Interchange, 1: GMU Conference, Debit or Credit?

Two more entries on interchange, which is becoming a major fight in the financial reform bill.

1) Here’s video of George Mason University’s Payment Card Interchange Fees: Picking Up the Tab, with Thomas Durkin, me, Geoffrey Manne, Felix Salmon, Steven Semeraro, Fred Smith, hosted by Megan McArdle. It was my first panel, so I start off nervous but, I think, eventually catch on. Megan was impressive getting 6 people to each engage each other and convey what they thought, though they had wildly different backgrounds and opinions.

2) As always, it is a good idea to clear the mind and start fresh with a classic Steve Waldman post at interfluidity, namely Distinguish between transactional and revolving credit. It starts with: “We won’t get very far in the debate about credit in the US economy if we fail to distinguish between transactional and revolving credit. These are two are fundamentally different products, and much ill has come from conflation of the two.”

This was my favorite conflation of the two, where you either had credit cards or you had cash. 2 minutes 30 seconds into Todd Zywicki’s keynote talk:

In particular, what strikes me as…just bizarre is the idea that for some reason we want to be using more cash and more checks. It’s just astounding to me that there are people who argue that what we need to have happen is more Brink’s truck drivers driving around with pieces of paper carrying guns. The idea that that is where the payment system should be going, towards more pieces of paper being driven around by armed guards is something that is quite strange to me.

Men in trucks with guns!

You can see Waldman’s point is important. Most of the “network” models you hear from George Mason and other people assume that there is a single fee to be split between two parties, but as the fee is a necessary condition of the transaction Coase-style mechanisms tell us that it is best if one parties internalizes all of it. However these models don’t take into account that there are multiple types of plastic, both high rewards, the abomination known as signature debit, and low fraud risk pin debt. You saw it with the arguments switching between “maximizing volume of credit card transaction” and getting an efficient volume of electronic payments through revolver debt.

3) Wilko Bolt and Sujit “Bob” Chakravorti have a paper – Consumer Choice and Merchant Acceptance of Payment Media, that builds a workhorse economic model when you take in multiple payment methods, and they find “Our model predicts that when merchants are restricted to charging a uniform price for goods that they sell, the bank benefits while consumers and merchants are worse off.” (If you like model building, that’s a really fun paper to take apart and put back together again.)

Who Benefits

Right now the system is setup to maximize the usage of credit cards over debit cards. It’s not an accident that this system is maximized and incentivized. Banks love it when consumers are sitting in the sweat box of only being able to pay the minimum and getting hit with fees. And even without that, this system has social costs. As the Former Providian CEO Shailesh Mehta, the person who created the current credit card system in the 1980s, noted to PBS:

Mehta: Now, if somebody pays their monthly bill in full, and zero interest income, and if you don’t charge annual fee, zero fee income. So you have to make up everything from the merchant side, which you cannot. So what banks ended up doing is therefore they were subsidizing this whole group, because still two-thirds of the people were not making full payment. And that interest income covered the losses of the people who were paying in full.

So overall, the business looked profitable. But … in a strange way, the banks were charging borrowers higher interest rates in order to give the wealthy people a break — in a strange way, if you look at it, because the people who have money were paying in full, and they were getting the break at the expense of the people who couldn’t pay in full.

PBS: So it was sort of an unintended transfer of wealth.

Mehta: It’s unintended, exactly. I don’t think anybody thought through that. But correct.

Mehta notes that our new 21st century payment system functions in part as a transfer of wealth from poor people to rich people, and nobody has an incentive to break the system. If merchants can give a discount to pin debit – if they can offer you a free loaf of bread if you type in your pin, or if they have a special check out line for the same – they will do so. And this will give us the socially optimal allocation of the types of payments, and prevent the very system we want to use to fund our real economy from being a regressive tax.

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