Archives For credit cards

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.

The new Consumer Financial Protection Bureau is right around the corner  Talk has now turned to who might run the powerful agency and what it might do.  The WSJ names names:

Democratic leaders in Congress say their top pick for the post is Elizabeth Warren, the high-profile Harvard law professor and an outspoken critic of what she sees as a too-cozy relationship between government and bankers.

Other potential candidates include Michael Barr, a Treasury assistant secretary and University of Michigan law professor with a longstanding interest in consumer finance; Democratic state attorneys general Martha Coakley of Massachusetts, Lisa Madigan of Illinois and Lori Swanson of Minnesota; Susan Wachter of the University of Pennsylvania’s Wharton School, who served in the Clinton Department of Housing and Urban Development; and Nicolas Retsinas of Harvard’s Joint Center for Housing studies, a former bank regulator and a low-income housing specialist.

As David Evans and I have discussed, the blueprint for what was then the Consumer Financial Protection Agency was based in large part on using the insights of behavioral economics to design regulation in consumer credit markets.  Advocates of behavioral law and economics have generally taken a dim view of consumer borrowing, arguing that consumers over-value current consumption and do not adequately account for the costs of repayment in the future.  Policy proposals from this literature include a variety of prohibitions of consumer lending, including restrictions on subprime lending, payday lending, banning credit cards, unbundling the transacting and financing services offered by credit card companies, and usury laws.

The new Consumer Financial Protection Bureau is likely to follow this blueprint.  Indeed, two of the top candidates to run the CFPB — Elizabeth Warren and Michael Barr — are law professors who were chief architects of what was then the CFPA.   It is highly likely that the CFPB, like the proposed CFPA, will maintain its commitment to the behavioral approach to consumer borrowing, and use its significant powers to adopt regulations consistent with the view that consumers are systematically irrational when it comes to financial products and that the government would make better decisions for consumers for their own protection.

As I’ve pointed out with Evans (and again with Todd Zywicki), the behavioral advocates have not adequately made their case as a matter of economic theory or empirical evidence, nor have they sufficiently overcome concerns that the behavioral approach satisfies a careful cost-benefit analysis that accounts for the dynamic costs of dampening individual incentives to improve decision-making and regulator error.

I suspect that it is very important for advocates of the behavioral approach to regulating consumer borrowing that an “insider” be the first director of the powerful new agency.  While the article suggests that Democratic leaders prefer Professor Warren, who would certainly fit the bill as one of the chief intellectual architects of this approach, I predict Professor Barr gets the nod.

I did find out part of the article refreshing: a frank admission from some consumer groups that the cost of credit will be likely to increase:

Some consumer advocates acknowledge that certain borrowers—particularly low-income consumers—are likely to find less credit available as products are regulated more closely than they were before. They maintain that modestly higher costs will be a worthwhile trade-off to thwart dangerous lending practices.

At least they are acknowledging some tradeoffs.  Given the underlying assumption at the heart of the behavioral approach to consumer borrowing, on top of the patchwork of state level regulations layered on top of the CFPB, this outcome should be fairly obvious.  But there are some who appear to believe that Congress can repeal the laws of supply and demand if they want it badly enough.   But how large will the reduction in credit be?  Who will bear it?  What will the social costs of that reduction?  And what will consumers get in exchange?

Here’s one opinion from the article:

“Credit is going to be a little more expensive,” said Prof. Engel of Suffolk University. “But I think most people in this country, having seen what happened to their pension funds and all of the external costs of risky lending, would be willing to take on paying a little bit more for credit to prevent this kind of crisis.”

If it were true that the CFPB-proponents really had compelling evidence that the sorts of regulations contemplated by Professors Warren, Barr and others would have prevented financial crisis, or even provide consumer benefits in excess of the costs, perhaps most people in the country should want to pay a little bit more for credit and we should willingly accept the reduction in access to credit (especially for traditionally disadvantaged groups with less access). 

If it were true.  But it isn’t.

Judge Posner offers his thoughts on financial reform, mostly negative, at Bloomberg.   The thrust of the essay is that the financial regulation produced by the political process has, at best, a poor nexus to the actual causes of the economic crisis, and that what we are left with is primary reorganization and reshuffling to look busy.  Judge Posner discusses the political advantages to reshuffling as a response to government failure:

Reorganization is a favorite response to a governmental failure because it is visible, easily explainable, and can be done without ruffling too many feathers among interest groups and bureaucrats. It also buys time, since no one expects such reshuffling to be effective immediately.The new financial overhaul bill is about 2,300 pages long, and though they are pages of large print and broad margins, I defy any single person to claim to have read and understood it all. So far as I can judge, though, much that the bill ordains is within the existing powers of the financial regulatory agencies and is therefore superfluous.

Posner also takes aim at the consumer protection aspects of the bill.  As I’ve noted with David Evans and again with Todd Zywicki, the consumer protection-related aspects of the legislation have always been troubling on substantive grounds and include substantial risk of a reduction in consumer access to credit.  Posner focuses here instead, as he does throughout the essay, on the redundancies of the bill.  For example, of locating the consumer protection arm in the Federal Reserve instead of the Federal Trade Commission (a solution I’ve supported), Posner writes:

A consumer-protection bureau lodged in the Federal Reserve? The Fed already has such a unit. It is ineffectual because the Fed cares about the solvency of banks, not the solvency of their customers. Congress proposes to cure this skew by making the head of the Fed’s consumer protection staff — renamed the Consumer Financial Protection Board, since renaming is the least arduous and hence an irresistible form of reorganization — a presidential appointee, which will create friction with the Fed’s chairman, who might (because he has a fixed term) be a holdover from a previous administration. …

The Federal Trade Commission already has extensive experience in consumer protection and could be given additional resources to police unfair and deceptive practices in mortgage and other consumer lending. If, as some students of finance infer from the extraordinary interest rates that people pay for credit-card debt and other forms of fringe banking, it’s true that Americans simply can’t handle debt responsibly, the only solution is to reinstate usury laws.

Posner’s op-ed is available here.

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

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.

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

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

In a recent commentary at, 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. Continue Reading…

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.

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.

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.