The debit swipe-fee market is broken

It is the role of our government is to establish a legal framework for our free-enterprise system, to ensure that our free markets are healthy and competitive so they can foster efficiency and innovation. Even hands-off free-market economists agree that sometimes a marketplace does not – or for any number of reasons cannot – function properly. The persistence of such failures over time, uncorrected by unencumbered economic forces, calls out for government to examine and possibly correct the underlying cause.

In its current form, the debit market presents a number of telltale signs of a market failure and a divergence from the competitive norm. One of those indications is the peculiar pattern in which swipe fees are set. If you look at Visa’s swipe-fee schedule, you’ll see that grocery stores generally pay lower swipe fees than restaurants. According to the Federal Reserve the cost to process the transaction is basically the same, no matter the type of merchant. For any economic purist, it’s a red flag. It’s a signal that something other than cost and competition is shaping prices.

Additionally, Visa has stated publicly that swipe fees are “not a cost-based calculation, but a value-based calculation.” Banks and networks argue that the higher cost reflects the considerable “value” merchants derive from being able to accept debit cards.

According to data from the Federal Reserve, this explains why merchants pay on average 44 cents on a transaction that costs just 4 cents to process. Well, water is arguably one of the most valuable things on Earth; it is essential to life. Why is it not priced as such? Because competition and access to alternatives ensures that water is affordable to all. The debit market’s failure in this regard is another clear example of poor marketplace health.

Finally, despite the fact that there are thousands of banks that issue debit cards and collect swipe fees, there are essentially two nearly identical swipe fee schedules, one set by Visa and the other set by MasterCard. This suggests that the thousands of banks are not competing on the basis of price. Instead, we see a pattern of Visa and MasterCard competing to drive fees up. This is the opposite of how competitive markets are supposed to work and demonstrates a real market problem. The result, of course, leaves merchants and, ultimately, all of us, to pay the bill.

So when reforms were proposed, considered, and passed into law a year ago, I was neither surprised nor displeased. Quite the contrary. The intervention was government doing exactly what it should do to protect free enterprise; fix broken markets. What is remarkable is that it took so long to happen. A cursory look at the market is all that’s needed to realize something is wrong and needs to be fixed.

Having now determined that the market is broken and needs to be fixed, the only relevant becomes whether government is up to the task of implementing the reforms in such a way that corrects the market without causing dysfunction elsewhere. Evidence suggests that it is.

Last year, the Federal Reserve surveyed banks and solicited comments from a wide variety of stakeholders. The proposed rule released in December, reflected that input and the Fed’s attention to detail. During the subsequent public comment period the Fed received more than 11,000 communications from bankers, merchants, and consumers. Recently Chairman Bernanke assured Congress that the Fed had all the information it needed to produce a final rule aimed at fixing the market in a timeframe consistent with the statutory deadline.

As an economist predisposed to viewing regulations skeptically, my view on this issue might come as a surprise to some. However, anyone who is committed to our free enterprise system must acknowledge that from time to time, markets fail. This is one of those cases, and the Federal Reserve is up to the challenge of ensuring that when the targeted reforms go into effect this summer, they will correct the failures in the market properly.

James C. Miller III served as chairman of the Federal Trade Commission under President Ronald Reagan, as well as director of the Office of Management and Budget. He also served then-Vice President George H.W. Bush as executive director of the Presidential Task Force on Regulatory Relief. He is a consultant to the Retail Industry Leaders Association. 


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