The Case for Regulation, 1: Interchange

Matt Yglesias writes a good post I’d normally agree with:

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.

Kevin Drum responds. I’m going to respond as well in two posts, one on interchange and one on consumer finances.

Meta Interchange

The first meta-question is whether or not it is socially desirable to have a payment system trade “at par.” If I write you a check for $100 you can cash it for $100. This is not a state of nature event; it’s a result of the Federal Reserve’s action in taking on some of the clearing risk. Do we need a payment system of debit where companies with shareholders gets to take a 2% cut of debit transactions? This is a transaction of moving my money from point A to point B, not lending credit through a credit card’s revolver line. If you are uncomfortable with this, you may also be uncomfortable with the way the clearing mechanisms on checking accounts work. I would like to see this cut as narrow as possible, to keep a financial sector that allows us to transact in the real economy, not the other way around.

The second meta-question is whether or not there is something unhealthy about a payment system that blurs the line, on purpose, between transactions and revolving lines of credit. The system is set-up to encourage you to use credit as much as possible, and then pay that credit off later. This is not an accident. The common phrase among credit card company people is that people are “sloppy payers”, and these sloppy payments function as a major profit center for businesses. This system also transfer money upwards in a regressive, tax-free manner and distorts prices so that shareholders of financial companies can get a cut.

My regulatory impulse kicks in for a couple of reasons. One is that interchange rates are the highest in the developed world and increasing. Rates have been jacked in the past year and we’ve seen no slack in demand for the services.

No Fix in Sight

The two obvious things I would expect to combat this don’t look likely to move. Competition is actually backwards. Since the credit market is so crowded, and people already have so many cards, competition works by getting more rewards into a card to get people to buy them. Those rewards come from merchants. So competition among interchange will drive up the rate.

Technology breakthroughs, the other things to break up oligarchies, also don’t look likely. I can’t find it now, but recently there was an article about the future of consumer finances online (maybe in Wired?). A lot of revolutionary stuff could be coming, but none of it looks to be able to cut the legs out from the interchange system. I talk a lot to the online tech finance people, and try to keep up on what is happening in the medium term, and I don’t see much that is moving in order to put competitive pressure on the credit card model. I think that plastic will be the future in the 21st century, and there’s a clear structure of who sets these prices.

Merchant Restraints

There’s a lot of talk about markets, but markets are abstractions that form over the ability to contract. And right now the “merchant restraints” in the contract that merchants sign with the financial industry are distorted. The contracts they sign prevents them from distinguishing between debit and credit, and it is not surprising that the market that forms over this is also distorted.

And this is the payment system. If it was a random consumer good, I would care much less about cross-subsidies and squeezing. If people who drink their coffee black subsidize cream and sugar coffee drinkers, whatever. But this is the very mechanism of which our economy runs – the way in which we trade goods and services. If distortions goes to the core of the economy, it doesn’t surprise me that we have a lot of bad scenarios much further downstream.

And my preferred solution to this problem is simple and elegant: let merchants give discounts for debit. Many won’t. I offer to type my pin in, and many places don’t care if they are busy and encourage me to just sign. Merchants are in the best place to determine how much they value speed, convenience and extra volume, to the extent there is value in these things for signature credit, versus the discount of debit. And give the Federal Reserve the ability to monitor and regulation interchange fees for debit, much in the sense they do a similar function for our checking accounts (though this bill doesn’t go as far as the Fed deal with checking). Taxing people’s rewards is the other way to go, but I imagine that would be much more of a headache.