Fixing The Credit Card System
It’s great for the well-off but increasingly problematic for the larger economy.
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Saturday, March 16, 2024
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19 comments
Former Obama Treasury official and Brookings scholar Aaron Klein assesses “What the Fight Over the Capital One-Discover Merger Misses About Our Terrible Credit Card System.”
A fight has commenced over Capital One’s effort to acquire Discover, a deal that would birth an enormous credit card company rivaling Visa, Mastercard and American Express. The resulting competition could, in the short run, lower some costs to businesses and consumers. However, over the longer term, the merger would keep intact the broken and predatory system in which credit card companies profit handsomely by rewarding our richest Americans and advantaging the biggest corporations.
Credit card companies increasingly generate money via swipe fees, or the money merchants pay issuers every time a credit card is used. Total swipe fees rose 20 percent in 2022 to an estimated $160 billion a year nationally. The pandemic changed how we buy things, significantly increasing the share of transactions put on credit cards rather than conducted in cash, adding to the swipe fees merchants pay.
On top of this, a 2018 Supreme Court ruling effectively forces merchants to accept either every type of card — from, say, a basic Green Card to the Platinum Card — from an issuer like Amex or none of them. And even though fancier types of cards generally demand higher swipe fees, the ruling also barred merchants from incentivizing consumers to use the cheaper ones. These facts combine in a way that makes it even more appealing for Capital One, a giant credit card issuer, to merge with Discover, which owns a payment system, and generate greater profits from credit cards, particularly higher-end reward cards.
So, Klein is using a classic pundit’s trick of leveraging a development in the news as a hook to tout a pre-existing policy preference. Indeed, it’s not obvious that a possible Chase-Discover merger would have much impact at all on this particular set of facts.
Still, his concern is a valid one and at least some of his policy solutions are ones I haven’t seen before.
Credit card companies found they could command ever-greater swipe fees from merchants while at the same time offering their wealthiest consumers more deluxe credit cards that reward big spending with cash back, travel points, access to fancy airport lounges and the like — and then pass on the cost of those rewards to merchants. Merchants must then choose whether to accept and pay the higher swipe fee demanded by these platinum expensive cards or not take any from that card company.
As a quick aside, I don’t read the above-linked SCOTUS decision the same way Klein does. The case seemed to be a narrow one: whether Amex’ policy of disallowing merchants to steer customers to non-Amex cards, which charge lower swipe fees, violates anti-trust law. In a narrow 5-4 case, the Justices said No. But it’s quite possible that subsequent litigation has expanded that interpretation. (And, regardless, it’s quite likely Amex’s policy that its merchants must accept all of their cards or none.)
In our increasingly digital economy, most merchants have little alternative but to accept the pricey versions and to pay for the privilege. Naturally, merchants pass on their increased cost to all of their customers.
That, of course, is ultimately the main issue. Although, as Klein notes, there are smaller and less obvious ones as well. More on those shortly.
That’s how the rest of us, whether we pay with cash, a debit card or a middle-of-the-road credit card, wind up paying more — because we are subsidizing these rewards cards for whom only the wealthiest qualify. One study from economists at the Boston Federal Reserve estimated that the highest-income households profit over $1,000 a year tax-free from the payment system, adjusted for inflation.
That seems quite plausible. Points on my Costco Visa pay for the annual executive membership with a couple hundred bucks left over. And my Amazon spending is slightly subsidized by my Amazon Visa—which I don’t even have a physical copy of and use exclusively for purchases with them. And I have yet another Visa with Marriot used almost exclusively for stays with them. It’s not exactly lifestyle-changing, but better than nothing.
Remember those “smaller and less obvious” problems? Here we go:
Because swipe fees include a fixed cost in addition to a percentage of the total cost, small-dollar transactions are extremely expensive for merchants. My research found huge costs for such transactions as buying a cup of coffee or paying for a bus or subway ride. One year my oldest friend’s small coffee shop paid more in card processing costs than for coffee beans.
Big companies can leverage their resources to lower swipe fees, giving them a leg up. Starbucks stole a page from the credit card playbook and built an app that gives consumers rewards on future purchases if they upload larger amounts of money from their credit cards, thus lowering the total fees Starbucks has to pay the credit card companies for each swipe.
Some big businesses negotiate discounted swipe fees. Costco is the most aggressive; there have been reports that the big discount retailer’s contract with Citibank and Visa lowered its costs to 0.4 percent while a local dry cleaner may be paying closer to 3 percent.
The problem isn’t limited to nonwealthy consumers and small businesses: Parking meters that used to run on coins now rely on credit-card-powered apps, which charge transaction fees that can be over 20 percent, such as 45 cents on $2. Public transit agencies can lose 7 percent of the money they generate in fares in card-processing fees. A growing gap between what users pay and local agencies receive could stress budgets and require higher taxes, increased fees or reduced public services.
This is indeed problematic.The issue of micropayments is one that hadn’t really occurred to me. Once upon a time—as recently as 10 or 15 years ago—it would never have occurred to me to pay for something under $20 with a credit card. Now, I do so routinely.
Even more recently, I would routinely withdraw $200 or $300 from my ATM every few weeks. Now, even though that amount has diminished in buying power, it’ll last months. Indeed, I can’t remember the last time I withdrew cash. I pay for pretty much everything digitally or with a physical credit card now.
Amusingly, while I get small bonuses for using various cards, it only impacts my purchasing habits at the margins—using the three aforementioned merchant cards when shopping with those companies. For example, a local gas station that I frequently fill up at on the way to work has typically offered a 3-cent-a-gallon discount for using a debit card rather than a credit card and I’ve thus used my debit card there. Yet my Costco Visa gives me 5% “cash back” on gas. When gas was $4 a gallon, I’d have been far better off getting 20 cents cash back rather than saving the 3 cents. That would be true even at $3 or, hell, $1 a gallon. Rather obviously, though, the seller desperately wants customers to make the opposite choice.
Klein thinks an intervention is in order:
To fix the problem, Congress should legislatively correct the Supreme Court’s mistake. For starters, give merchants the power to reject the priciest credit cards, and let’s see if their users are willing to pay the true cost of their rewards. This solution ought to have some bipartisan support; the idea was strong enough politically to be supported by states as diverse as Ohio, Texas and Maryland. Bipartisan legislation to overturn a conservative Supreme Court ruling may sound like a pipe dream, but in payments policy we’ve seen a few examples such as the Durbin Amendment to what became the Dodd-Frank Act, which lowered debit interchange fees, received 64 votes (including 16 from Republicans) in the Senate and made it into law.
This sounds good in theory but I’d be angry if a merchant rejected my card at the point of sale. And it would be incredibly awkward at, say, a restaurant where the transaction was already completed minus the payment. And I suspect most people don’t carry an array of cards.
Second, brave policymakers could start taxing reward points. The richer you are, the more likely you qualify for bigger rewards. Progressive taxation rates mean that exempting rewards from taxation makes them nearly four times as valuable to those in the top tax bracket as the bottom. Why is interest from my savings account taxed, but the cash back from card spending not? Once upon a time the value of frequent flier miles was hard to quantify; now the Points Guy has it down.
I must admit that it had never occurred to me that points should be taxed but it’s perfectly reasonable. But if someone is making a million dollars a year and getting a whopping “$1,000 a year tax-free from the payment system,” are they really going to notice—much less change their behavior—over a $372 increase in their tax bill? Most of them would likely forgo the $1000 entirely for upgraded travel perks.
Finally, we could require all merchants have access to the same swipe-fee pricing, regardless of size. Why should the payment system give big business another advantage? The electronic cash register should not tilt the playing field.
This seems the most obvious solution to the larger problem. But I suspect that the second-order effect would be some combination of 1) higher fees to join the network and 2) exclusion of smaller businesses from the network.
As to the Capitol One-Discover merger:
Our payment system’s problems will not be solved by allowing or stopping a combination of Capital One and Discover. Adding a fourth major issuer to compete with the big three will make little difference if the system’s rules remain the same. Capital One already seems to be competing with American Express for wealthy customers who like elite airport lounges and big travel perks, which are funded in part from higher swipe fees. The rewards have kept getting richer over the past 20 years. Simply adding one more company to earn large profits through the existing system will hardly stop it.
Blocking the merger will fail to change the payment system that continues to drive greater rewards to those with the most money already, paid for by merchants and consumers who use cash, debit or lower-tier cards because they are not rich enough to qualify. As the economy continues to digitize with more micropayments, the credit card burden will keep growing, particularly on smaller businesses. Today’s large banks and payment companies will make more profit, sharing it based on who qualifies for elite status.
That strikes me as correct.
Klein concludes:
Until legislators are willing to change a system that showers tax-free rewards on the upper middle class, the cash register will continue to exacerbate the wealth gap and help big business get even bigger. It may feel great to stand up against a merger and fight those “big banks” — while enjoying a “free meal” at an exclusive airport lounge before taking a vacation using frequent flier miles. But if victory is more of the status quo, then the biggest losers will be those the government should protect the most.
I’m honestly surprised Klein, who’s considerably to my left on economic issues, didn’t propose a more radical but obvious solution: a government-run alternative. Given that digital currency has all but replaced traditional forms, it strikes me as perfectly reasonable for the Treasury to facilitate that new reality. There’s no reason it couldn’t back a digital payment network that charges an incredibly low break-even fee. It’s squarely within Congress’ enumerated powers under Article I, Section 8.
While the financial industry would obviously fight this tooth and nail, I don’t envision this totally supplanting credit cards, in that they would either be pay-as-you go (essentially debit cards) or at most a float (due at fixed intervals, as is the case with Amex and the practice most of us likely practice even with our points-earning credit cards; otherwise, they cost money rather than earn it). I would, for example, at a minimum continue using my Amazon, Costco, and Marriot cards when transacting business with them. Frequent travelers would continue building perks on cards designed for that purpose.
This would solve the micropayment issue, in that Starbucks and others who business primarily consists of transactions under $10 would presumably eschew all other payments unless they matched the government fee. And smaller merchants who can’t afford to pay exorbitant fees would do likewise and, since we’d probably all carry one, we’d get used to that pretty quickly. It sure beats “Cash Only.”
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