on swipe fees, the Open Internet Order was not directed by Congress. This shortcoming alone might be fatal for the Appeals Court. And unlike the Fed’s rulemaking, the FCC’s rulemaking regulates the merchant fee out of existence. Regulating prices below market-levels (as the Fed did) is one thing—regulating them to zero (as the FCC proposes) is beyond the pale.

Under the Open Internet Order, Internet access providers are banned from charging websites a surcharge for priority delivery. Indeed, the mere offering of such a fee to one website would be “discriminatory” and thus presumptively anticompetitive, even if the same offer were extended to other websites. Self-described public interest groups advocating for the Open Internet Order believe that if the smallest website in America can’t afford a surcharge for priority delivery, then no one should be allowed to buy it.

Assuming the FCC’s Order withstands legal scrutiny, the rules will clearly retard innovation among application developers: Why develop the next, killer real-time application if you can’t contract for priority delivery?

And if the Durbin Amendment is any guide, the effect of the Open Internet Order will be higher Internet access prices for consumers.

The same Bob Litan who accurately predicted price hikes in banking caused by price regulation made a similar prediction for broadband networks: “Even according to a theoretical model championed by net neutrality proponents, end users are unequivocally worse off under net neutrality regulation, as the end-user price of broadband access is always higher when ISPs are barred from raising revenues from content providers.” Will his sage advice be ignored by regulators twice in the same year?

The Appeals Court should force the FCC to defend the notion that the agency’s Open Internet Order is consistent with the public interest: If higher access prices and less innovation among application developers are the unintended consequences of an “open” Internet, then the FCC will fail on this score. With luck, the Open Internet Order will be seen as the ugly cousin of the Durbin Amendment, and the FCC’s experiment in price regulation will be curtailed.

Here’s Professor Zywicki in the WSJ on the debit card interchange price controls going into effect, and their unintended but entirely predictable consequences:

Faced with a dramatic cut in revenues (estimated to be $6.6 billion by Javelin Strategy & Research, a global financial services consultancy), banks have already imposed new monthly maintenance fees—usually from $36 to $60 per year—on standard checking and debit-card accounts, as well as new or higher fees on particular bank services. While wealthier consumers have avoided many of these new fees—for example, by maintaining a sufficiently high minimum balance—a Bankrate survey released this week reported that only 45% of traditional checking accounts are free, down from 75% in two years.

Some consumers who previously banked for free will be unable or unwilling to pay these fees merely for the privilege of a bank account. As many as one million individuals will drop out of the mainstream banking system and turn to check cashers, pawn shops and high-fee prepaid cards, according to an estimate earlier this year by economists David Evans, Robert Litan and Richard Schmalensee. (Their study was supported by banks.)

Consumers will also be encouraged to shift from debit cards to more profitable alternatives such as credit cards, which remain outside the Durbin amendment’s price controls. According to news reports, Bank of America has made a concerted effort to shift customers from debit to credit cards, including plans to charge a $5 monthly fee for debit-card purchases. Citibank has increased its direct mail efforts to recruit new credit card customers frustrated by the increased cost and decreased benefits of debit cards.

This substitution will offset the hemorrhaging of debit-card revenues for banks. But it is also likely to eat into the financial windfall expected by big box retailers and their lobbyists. They likely will return to Washington seeking to extend price controls to credit cards. …

Todd closes with a nice point about where the impact of these regulations will be felt most:

Conceived of as a narrow special-interest giveaway to large retailers, the Durbin amendment will have long-term consequences for the consumer banking system. Wealthier consumers will be able to avoid the pinch of higher banking fees by increasing their use of credit cards. Many low-income consumers will not.

Read the whole thing.


[Cross-posted at PYMNTS.COM]

Richard Cordray’s nomination hearing provided an opportunity to learn something new about the substantive policies of the new Consumer Financial Protection Bureau.  Unfortunately, that opportunity came and went without answering many of the key questions that remain concerning the impact of the CFPB’s enforcement and regulatory agenda on the availability of consumer credit, economic growth, and jobs.

The Consumer Financial Protection Bureau’s critics, including myself, [1] have expressed concerns that the CFPB— through enforcement and regulation—could harm consumers and small businesses by reducing the availability of credit.  The intellectual blueprint for the CFPB is founded on the insight, from behavioral economics, that “[m]any consumers are uninformed and irrational,” that “consumers make systematic mistakes in their choice of credit products,” and that the CFPB should play a central role in determining which and to what extent these products are used. [2] The CFPB’s recent appointment of Sendhil Mullainathan as its Assistant Director for Research confirms its commitment to the behaviorist approach to regulation of consumer credit.  Mullainathan, in work co-authored with Professor Michael S. Barr, provided the intellectual basis for the much debated “plain vanilla” provision in the original legislation and advocated a whole host of new consumer credit regulations ranging from improved disclosures to “harder” forms of paternalism.  The concern, in short, is that the CFPB is hard-wired to take a myopic view of the tried-and-true benefits of consumer credit markets and runs the risk of harming many (and especially the socially and economically disadvantaged groups in the greatest need of access to consumer credit) in the name of protecting the few.

To be sure, there is absolutely no doubt that there are unscrupulous and unsavory characters in lending markets engaging in bad acts ranging from fraud to preying upon vulnerable borrowers.  Nonetheless, it is critical to recognize the positive role that lending markets and the availability of consumer credit has played in the American economy, especially in facilitating entrepreneurial activity and small business growth.  Taking into account these important benefits is fundamental to developing sound consumer credit policy.  I had hoped that the hearings might focus upon Mr. Cordray’s underlying philosophical approach to weighing the costs and benefits of credit regulation and how that balance might be struck at his CFPB.  They did not, instead focusing largely upon another important issue: the precise contours of CFPB authority and oversight.

Currently, the unemployment rate is over 9 percent and all of the available evidence suggests the CFPB’s approach will run a significant risk of overregulation that will reduce the availability of consumer credit to small businesses and thus further depress the economy.  Therefore, getting hard answers concerning how the CFPB views and will account for these risks in its enforcement and regulatory decisions is critical.  Certainly, the nomination hearing offered small hints toward this end.  We learned that under Mr. Cordray’s watch, CFPB enforcement will involve not only lawsuits but also a “more flexible toolbox” that includes “research reports, rulemaking guidance, consumer education and empowerment, and the ability to supervise and examine both large banks and many nonbank institutions.”

The job of protecting consumers in financial products markets—the domain of the new CFPB—extends to all such consumers.  The benefits of healthy markets and competition in consumer credit products has generated tremendous economic benefits to the most disadvantaged as well as to small businesses.  If the CFPB agenda were limited to educating consumers about the costs and benefits of various products and improving disclosures, there would be far less need for concern that it will be a drag on consumers, entrepreneurial activity, and economic growth.  However, the CFPB’s intellectual blueprint suggests a more aggressive and dangerous agenda, and the authority it has been granted renders that agenda feasible.  The CFPB must account for the benefits from lending markets and balance them against its laudable objective of preventing deceptive practices when crafting its enforcement and regulatory agenda.  Unfortunately, after Tuesday’s nomination hearing, the CFPB’s approach to this complex and delicate balance remains an open question.


[1] David S. Evans & Joshua D. Wright, The Effect of the Consumer Financial Protection Agency Act of 2009 on Consumer Credit, 22(3) Loyola Consumer L. Rev. 277 (2010).

[2] Oren Bar-Gill & Elizabeth Warren, Making Credit Safer, 157 U. Pa. L. Rev. 1, 39 (2008).

There has been plenty of Hurricane Irene blogging, and some posts linking natural disasters to various aspects of law and policy (see, e.g. my colleague Ilya Somin discussing property rights and falling trees).   Often, post-natural disaster economic discussion at TOTM turns to the perverse consequences of price gouging laws.  This time around, the damage from the hurricane got me thinking about the issue of availability of credit.  In policy debates in and around the new CFPB and its likely agenda — which is often reported to include restrictions on payday lending — I often take up the unpopular (at least in the rooms in which these debates often occur) position that while payday lenders can abuse consumers, one should think very carefully about incentives before going about restricting access to any form of consumer credit.  In the case of payday lending, for example, proponents of restrictions or outright bans generally have in mind a counterfactual world in which consumers who are choosing payday loans are simply “missing out” on other forms of credit with superior terms.  Often, proponents of this position rely upon a theory involving particular behavioral biases of at least some substantial fraction of borrowers who, for example, over estimate their future ability to pay off the loan.  Skeptics of government-imposed restrictions on access to consumer credit (whether it be credit cards or payday lending) often argue that such restrictions do not change the underlying demand for consumer credit.  Consumer demand for credit — whether for consumption smoothing purposes or in response to a natural disaster or personal income “shock” or another reason — is an important lubricant for economic growth.  Restrictions do not reduce this demand at all — in fact, critics of these restrictions point out, consumers are likely to switch to the closest substitute forms of credit available to them if access to one source is foreclosed.  Of course, these stories are not necessarily mutually exclusive: that is, some payday loan customers might irrationally use payday lending while better options are available while at the same time, it is the best source of credit available to other customers.

In any event, one important testable implication for the economic theories of payday lending relied upon by critics of such restrictions (including myself) is that restrictions on their use will have a negative impact on access to credit for payday lending customers (i.e. they will not be able to simply turn to better sources of credit).  While most critics of government restrictions on access to consumer credit appear to recognize the potential for abuse and favor disclosure regimes and significant efforts to police and punish fraud, the idea that payday loans might generate serious economic benefits for society often appears repugnant to supporters.  All of this takes me to an excellent paper that lies at the intersection of these two issues: natural disasters and the economic effects of restrictions on payday lending.  The paper is Adair Morse’s Payday Lenders: Heroes or Villians.    From the abstract:

I ask whether access to high-interest credit (payday loans) exacerbates or mitigates individual financial distress. Using natural disasters as an exogenous shock, I apply a propensity score matched, triple difference specification to identify a causal relationship between access-to-credit and welfare. I find that California foreclosures increase by 4.5 units per 1,000 homes in the year after a natural disaster, but the existence of payday lenders mitigates 1.0-1.3 of these foreclosures. In a placebo test for natural disasters covered by homeowner insurance, I find no payday lending mitigation effect. Lenders also mitigate larcenies, but have no effect on burglaries or vehicle thefts. My methodology demonstrates that my results apply to ordinary personal emergencies, with the caveat that not all payday loan customers borrow for emergencies.

To be sure, there are other papers with different designs that identify economic benefits from payday lending and other otherwise “disfavored” credit products.  Similarly, there papers out there that use different data and a variety of research designs and identify social harms from payday lending (see here for links to a handful, and here for a recent attempt).  A literature survey is available here.  Nonetheless, Morse’s results remind me that consumer credit institutions — even non-traditional ones — can generate serious economic benefits in times of need and policy analysts must be careful in evaluating and weighing those benefits against potential costs when thinking about and designing restrictions that will change incentives in consumer credit markets.

The Durbin Fee

Thom Lambert —  18 August 2011

Given the crucial role debit card “swipe” fees played in causing the recent financial crisis, Illinois Senator Dick Durbin insisted that the Dodd-Frank law (you know, the one that left Fannie and Freddie untouched) impose price controls on debit card transactions.  Ben Bernanke, who apparently doesn’t have enough on his plate, was tasked with determining banks’ processing and fraud-related costs and setting a swipe fee that’s just high enough to cover those costs.  Mr. Bernanke first decided that the aggregate cost totaled twelve cents per swipe.  After receiving over 11,000 helpful comments, Mr. Bernanke changed his mind.  Banks’ processing and fraud costs, he decided, are really 21 cents per swipe, plus 0.05 percent of the transaction amount.  In a few weeks (on October 1), the government will require banks to charge no more than that amount for each debit card transaction.

SHOCKINGLY, this price control seems to be altering other aspects of the deals banks strike with their customers.  The WSJ is reporting that a number of banks, facing the prospect of reduced revenues from swipe fees, are going to start charging customers an upfront, non-swipe fee for the right to make debit card purchases.  Wells Fargo, J.P. Morgan Chase, Suntrust, Regions, and Bank of America have announced plans to try or explore these sorts of fees — “Durbin Fees,” you might call them.

Whoever would have guessed that Mr. Durbin’s valiant effort to prevent future financial crises by imposing brute price controls would have had these sorts of unintended consequences?

Fortunately for me, I can just switch to using my credit card, which will not be subject to the price controls imposed by Messrs Durbin and Bernanke.  Because I earn a decent salary and have a good credit history, this sort of a switch won’t really hurt me.  In fact, as banks increase the rewards associated with credit card use (in an attempt to encourage customers to use credit in place of debit cards), I may be able to earn some extra goodies. 

Of course, lots of folks — especially those who are out of work or have defaulted on some financial obligations because of the financial crisis and ensuing recession — don’t have access to cheap credit.  They can’t avoid Durbin Fees the way I (and Messrs Durbin and Bernanke) can.  Oh well, I’m sure Mr. Durbin and his colleagues can come up with a subsidy for those folks.

I have submitted a comment to the Federal Reserve Board concerning Regulation II, along with the American Enterprise Institute’s Alex Brill, Christopher DeMuth, Alex J. Pollock, and Peter Wallison, as well as my George Mason colleague Todd Zywicki.  Regulation II implements the interchange fee provisions of the Dodd-Frank Act.

The comment makes a rather straightforward and simple point:

We write to express our concern that the Federal Reserve Board has not to date taken the prudent and, importantly, legally required step of conducting a competitive impact analysis of Regulation II, which implements the interchange fee provisions of section 1075 of the Dodd-Frank Act (Pub L. 111-203). We consider this to be one of the most significant legal changes to the payment system’s competitive landscape since the Electronic Funds Transfer Act in 1978. This dramatic statutory and subsequent regulatory change will undoubtedly trigger a complex set of consequences for all firms participating in the payment system as well as for consumers purchasing both retail goods and financial services. The Federal Reserve’s obligation to conduct a competitive impact analysis of Regulation II is an appropriate and prudent safeguard against legal change with potentially pernicious consequences for the economy and consumers. Given the Board’s own well-crafted standards, we do not believe it is appropriate for the Board to move forward in implementing Regulation II without the required competitive impact analysis.

The rest of the comment appears below the fold.

Continue Reading…

With all the talk about the CFPB, Elizabeth Warren has been in the news lately.  The blogs too.  Most of the discussion has been about whether or not Timothy Geithner is a friend or foe to the Democrats’ preferred option of getting Warren nominated as the first chief of the CFPB.  Today, Megan McArdle started on what is a less interesting political topic, but a more interesting one for this blog with a long and detailed post on Elizabeth Warren taking on then-Professor Warren’s use of theory and data in the Two Income Trap and her controversial work on medical bankruptcies.  McArdle later doubled-up with a be re-posting Todd Zywicki’s WSJ op-ed pointing out the odd manner in which tax data are presented in Two Income Trap.  Put directly, Zywicki provides some evidence that the presentation (made in an attempt to show the increasing burdens of mortgage, car and health obligations) presents the data percentage terms in order to obfuscate the fact that changes in tax obligations play a much larger role in the economic burden facing the middle class than convenient for the story told in the book.

Larry’s post responding to an earlier blog post from Professor Warren relates not exactly to empirical skills, but empirical teaching and (do read the post) a view on law, theory and facts that reveals what I take to be a fairly deep misunderstanding of economic theory and methodology.  David Evans and I make a similar point on the use and abuse of the behavioral economics literature to bolster the case for a consumer protection agency.  Larry’s post also reminding me that as long as we are reprising old posts, I have one directly on topic that provides an example that I think gets at what McArdle, Zywicki and Ribstein are each discussing.  Frankly, I also think it is a bit more interesting than both the tax and medical bankruptcy examples for the purposes of discussing the CFPB because I believe Warren’s actual data skills matter less than how she interprets data for legal and policy applications because she will have a large staff of competent economists to do data analysis.  I do not suspect she will be running many regressions on her own.

The exercise is a fairly simple one.  Warren authored a blog post pointing to an empirical study by Agarwal, Liu, Souleses, and Chomsisengphet (“ALSC”) which examines consumer credit card selection in a natural experiment setting in which a card company offers two cards to consumers: (1) a high interest rate, no annual fee card and (2) a low rate card with an annual fee. A bullet point summary of some of their findings:

  • About 60% of consumers get the decision right with the benefit of hindsight
  • 40% do not make initially select the right card
  • Many of these initial errors are subsequently corrected as a result of consumer card switching, while ALSC report that “a small minority of consumers persists in holding substantially sub-optimal contracts without switching.”

So how are we to interpret these data?  Going back to Larry’s post, recall the importance of economic theory as a lens through which to view “facts.”  Warren asks whether “these data support the notion legal policy can be shaped by the presumption of economic rationality, or do the data support a call for more regulation?”

Its a good question.

Warren’s answer: is more regulation in light of what she describes as the “staggering” 40% error rate. Professor Warren writes:

Would it help to frame the policy question is from the provider angle? What’s the point of offering two different products, except to hope that the number of consumer who get it wrong will exceed in dollar volume the number who get it right. Or, from an informed consumers’ perspective, perhaps the optimal system is one in which they make good decisions and hope for cross-subsidization from less-clever consumers who help keep credit cards highly profitable and easy to use in a variety of settings (e.g., grocery stores, cabs, pizza deliveries, etc.). I realize it is heresy in many circles to ask if consumers should have fewer choices. But at some point the empirical studies about high error rates bring into question the assumptions that underlie the claim that more choice is always good.

Its a simple answer.  High error rate implies irrationality.  And irrationality implies regulation.  Its important to note this particular answer is not without an economic model of its own to interpret facts.  And it is not unlike the leap from evidence of irrationality to conclusions about market failure that Commissioner Rosch has made in the antitrust context.  But I think its the wrong model (because it commits the Nirvana Fallacy).  More importantly for our purposes, this is a great example where interpreting the data carefully can lead to vastly different policy conclusions which I discussed in my earlier post. And perhaps most importantly, this is an example involving interpreting data in the credit card market, something I suspect the head of the CFPB will be called upon to do frequently in forming policy.  From here on out, I’m going to copy the earlier post verbatim:

While the burden of proof is on Warren and others advocating more regulation here to demonstrate that less choice would improve consumer welfare, not only does this study not satisfy the burden, I think a reasonable interpretation of the results cuts the other way. The results suggest that consumers making credit card contract decisions behave rationally, the initial error rate is not strong evidence of consumer irrationality in light of relative costs and benefits of card switching, and the error costs are very small.  A little context is necessary to make the case for this interpretation of the data, as well as the reporting of some key results in the ALSC paper that Warren does not discuss in her post but shed light on the question of consumer rationality in the credit card market. In light of these findings, discussed below the fold, I think it is pretty clear that these findings support a standard economic model of credit card borrowing.

First, and consistent with standard economic theory, the consumer error rate decreases in the cost of the error as well as the number of times a consumer makes the decision. In other words, consumers correct bad decisions with repeat play and perhaps most importantly, make fewer errors when stakes are higher. It is difficult to square these findings with models of irrational consumer behavior. As an aside, economic theory does not suggest that consumers are immune to errors! At the very least, an error rate that decreases in the cost of error is inconsistent with the simple behavioral/ consumer irrationality-based models of consumer behavior that frequent the legal literature. By the way, another empirical study using micro-level data on this and related questions (Brown & Plache (Paying with Plastic, 73 U. Chi. L. Rev. 63 (2006)) reaches very similar results concerning consumers’ abilities to select credit card contracts optimally and is a paper very much worth reading for those interested in this topic.

Second, what about the “staggering” magnitude of the social cost involved with the initial errors? Warren does not report that ALSC report that these error costs are generally bounded in magnitude by the size of the typically small annual fee (see Table 3, the median fee is $25). The most common “behavioral” call for regulation of the credit card market is the claim that unsophisticated users will be seduced by cards with low annual fees and higher interest rates, unknowing that this decision is sub-optimal ex post and incurring large chunks of debt at higher interests rates as a result. However, ALSC find that of those consumers in their panel that do not pay annual fees, the net annual error costs exceed $200 for only 225 out of over 64,000 no-fee accounts.

If one knew the credit card market only by reading the legal literature, the most staggering feature of the ALSC (and Brown & Plache) results would be shock at how often consumers are selecting contracts optimally, switching cards, minimizing error costs. To be sure, there are a very small margin of consumers who make persistent errors. But what are we to make of this group in the context of a decision where the costs of getting the decision “right” are, on average, bounded by the magnitude of the annual fee? How large are these costs relative to the costs of switching cards, or better yet, of regulation? Of the consequences (intended and otherwise) that regulation might have on these consumers?

So, do the ALSC findings support the inference that credit card consumers are irrational and in need of regulation or less choice? It appears not. After all, most consumers here are selecting cards optimally: i.e. they are better off because of their decision! Further, the cost of failing to do so is low, and yes, reducing consumer choice is likely to reduce welfare in this setting. If those advocating regulation here have a more nuanced view of these results that supports the view that prohibiting a menu of contracts would increase welfare, I would like to hear it. Note: my naive cost/benefit analysis also does not account for other obvious (and likely enormous) benefits of credit card spending versus cash or other payment forms for the large proportion of users that do not revolve debt.

Third, the relatively small error costs (and the fact that the majority of credit card users appear not to revolve balances at all) recast the 40% initial error rate in a different light in my view. If the expected benefit of card switching is small relative to search costs, it is not especially surprising that many consumers do not incur these costs. These findings, to me, suggest caution about overstating the magnitude of the effects of “consumer irrationality” in the credit card market.

As to Warren’s question of whether it would be helpful to reframe the policy question as something like: “why WOULD the provider offer multiple products but for the exploitation of consumer error?” No. I don’t think this reframing is helpful. It is the wrong policy question to be asking. Yes, we care about an explanation of why providers offer multiple products — but isn’t the dispositive question here whether regulation would improve welfare relative to the status quo net of the costs of regulation? Further, I can think of one obvious reason why the provider would offer multiple products just like multitudes of suppliers in other markets: consumer heterogeneity in demand for different credit card attributes.

Consumers who regularly revolve debt might want a different type of credit card than convenience users that pay off their debt every month and value different card attributes. Providers offer different products to different types of consumers because the consumers value different card attributes and consumers select cards accordingly. The ALSC results suggest that they do so pretty well, and it is well known that this sort of competitive price discrimination is generally welfare-enhancing.

In sum, these findings suggest that consumers generally behave rationally in the credit card market and select the optimal card. When they don’t do so initially, the probability of error in subsequent decisions decreases in the costs of error. In the context of a decision where the costs of errors are low, one should not necessarily be surprised at a high error rate. Persistent errors may well consist of “rational ignorance,” and it is a significant leap from high error rates to, as Warren puts it, “bring[ing] into question the assumptions that underlie the claim that more choice is always good.”   The leap becomes much more daunting in light of the ALSC findings Warren does not report: error rates decrease in the size of the error and in experience with the decision. Sounds like fairly rational behavior to me.

There are a number of interesting things to comment on here, but I will limit myself to two for now.

The first is that a close, careful reading of the evidence does not “call into question the assumptions that underlie the claim that more choice is always good.”

The second is that contra the post Larry Ribstein responds to, here is an example where economic theory is not a substitute for empirical facts in the lawyer or regulator production function but rather economic theory helps one see the facts clearly.  Oddly, the important data suggesting rationality and limits to the social costs of consumer mistakes are ignored.  That is important.  And not unlike Zywicki’s tax obligation example.  But I think the most important point is that if one does not understand the fundamental economic concept that the optimal error rate in the credit card market is positive because of information and switching costs, one observes an error rate above zero and concludes that there is market failure.  An economist would ask the “compared to what” question, i.e. about the optimal error rate.  An economist might also look closely at the magnitude of the social harms discussed, as well as evidence of learning which reduces social costs, and compare those costs to the perceived benefits of a proposed regulatory solution.  But the fundamental point is economics is not a substitute for facts, it helps understand them in a legal and policy relevant sense.

I’ve been, for some time, a behavioral law and economics skeptic.  Sometimes this position is confused with skepticism about behavioral economics, as in — believing that behavioral economics itself offers nothing useful to economic science or is illegitimate in some way.   That’s not true.  Now, I have some qualms about the explanatory power of some of the behavioral models as well — but the primary critique (in my view) has always been the threat that behavioral economics will be used as the intellectual cover for regulation judged by the preferences of the regulators rather than rigorous economic analysis of any sort.

Recall, that much of behavioral economics amounts to a demonstration that individuals exhibit inconsistent preferences.  But as Glen Whitman points out, the absence of knowledge about true preferences requires that the policy maker make some decisions about actual preferences.   That’s hard to do.  It requires a lot of information.  In the case of hyperbolic discounting, for example, the conventional approach is to arbitrarily assume that true preferences are reflected by the utility function of today’s “self” rather than future “selves.”   The point is that the behavioral law and economic exercise necessarily requires that planners impose some decisions about true preferences — or in the case of firm, optimal decision-making.  What will be the basis for those decisions?  One can naively dream that they will always be founded on the best economic theory and evidence available.  But in the real world, it is apparent that one can and should be concerned that these decisions will reflect the regulators’ priors and own preferences and perhaps also those of special interests.  While there are other important methodological debates about behavioral economics, this argument is at the heart of the Rizzo and Whitman “slippery slope” objections to behavioral law and economics — and suggests that behavioral economics will be used in ways that extend beyond its limitations.

One possible response to the high likelihood of this kind of abuse is to play the “I can’t help it if…” card.  Here’s Richard Thaler in the Cato Unbound exchange, that one “cannot control how my ideas are used, either by those who advocate similar but more intrusive policies.”   But that is hardly satisfying when one is selling the ideas to the general public (now just one-click away at Amazon and sure to “improve decisions about health, wealth and happiness ” all for under $20!).  In the exchange, Thaler seems to at least implicitly agree that the ideas have been or will be used to make bad policy.  Perhaps the ideas should come with an instruction manual for how to implement policies.  But alas, the behaviorists tell us that nobody reads those sorts of disclosures anyway.  Maybe a nudge is in order?  Of course, I think Sunstein and Thaler ought to be able to sell the book without a nudge.  In fact, I bought a copy.  But note than many of the policy proposals in the behavioral law and economic literature — restrictions on credit cards and sin taxes for tobacco and soda come immediately to mind — involve products that some folks will use to make themselves better off and some, because of cognitive biases, will not.  If cognitively biased regulators’ decision-making processes are skewed toward policies that are consistent with their policy preferences and ideological views rather than what maximizes social welfare — one would think the creator of the “choice architecture” concept could come up with something a bit more creative to “debias” the decision-maker than “I cannot control how my ideas are used.”

Its a bit of an odd moment to decide to that influencing the choices of others no longer makes sense isn’t it?  In the CFPA, the so-called “plain vanilla” provision would have required those selling consumer credit products to offer consumers a “plain vanilla” version of the product and disclose the risks of the alternative product before selling any “flavored” variations.  Perhaps what is called for is a similar “plain vanilla” provision for behavioral interventions where the regulator or policy maker must show that they carefully thought through the alternative, “standard” economic interventions before choosing the riskier behavioral intervention.

Its also a critical moment.  Evidence in support of the suggestion that behavioral economics is being used in ways that extend well beyond its limits, and are quite plausibly welfare-decreasing, are not hard to find.  For example, my recent critiques of behavioral antitrust (Nudging Antitrust Part I, Part II) suggest an abuse of behavioral economics to solve policy problems without regard to its limits.  I’ve also pointed out (with co-author David Evans) that the intellectual arguments for some of the regulatory interventions in credit markets found in the CFPA/CFPB, explicitly based on behavioral economics, extend well beyond its logic and limits.   Claims of legal scholars about the policy implications of behavioral economics for consumer contracting also extend well beyond any intellectual and empirical support the behavioral economic literature can provide.  And as readers of TOTM will know, the legal literature in particular has played fast and loose with the endowment effect for quite some time.

Of course, the abuse of behavioral economics by regulators and legal scholars is a danger with any sort of methodological commitment and so, one can equally point out that the same regulators and judges might abuse Chicago School microeconomics, or game theory, or a non-economic methodological commitment, e.g. originalism.  In these situations it is especially important for academics to identify those sorts of abuses.  But it is especially beneficial for leading figures in the “abused” field to stand up and identify policy proposals do not really fit the model.  This is one of the questions that I’ve had about the behavioral economics movement.  Why doesn’t one see a prominent leader of that movement saying: “Wait a minute, that’s not what we had in mind” or “no, that is really not what behavioral economics says.”

Asked and answered.  Much to their credit, in Wednesday’s New York Times, behavioral economists George Loewenstein and Peter Ubel do exactly that.  Loewenstein and Ubel write:

But the field has its limits. As policymakers use it to devise programs, it’s becoming clear that behavioral economics is being asked to solve problems it wasn’t meant to address. Indeed, it seems in some cases that behavioral economics is being used as a political expedient, allowing policymakers to avoid painful but more effective solutions rooted in traditional economics.

While they don’t talk about some of my favorite examples in antitrust and the credit markets, they offer some of their own:

Take, for example, our nation’s obesity epidemic. The fashionable response, based on the belief that better information can lead to better behavior, is to influence consumers through things like calorie labeling — for instance, there’s a mandate in the health care reform act requiring restaurant chains to post the number of calories in their dishes.  Calorie labeling is a good thing; dieters should know more about the foods they are eating. But studies of New York City’s attempt at calorie posting have found that it has had little impact on dieters’ choices.

Obesity isn’t a result of a lack of information; instead, economists argue that rising levels of obesity can be traced to falling food prices, especially for unhealthy processed foods.  To combat the epidemic effectively, then, we need to change the relative price of healthful and unhealthful food — for example, we need to stop subsidizing corn, thereby raising the price of high fructose corn syrup used in sodas, and we also need to consider taxes on unhealthful foods. But because we lack the political will to change the price of junk food, we focus on consumer behavior.

Loewenstein and Ubel also discuss other interventions where standard economics might provide better results:

Our over-reliance on behavioral economics is not limited to health care. A “gallons-per-mile” bill recently passed by the New York State Senate is intended to help drivers think more clearly about the fuel consumption of the vehicles they purchase; research has shown that gallons-per-mile is a more effective means of getting drivers to appreciate the realities of fuel consumption than the traditional miles-per-gallon.

But more and better information fails to get at the core of the problem: people drive large, energy-inefficient cars because gas is still relatively cheap. An increase in the gas tax that made the price of gas reflect its true costs would be a far more effective — though much more politically painful — way to reduce fuel consumption.

The one thing that is missing are examples where the problem is not just that the behavioral intervention improves things marginally while the standard intervention (or the combination of the two) would be optimal, but that the behavioral intervention reduces welfare.  And from some of the examples they use, I suspect I might disagree with the authors on what policy prescriptions “standard” economics would recommend.  I believe that the credit examples in the CFPA/CFPB provide exactly that case; I also strongly believe that behavioral antitrust policy of the sort proposed by Commissioner Rosch (Part 3 of Nudging Antitrust will discuss this next week) would make consumers worse off.

Nonetheless, Loewenstein and Ubel should be applauded as “insiders” starting a high-profile discussion on the limits of behavioral economics.  From the examples the authors give, and the ones I mention above, it appears inevitable that regulators and will abuse the new tools provided them by behavioral economics.  Perhaps its time to talk about what to do about it.  Behavioral economists ought to have something valuable to say about this rather than merely punting.  The question is how to frame the policy discussion in a manner that “debiases” regulators and provide incentives for decisions that are based grounded in theory and evidence and away from their own preferences.  If the plain vanilla proposal or rules like it to encourage serious deliberation about choices are good enough for credit cards, certainly such rules should also sensible for regulatory decisions about credit cards.