Anyone who tracks DC-based blogs and journals has seen the PR and lobbying war between the electronic funds transfer industry (banks and credit card companies) and the major retailers over limitations on debit card fees contained in the Durbin amendment to last year’s Dodd-Frank financial reform bill.

A cynic might dismiss this as a classic Washington battle, with powerful economic interests warring in the Congress, egged on by the politicians who like to keep the outcome uncertain so they can keep collecting contributions from the lobbyists.

A deeper delve concludes that this view is actually not cynical enough, because it misses the bigger point, which is the attitude of Congress and government generally toward capital that has been committed to productive business uses—they see such sunk private capital as a political opportunity, since it can be seized and given away to favored constituencies.

Respecting Sunk Capital

Is the budget tight, making it difficult to provide benefits to your political supporters? No problem, the nation’s store of sunk capital is just sitting there, like a fat duck on the political waters, ready for redistribution. Furthermore, unlike some third-world nation with a thin capital base, the United States is an investment-heavy economy, which means, to the Congress or the freelancers of a single-purpose agency such as the Environmental Protection Agency, it is a target rich environment.

The nation’s store of sunk capital is just sitting there, like a fat duck on the political waters, ready for redistribution.

A crucial reason for this hefty investment, of course, is that the United States has historically been a land of the rule of law, in which the temptations of government to treat sunk capital as a fat duck have been held somewhat in check.

So a sobering assessment of the Durbin amendment is that it is another ratchet toward perdition for a political system that has lost its memory of the importance of respecting sunk capital. This gives the conflict a direct bearing on our current economic problems, in which the Federal Reserve Board (FRB) keeps shoveling money out the door and the corporations keep refusing to borrow it and instead sit on the capital rather than investing it. Investors notice such things, and, while the trends are obscured by the necessity for companies with existing commitments to continue to invest to protect them, those with a choice will forego the honor of becoming Durbin’s newest duck.

The Durbin amendment was a dead-of-night add-on to last year’s Dodd-Frank bill that requires the FRB to issue regulations limiting the interchange fees charged by debit card issuers to an amount that is “reasonable and proportional to the cost incurred by the issuer with respect to the transaction.” The meaning of this phrase is then whittled down some more: the FRB is to distinguish between “the incremental cost incurred by an issuer for ... a particular electronic debit transaction,” which it can consider in setting the rate, and “other costs incurred by an issuer which are not specific to a particular electronic debit transaction,” which must be ignored.

The obvious interpretation of the law is that it requires marginal cost pricing of a service that can be offered only as the result of a process of hefty capital investment. The analogy would be a law noting that it costs very little for a telecommunications company to send a TV program to a consumer, so it must charge only for the electrons used, not for the investment in laying cable, buying routers, developing the necessary software code, or producing the content in the first place.

A sobering assessment of the Durbin amendment is that it is another ratchet toward perdition for a political system that has lost its memory of the importance of respecting sunk capital.

The fact that Congress could use the phrase “incremental cost ... of a particular ... transaction” shows how out of touch it is with industrial realities. Visit a Network Operations Center for a telecom carrier or electronic funds transfer firm and you see bays the size of two football fields filled with hundreds of millions of dollars of computer equipment, and surrounded by cubic yards of concrete and security protections, in which a few people oversee the processing of 20,000 transactions per second. “Incremental cost ... of a particular ... transaction” is a ridiculous concept, since the cost of any transaction is the cost of the electrons moving over billions of dollars of capital investment.

The FRB proposed its regulation in December, and the banks pushed hard for a rational interpretation—essentially, “use average cost”—but the FRB resisted on the basis of the statutory language, with its reference to “particular” transaction, and, after a bit of muddled discussion about various philosophies of defining variable cost, said, “12 cents should do it!”

The cap on interchange fees is the centerpiece of Durbin, but it has a number of other provisions that complicate any understanding, including an exemption for card-issuing banks with assets under $10 billion, requirements that merchants be allowed to choose payment networks, and inscrutable provisions governing expenditure on security.

In its NPR (Notice of Proposed Rulemaking), the FRB notes the questions it cannot answer, which include practically every issue of interest, such as the impact on the banks, competition, customers, security systems, the more-complex four-party payment systems, and the movement toward mobile-phone-based payment systems. This ignorance will not keep the agency from making the rule final, however. Its notice deals with the utter unpredictability of the rule’s effects by using the ploy of asking the public for comment on all these issues, so in the final rule the agency can simply blame the public for failing to answer the unanswerable, and then ignore the uncertainties.

My organization filed comments on the NPR urging the Fed to explicitly refuse to act until Congress provides instructions on its intentions and resolves crucial policy issues, and I continue to believe that this would be the correct course for the agency. There comes a point where an agency should refuse to be bound by the legal fiction that Congress has acted rationally.

The analogy would be a law noting that it costs very little for a telco to send a TV program to a consumer, so it must charge only for the electrons used.

The rule has not yet become final, and the current battleground is S.575, which would kill the ongoing rulemaking and delay action for a time while various financial agencies study the issues which were not studied before passage. A vote is expected any day, and the DC political horse race touts are not betting either way.

If S.575 wins, the proceeding will be delayed, but the law will not be repealed. So the study could find that the law is very damaging, but that it must be implemented anyway. If S.575 loses, then the FRB will finalize its rule, and the law suits will begin (or rather intensify, since the statute is already under legal attack by Minneapolis bank TCF).

Hi-Tech Train Wreck

The Durbin amendment is a bird of particular ill-omen for the high-tech industries.

The usual mental map of industrial organization is that the U.S. economy consists of an orderly collection of firms with defined niches. Some companies provide goods or services to consumers. Others supply components, goods, or services to these consumer-oriented companies, while still others are further back in the chain, supplying raw materials or other basic things to the suppliers, and so on.  

Led by the high-tech world, this simple model is being replaced by amorphous “ecosystems,” shifting networks of companies which both compete and cooperate, and in which part of the game is to struggle over which firm controls the customer. The paradigm case is the mobile phone, which requires cooperation among telecom service providers, handset makers, operating system purveyors, applications writers, and search engine/data miners in various and changing combinations, and in which the rules about the division of the payments among the participants are in complete flux, as each layer seeks to turn all the others into commodities.

It is fair to say that understanding of the functioning of these ecosystems is very poor. They have greatly expanded in the past few years so our experience is limited, and they do not model mathematically. We do know, however, that they have grown quickly into complex and intricate organisms, adapting to the perceived needs of the participants acting in their own interest, and aided by the fact that their growth has outstripped the ability of the political system to muck them up.

These ecosystems have greatly expanded in the past few years so our experience is limited, and they do not model mathematically.

The electronic payments system is such an ecosystem. Banks, sellers of goods and services, debit/credit card brands, and specialized payment service companies all need each other, but they also compete to be the primary connection to the customer, and argue fiercely over who should get paid what. As is true of other high-tech ecosystems, there is no such thing as the “just price,” and the division of the revenue is a question best settled by the interactions of the players in a competitive marketplace. If the retailers think the card issuers charge too much, let them start their own cards, or make exclusive deals, as Costco has done with American Express.

The Durbin amendment shows that the political system is catching up with market developments, which is not good news, because its operatives have no hesitation about intervening quixotically in one of these ecosystems at the behest of an interest group without the foggiest idea of what the ultimate result will be.

The net neutrality movement presents similar threats to an existing tech ecosystem because its essence is an effort to capture and redistribute the value of the sunk costs of capital investments, but there the threat has been fended off for the moment. The Durbin amendment indicates just how fragile such rationality can be.

The ironist may get further entertainment, though. When you come down to it, the big retailers that are behind Durbin, such as Walmart or The Home Depot, are themselves varieties of the new style of ecosystem organization, depending on high-tech for their efficiency and intermediating between manufacturers, suppliers, and customers, in a complicated multi-sided market, and, of course, interacting with the payment systems. So if interchange fees are to be regulated, why not other parts of the system? If a congressman thinks that Walmart treats a supplier (who happens to be in his district) in niggardly fashion, why shouldn’t he join with others to pass a law forcing Walmart to share more of its gains? Or to charge customers more, for the sake of the suppliers?

The great speech that playwright Robert Bolt gives to Thomas Moore is apt here:

And when the last law was down, and the Devil turned 'round on you, where would you hide … the laws all being flat? … And if you cut them down … do you really think you could stand upright in the winds that would blow then?

So, DC influence peddlers should consider whether it is really in the interests of their principals to flatten all the protections for sunk capital, and make everything into a contest of political influence, especially when one of the predictable results is to also flatten the incentives to invest, and the economy.

Actually, DC as a hive has considered the issue, and decided that such a world is fine for DC itself, so who cares about such bagatelles as the long-term true interests of the principals in the rule of law or the fate of the economy?

The last bastion of protection may be in the courts, which once understood the importance of protecting sunk capital, as Michael Greve has documented, but which have been stricken with severe amnesia. That will be the subject of a continuation of this article in the near future.  

James V. DeLong is vice president and senior analyst at the Convergence Law Institute. He predicts "The Coming of the Fourth American Republic" after America's special interest state decays.

FURTHER READING: DeLong has recently written “Eminent Domain (at a Price)” and “Tea Time for Vets.” Other articles written about Dodd-Frank include “End It, Don’t Mend It” by Peter J. Wallison and “More Equity, Less Government: Rethinking Bank Regulation” by Mark J. Perry and Robert Dell.

Image by Darren Wamboldt/Bergman Group.