The Credit and Debit Card Industry, Take 2

After reading my post on Thursday about the depredations of the credit and debit card industry, Matt Yglesias objects to my plan to "micro-manage" their business:

Regulate business to prevent negative environmental externalities, sure. Basic safety, okay. But the idea that what we need is for a bunch of people to get together and say that it would be better to ban this and that and the other capitalist act between consenting adults just strikes me as the wrong way of going about things. Purely economic regulation of this sort doesn’t have a compelling track record, runs into all kinds of Hayek-esque knowledge problems, and is basically an open invitation down the road for regulatory capture and the use of rules to prevent the emergence of competition. Count me out.

This is a very good point, and it's one that normally I'd find persuasive. So much so, in fact, that I originally planned to address it in my initial post. But that post ended up running too long as it was, so I decided to leave it for another time. Which this is. So let me take a crack at persuading Matt and other doubters that although there are indeed some important issues here related to consenting adults, competition, and Hayek-esque knowledge, they mostly point in a non-intuitive direction. There's a lot less micromanagement here than meets the eye.

Here's the thing: in my initial post I actually proposed only two pieces of government action: one to regulate interchange fees (the 1-2% fees that merchants are required to pay card issuers on every debit or credit transaction) and another to regulate overdraft fees. Let's take a look at those

First, interchange fees. The problem here is twofold: (a) the fees themselves are non-transparent to consumers and (b) they're administered by an effective monopoly. There are lots of banks and credit unions that issue credit and debit cards, but two companies — Visa and MasterCard — control the vast bulk of the payment network and set the interchange fees. Even the most ardent free marketers usually concede that a combination of monopoly power and opaque pricing is a problem, and that's what we have here.

So let's try a thought experiment. What if credit and debit cards lived in a real free market with transparent pricing? Suppose that instead of just two payment networks there were a dozen. And suppose that instead of hiding interchange fees by extracting them from merchants, who pass them along to consumers invisibly, the card companies actually charged consumers directly. What would happen?

Answer: banks and payment networks would compete for customers' business, and they'd largely do this by trying to offer the most efficient, lowest-cost service. After all, if consumers actually saw the interchange fee tacked onto their bill each month, they'd gravitate toward banks and payment networks with the lowest fees. Those fees would very quickly converge on an amount just slightly over the actual cost of running the network, and given what we know about that from the early days of debit card networks before Visa and MasterCard took over (you can read the astonishing story here), that means fees would be about a quarter of what they are now.

Now, would some card issuers try to compete on other factors? Maybe. American Express charges an annual fee and lots of customers consider it a good value anyway. So maybe some banks and one or two of the payment networks would charge a higher interchange fee and then offer rewards cards to customers to make it worth their while. This sounds like a pretty improbable business model to me — would you knowingly pay a higher monthly fee in order to get a fraction of it back in rewards? — but you never know. And if it works, I'm fine with it. That's the free market at work. A real free market with competition and transparent price signals.

Unfortunately, as economists since Adam Smith have pointed out, most of our rock-jawed titans of industry don't really like free markets. They much prefer cozy cartels and opaque pricing, which are far more profitable. So although I'd be fine with regulations that forced a genuine free market onto the card industry, I'm not sure it's feasible. As a next-best alternative, then, I favor federal regulations that push down interchange fees to something within shouting distance of what they'd be in a free market.

Second, overdraft fees. The problem here is simpler: overdraft protection is, by any common sense definition, a short-term loan. And it should be regulated as a short-term loan. Unfortunately, back in 2004 the banking industry strong-armed the Greenspan-era Fed into declaring that up is down and black is white. The Fed conceded, in its final report on the matter, that banks promote overdraft protection "in a manner that leads consumers to believe that it is a line of credit." And the Fed politely encouraged them to be a little more honest about this. But that was it. Officially, overdraft charges still weren't loan payments, they were fees, and banks could charge whatever they wanted.

There are a couple of problems here. The first is that regardless of the Fed's Alice-in-Wonderland opinion, overdrafts really are loans and ought to be regulated as loans. This is, obviously, an intrusion on a pure free market, but it's not much of one: regulating consumer loans is a long-accepted role for the federal government, and regulating overdraft fees fits right into this role. All we need are rules for overdraft fees that are roughly the same as for any other consumer loans. That includes limits on interest rates, transparency about what's being charged, and restrictions on the fees and charges that surround the origination of the loan.

Beyond that, though, there's also a pure free market distortion in the way overdraft protection works today. In a proper free market, consumers have a choice. If they don't want your good or your service, they can choose not to buy it. But until recently, that wasn't the case: consumers weren't notified that they were about to overdraw their account. They weren't given the option of choosing to accept or decline the purchase anyway. Hell, they weren't even given the option of not having overdraft protection in the first place. On the contrary, overdraft protection was deliberately set up to rope low-income consumers into paying wildly abusive fees for small mistakes. What kind of free market is that?

So that's my case. In the case of interchange fees, the free market has been so badly distorted that it simply doesn't work in any recognizable way. There are two options to fix this: either force transparency and competition on the industry or else regulate fees down to levels that aren't too flagrantly abusive. I suspect that the latter is, at this point, the only feasible option. [Update: And the latter is, at least partly, going to get done. Three cheers for Sen. Dick Durbin.]

In the case of overdraft fees, simply regulate them as short-term loans with a maximum interest rate of, say, 100%. It's an intrusion on the free market, but it's a small and long-accepted one. As a rich member of a rich society, I have a hard time accepting that we aren't willing to impose this kind of modest regulation in order to rein in a genuinely contemptible practice that's cynically set up to prey on the weakest, poorest, and most unsophisticated consumers as a way of subsidizing finance for the best off among us.

And one final thing. You can, as some pious conservatives say, avoid both interchange fees and overdraft fees simply by not using credit or debit cards. If you don't like the way the industry works, exercise your right in a free market not to participate. And 20 years ago that was a perfectly good option. But in practical terms, it just isn't anymore: it's close to impossible to live an ordinary working class or middle class lifestyle without credit and debit cards, and it's only going to get even more impossible as time goes on. For better or worse, credit and debit cards are now required parts of our existence, and that means consumers need to have real choices and real competition within the e-payment network we all live in. And that's what I want: choice and transparency, with modest regulation to prevent abuse of the most vulnerable among us. Fifty years ago that wouldn't have been controversial. It still shouldn't be.

POSTSCRIPT: Just to address a couple of likely questions before they come up:

First: So how will banks make money on credit and debit cards? Answer: interchange fees would still offset the cost of actually running the payment network. Beyond that they'll charge annual fees and make money on interest from outstanding balances. You say you don't like annual fees? Well, you're already paying one, and it's a lot bigger than you think. The only difference between interchange fees and an old-fashioned annual fee and is that an annual fee is usually smaller and is always transparent.

Second: what does this have to with financial reform? Answer: nothing much. These fees weren't directly responsible for the credit bubble or the collapse of 2008, and fixing them won't do much to prevent future disasters. It's just the right thing to do for other reasons.

Home page image: BigBeaks/Flickr

Friday Cat Blogging - 18 June 2010

Hey, you know those coffee table books that specialize in aerial views? Above London, Above New York, Above the Oil Spill, etc.? Well, I'm creating a new one: Above Lakeside. (Yes, that's the faux name of the development I live in.) Today we start with aerial views of Inkblot and Domino. Next week, it'll probably be Inkblot and Domino again. And the week after? I'm thinking maybe Inkblot and Domino. What do you guys think of my plan?

For more feline goodness, check out the LOLcat Bible here, and a MoJo interview with Ben Huh, the man behind the LOLcat empire. Interesting factoid: he's allergic to cats. Another interesting factoid: so am I. But only slightly.

Why Congress is at a Standstill

Here is Gallup's latest poll on what legislation Americans would like to see passed this year:

Is this good news? I'd say no for two reasons. First, those are pretty thin margins. Stimulus polls the best, but even that's only 60-38. There's just not much sense of urgency there. You generally need stronger support than that to get Congress to take action.

But the second reason is that these are lousy questions. Should Congress try to create jobs and stimulate the economy? Sure. Who wouldn't want Congress to do that? Astonishingly, though, 38% are opposed anyway. But what do you think the breakdown would be if the question asked if Congress should create jobs and stimulate the economy "even if it increases the federal deficit"? Or if the second question added "even if it raises the cost of gasoline and electricity"? Or if the third question added "even if it makes credit more difficult to get"?

It doesn't even matter if those are fair arguments that come after the "ifs." All that matters is that those are the arguments that would be made. And there's not much question, I think, that support for these items would all drop at least five or ten points once those "ifs" were tacked on. And that's why Congress is unlikely to take action on any of them.

In the Citizens United case, the Supreme Court ruled that corporations could spend freely on political campaigns but left the door open for Congress to impose disclosure and transparency rules. So that's what House Democrats set about doing. Unfortunately, the NRA doesn't really want anyone to know who their funders are, and they threatened to carpet bomb Capitol Hill with postcards if they weren't exempted from the proposed rules. So they were. Now everyone else wants a piece of the action too:

Top Democrats abandoned plans for a Friday vote in the House on the legislation, known as the Disclose Act, after liberal groups and members of the Congressional Black Caucus rose up against the deal with the NRA.

....The anger boiled over Thursday afternoon during meetings between House Speaker Nancy Pelosi (D-Calif.) and members of two crucial voting blocs: the CBC and the conservative Blue Dog Democrats. The Black Caucus objected to the bill's potential impact on the NAACP and other civil-rights groups, while the Blue Dogs are spooked by opposition from the business lobby ahead of the November elections, according to aides familiar with the meetings.

[Chris] Van Hollen's office said he remained confident a deal could be reached. He attempted to bridge differences Thursday by expanding the number of potential groups that would be exempted from disclosure requirements, from those with more than 1 million members to those with more than 500,000.

Give it time. We'll eventually get that number down to groups that have more than 100 members and have been in existence for at least two weeks. And then the Supreme Court will say they were just kidding the first time around, and Congress doesn't actually have the power to mandate disclosure on private groups anyway. Ain't politics grand?

Bending the Rules on the Gulf

Lousiana governor Bobby Jindal is mad at the Coast Guard because they shut down some oil skimming barges while they confirmed that there were fire extinguishers and life vests on board. Doug Mataconis sympathizes:

I’m not against martime safety, of course, but it strikes me as more than a little absurd that the Coast Guard it worry about life vests and fire extinguishers while the Governor of Louisiana is worrying about stopping the oil from entering the Louisiana marshes. At the very least, it would seem reasonable that, in an emergency situation such as the one the Gulf Coast has been in since April 20th, the enforcement of rules like these could be modified so that they don’t interfere with actual productive work.

If there is a reason to fault the Federal response to the oil spill, I think it can be found in actions like this where the blind adherence to rules stands in the way of reasonable efforts to get the job done.

It's pretty hard to take the other side of this argument. But I wonder. We are, after all, talking about barges that are sucking up oil, and the last time I checked oil was pretty damn flammable. Everyone wants the cleanup operation to proceed with breakneck speed, but that's exactly when people get tired and sloppy. And I wonder what everyone would think of the Coast Guard's ridiculous rules if they waived them and then some boat went up in a huge fireball because a spark caught somewhere and no one had a fire extinguisher handy? Do you think we'd all understand and give the Coast Guard a pass for not enforcing its own safety rules because this was, after all, an emergency? Or would there be a raging 24/7 media-fueled hysteria about yet another government agency that hasn't learned the lesson that you can't cut corners on obvious common-sense safety rules? Do I even need to ask?

Anyway, the boats were only idle for 24 hours. Maybe the Coast Guard screwed up by making them wait even that long, but it's not quite the open and shut case Jindal thinks. Ditto for all the other ideas that local authorities have. Some of them are good and the feds should green light them. But you know what? I'll bet a fair number are kind of stupid too, and the feds are right to put their resources elsewhere.

Everyone Hates China

China has warned the rest of the world — again — to back off on demands to let its currency rise. Dan Drezner comments:

China's strategy here is of a piece with their behavior over the past nine months or so, which, intentionally or not, could be characterized as "Pissing Off as Many Countries As Possible."

Seriously, it's a distinguished list. The Europeans are furious at China because of how the country acted at Copenhagen. The Japanese and South Koreans are furious at China because of how Beijing has handled the Cheonan incident. India is unhappy with China's naval aspirations, nuclear aid to Pakistan, trade imbalances, and an unsettled border. A fair number of ASEAN nations are upset with China's currency policies and its reassertion of territorial claims and spheres of influence in the South China Sea. And then there's the United States, where despite some understanding between Obama and Hu, the People's Liberation Army and the Ministry of Commerce seem bound and determined to derail any warming trend between the two countries.

My guess is that Chinese authorities just don't feel like they have any choice. They've got a tiger by the ears and no good way to get it under control. More broadly, they seem to have fully bought into the idea that any growth rate less than 8% or so spells doom, and that simply doesn't give them any breathing space. So they're holding on for dear life and figuring that Western annoyance, as usual, will be fairly transient. We gotta have someone to make cheap toys for us, after all, the same as we gotta have cheap oil. So we'll gripe at China for a while, just like we'll gripe about OPEC from time to time, but in the end we put up with trade deficits from both — a bigger one from OPEC than from China — because we don't really know how to correct the imbalances in our own economy that prompted the deficits in the first place. We're riding the same tiger as everyone else.

Investing in the Real World

The Financial Times reports that U.S. corporations are flush with cash and plan to use it to.....engage in stock buybacks. "From an economy-wide perspective," frets Matt Yglesias, "a general perception among firms that increased buybacks are the way to go is a sign of a world in which the people running successful businesses don’t see profitable investment opportunities."

Yep. And the same was largely true during credit bubble of the aughts. It's one of our economy's most fundamental problems: increasingly, investors simply don't believe that there are great opportunities to invest in the real world. So instead they invest in the shiny, bubbly financial world. This is, needless to say, not a good thing. In the long run, it's only investment in the real world that provides sustainable growth and prosperity, and it's only rising income and consumption among the broad middle class that makes the real world an attractive investment opportunity in the first place. Our ruling classes need to figure this out pronto.

Fixing Global Warming For 40 Cents a Day

I was pretty hard on President Obama's oil spill speech on Tuesday, and one reason was his unwillingness to use the occasion to press for a serious climate policy. It's true, as Dave Roberts points out, that Obama talked about raising efficiency standards, investing in clean energy tech, and setting renewable energy standards, all of which are important things. But he very deliberately didn't mention climate change, didn't mention cap-and-trade, and didn't mention carbon pricing even in passing. He just punted.

Would talking about a carbon policy have made any immediate difference? Probably not. The politics of the energy bill currently in Congress look pretty dismal right now, and no amount of presidential oratory is likely to change that. Still, changing public opinion takes time and repetition, and when you have a big audience primed to hear about energy policy, it's foolish to let the chance pass without even giving it a mention.

But there's another reason it was disappointing that Obama didn't mention carbon pricing: his own EPA had handed him a perfect excuse just one day before. In a detailed analysis of John Kerry's American Power Act, the EPA provided estimates of how it would affect carbon emissions and how much it would cost the average American. The results were remarkably reassuring.

On the emissions front, the APA would have a dramatic effect: US emissions would be cut nearly in half by 2030 compared to doing nothing. That's an enormous impact.

But how much would it cost? The answer is: almost nothing. According to EPA's models, if we do nothing, consumption of goods and services in the United States will increase 74.1% by 2030. If APA is passed, consumption will increase 73.4%.

That's it. We can cut carbon emissions nearly in half, and the net cost will be a decrease in consumption of 0.7% in 2030. EPA figures this comes to an average annual cost of $146 per household. That's 40 cents a day per family.

A prime time address was the perfect time to plant this seed with the American public, to let them know that we can address climate change at a distinctly non-scary cost. But that chance slipped away unused. It was a wasted opportunity.

The Global Economy as Slow Motion Train Wreck

With governments around the world now obsessed with cutting spending even though the economy is still in a deep slump, here is Barack Obama in a statement aimed mainly at European leaders:

"I am committed to the restoration of fiscal sustainability," Obama said, "but it is critical that the timing and pace of consolidation in each economy suit the needs of the global economy, the momentum of private sector demand, and national circumstances." The United States is setting budget goals for 2013, for example, but in the interim "will pursue measures to support the recovery in private demand and return the unemployed to work," he wrote.

And here is Paul Krugman translating Obama's government-ese into English:

Many economists, myself included, regard this turn to austerity as a huge mistake. It raises memories of 1937, when F.D.R.’s premature attempt to balance the budget helped plunge a recovering economy back into severe recession....But despite these warnings, the deficit hawks are prevailing in most places — and nowhere more than here [in Germany], where the government has pledged 80 billion euros, almost $100 billion, in tax increases and spending cuts even though the economy continues to operate far below capacity.

....German deficit hawkery [...] has nothing to do with fiscal realism. Instead, it’s about moralizing and posturing....There will, of course, be a price for this posturing. Only part of that price will fall on Germany: German austerity will worsen the crisis in the euro area, making it that much harder for Spain and other troubled economies to recover. Europe’s troubles are also leading to a weak euro, which perversely helps German manufacturing, but also exports the consequences of German austerity to the rest of the world, including the United States.

But German politicians seem determined to prove their strength by imposing suffering — and politicians around the world are following their lead. How bad will it be? Will it really be 1937 all over again? I don’t know. What I do know is that economic policy around the world has taken a major wrong turn, and that the odds of a prolonged slump are rising by the day.

I'm not sure I agree with that last sentence. The odds of a prolonged slump seem to me to be within a hair of 100% right now. I'm really not sure there's anywhere for them to rise to.

How to Stimulate the Economy in One Easy Step

I don't often agree with Tyler Cowen without reservation, but when he's right, he's right:

The real fiscal problem is spending contraction at the state level (expanding and contracting spending are not symmetric in their effects; contracting spend hurts more than expanding spending helps). The correct fiscal policy move would have been, and still is, to take Medicaid away from the states and make it fully federal. This would give state budgets a huge break, and help employment, yet as a one-time change it reduces the moral hazard problems from ongoing outright grants.

Sign me up!