Last month I introduced myself to the US banking complex. They immediately threw a credit card at me and offered me $200 if I promised to use it. What?
The bank associate must have misunderstood my confusion because she hastily added that that was not all, of course, the rewards program gives cashbacks of 2% on everything I buy. An introductory offer? No, forever. Huh? Oh, there’s an introductory offer too? I don’t have to pay anything back for the first 18 months? What?
What’s especially funny is that this seems completely normal to Americans and bizarre to almost everyone else. The rest of the world is not used to moneylenders begging you to take their money. It’s true! In the US too, moneylenders are actually so stingy with their money that they currently charge the US Federal Government a 5% interest on its loans. That they would then turn around and offer lil old me such generous terms begs an explanation1.
It’s a strange state of affairs. Almost as strange as another characteristic unique to the US.
US credit cards have some of the highest transaction fees in the world. Every time a merchant accepts payment by credit card, they are charged between 2-3% of the payment in various fees. Most of this is the interchange fee: a fee levied by credit card networks with no associated overhead transaction cost. For a merchant, 2-3% is a painfully large fraction of potential revenue to be perpetually losing to a credit card company — especially when that credit card company is barely lifting a finger to be able to extract this tariff. Competition is getting stiff, and our merchant needs to cut costs. Simply refusing to accept credit cards is inconceivable: her business would simply lose too many customers. In despair, she throws her hands up and cries out for the God of Competition and Free Markets. Why have you forsaken me?
Elsewhere, in an impossibly tall skyscraper, the evil credit card company CEO sits atop his throne, fingers steepled, smiling at the hordes of gold he’s amassed from countless poor merchants, that he gets to keep all for himself.
…No, that’s not what happens. The credit card network company isn’t actually keeping the fees. The shockingly high interchange fees are — believe it or not — probably set by competition. Except the pressure from this competition doesn’t decrease the fees, it increases it. That’s because the competition is for us. We, the consumers, are the prize, and credit card network companies throw absurd reward programs our way to compete with each other. These programs are expensive — because of needing to pay rewards, every transaction made imposes pretty significant costs on the credit card company. And this, they fund using the interchange fee. To offer ever greater rewards, they levy ever greater fees.
Without considering this, one might be tempted to explain away the high fees by citing the oligopoly of the credit card market. An oligopoly it may be, but it is not one so depraved that the players can extract a rent of 3% of all credit card transactions. That my credit card company keeps throwing money at me is evidence; this is not how a cartel behaves. This indicates that the interchange fee is not actually as bad as one might think — it’s not profitable to the banks. The worst thing in the entire world is economic rent — a tariff that one individual is able to extract from another at no cost or risk to themselves. The interchange fee is thus not ‘rent’ in the purest sense, because it has a corresponding marginal cost: the cost of paying for rewards. That makes it not the worst thing in the world.
Still, it is not optimal. And more importantly, it is strange. Credit card companies are tripping over themselves to extract huge tariffs from merchants, all just to… give it to us. The God of Competition and Free Markets coddles us, whilst ignoring the merchant’s cries. No other countries2 find themselves in this situation. To understand it, as always, we follow the money — in this case, the lack thereof.
The merchant is miffed with the 3% tariff. What solutions does the market offer me? she thinks to herself (she’s an economist too).
1. Simply refuse credit cards. (The naive neoliberal)
This is the cleanest idea of them all. Unfortunately, it doesn’t seem to work. We know that it doesn’t work because most businesses do in fact accept credit cards. Most businesses have calculated either through trial and error or otherwise that the customers they lose by refusing credit cards cost them more than the net revenue they gain from saving on fees. Everyone expects credit cards to work everywhere, so many don’t even carry cash. And if a customer with a card shows up at your business, refusing them means they go to your competitor. Repeat this enough times and you’re out of business.
There is one way to locally avoid this equilibrium – be famous, and be famous for not accepting credit cards. There is one old brunch cafe in New Haven called The Pantry. Known for its eggs, fancy pancakes, and accepting only cash. Another way to do this without being famous enough yourself is to be famous as a group. The Chinatown in Manhattan has some incredible restaurants. I know this because my friend told me that the Chinatown in Manhattan has some incredible restaurants, and that if I’m going I should carry cash. Customers know exactly what to expect, and even among the few who still show up without cash, turning them down doesn’t mean they’ll go to your competitor, because there’s nobody else quite like you. Alas, our merchant runs a drugstore, so she can’t quite pull this off.
2. Price-discriminate between credit card and cash-paying customers. (The savvy neoliberal)
That is, charge credit card users a small surcharge over what cash users pay, to offset the fees. This is the next best idea. Unfortunately, credit card companies have strong incentives to prevent our merchant from doing this effectively, and they usually succeed. For one, there are literally laws in several states that make such price discrimination illegal. For another, such surcharges might be against the terms of service of the credit card networks — terms that you must accept if you want to take payment by credit cards. One interesting way they do this is by having many different rewards programs so that each customer has a different cashback rate, but not allowing them to be surcharged differently by the terms.
3. Just increase the price of all wares, to offset fees. (The jaded general equilibrist)
But the price distortion creates a deadweight loss, taking away surplus from the merchant and the consumers. The worst part is that it’s the customers who don’t have credit — often the most disadvantaged — that are now at the worst end of the bargain: they are subjected to 3% higher prices, but don't get 3% cashbacks at the end of the month. They pay extra, in a sense, so that richer customers can get rewards. This is what many businesses end up doing, in practice. The higher prices do lose them some customers, of course, which reduces their overall revenue.
And… those are all the options the market has for her. It doesn’t serve her. It offers her no choices, no exit options that do not make her much worse off. No company is trying to capture any value and share it with her — all captured value is being shared with the consumers. The market has abandoned her.
She cannot unilaterally change this state of affairs, and nobody else wants to change this state of affairs. And so we have this equilibrium: the American Credit Card Equilibrium, an equilibrium characterized by near-universal credit card use, high fees, high cashbacks and rewards and incentives offered by credit card companies to consumers, and reduced surplus for everybody.
This equilibrium is somewhat unique to the Amerisphere. Other countries avoid it, and instead choose the low-fees, low-cashback equilibrium3. Much of Europe, for example, does this by simply imposing a hard cap on credit card fees, forcing their financial system to fall into the low equilibrium. This is very effective, no doubt. But it is not an elegant solution. It is coercive, and prevents an entire dimension of competition. It forever locks out any innovation that might one day find a way to have high fees but use it in a creative manner to create more surplus for all. It distorts the market during times of low supply. Price ceilings are often the first solution one thinks of, but they are rarely the way to go. There is a principle in public policy that is so tried and true I’d rank it among the fundamental insights of free markets: that a market failure should always be dealt with using the least coercive solution possible.
It’s hard to see, but there is one much more elegant solution. And it’s from right here in America.
There’s something funny that one realizes after closely examining the Credit Card Equilibrium, and it’s that it has nothing whatsoever to do with how credit cards work. The setup is unrelated to the lending of money; banks really are taking a small hit when they lend me money free for a month. They just make it back on fees, and on interest from late payments4.
Then why do they do this only with credit cards? The rewards and the fees are not exclusive to the mechanism of credit — banks could have been doing all these shenanigans with debit cards. The answer is that banks did in fact do these shenanigans with debit cards for a while, until one piece of legislation put an end to them. The Durbin Amendment, enacted in 2010 as part of the post financial crisis regulatory reform, completely killed the high debit card interchange fee.
When a buyer pays by card, the transaction gets routed through their own card’s network. The credit card network here serves the buyer, not the merchant. The buyer is their customer. Yet, the fee they charge is to the merchant. Who has no recourse as the fee goes up. This is the weak link in the market.
The Durbin Amendment requires that card companies offer merchants an alternative network through which they can route the payment if they wished. No longer are they locked into paying the interchange fee of the buyer’s card — they can just choose another network’s fee, if they find it lower. Now, the card company is forced to vie for the patronage of merchants too, since they now have outside options. Both buyers and merchants become customers of the networks. Balance is restored!
Alas, this is not quite the story. The Durbin Amendment couldn’t quite resist the temptation of imposing a hard cap on the debit interchange fees alongside these provisions. This unfortunately takes away much of the elegance of the idea, and creates the same distortion in the market as Europe did. Is there a reasonable justification for this? Maybe. But also, maybe not — the instinct to beat the market into submission runs deep. Even the land of the free and the home of the brave is sometimes not spared from the evils of economic illiteracy (and possibly the retail lobby). There was perhaps some moral reasoning that went into this, that a payment by debit card is as good as a payment by cash that they are choosing to keep in a bank, and that access to this cash shouldn’t come with a fee charged to anyone. Maybe. But also perhaps the market could have decided how much it valued the service of debit cards added, instead of one Richard Durbin and company.
On the bright side, there is a proposed equivalent legislation for credit cards (S. 4674), and it does not set a cap on credit card fees; it only mandates giving merchants the choice of an alternative network. This is the Way5. Our merchant rejoices; it gives her choices, and it will bring down her fees. It also fundamentally respects the market.
There yet remains one philosophical point to contend with: the question of whose welfare the state should try to maximize. The dominant school of thought in American regulatory philosophy is the Consumer Welfare Standard6 — the principle that regulators should only seek to maximize consumer’s welfare, and to not care about firm welfare at all. This seems reasonable and unambiguous. But in two-sided markets like this one, there are actually three parties at play — the card company, the buyers, and the merchants. Buyers are consumers, their welfare should be maximized. Card companies are firms, their welfare does not matter. But what about merchants? Are they firms? Or consumers? Should their welfare be taken into account whatsoever? If you thought ‘merchant’ and pictured ‘Walmart’, you might answer “no”. If you thought ‘merchant’ and pictured ‘local family store’, you might answer “yes”.
If you side with the former interpretation, then the current state of affairs is the dream. Firms are doing what they are designed to do, which is to improve your welfare. They are fighting each other to give you a few extra dollars.
This law philosophically sides with the latter interpretation7. The card-accepting-merchant’s welfare is being cared for by the Durbin Amendment, and by this new legislation. This will be at the cost of bank profit and, more importantly, at the cost of some buyer welfare, as compared to the status quo.
It’s hard to say which is right.
I am fortunate to be a part of the socio-economic class that the big banks deem very credit-worthy by default — certainly if I were a poor laborer my terms would not have been so generous. But still, even given that banks consider me low risk… it still seems like too much.
Except for some USesque ones like Canada and Australia
No other equilibrium is stable.
They do in a sense charge me more than the 5% interest they charge the US government, by giving me less rewards than they would have otherwise. Phew! The weight of the responsibility of being more credit worthy than the US government was too much for my poor shoulders.
Some have argued against the Durbin Amendment, saying that banks increased account fees to make up for losing interchange fees, locking out of the banking system some of the poorest members of society. This is bad, but this is a bad reason to oppose the Durbin Amendment. If America wants the poorest to be banked, then America can subsidize their bank accounts by its own godly hand. One instrument, one goal. No, the the correct reason to oppose the Durbin Amendment is bad is the same reason why almost every price cap is bad.
Also known (by me, mostly) as the Chicago Consensus, which is a much cooler name. I’m trying to make it a thing.
Despite the fact that most of the lobbying for it was probably done by Walmarts and Targets.
Thanks Agnes for the idea, the conversations, and generally pointing out when I say stupid things.