Tuesday, July 7, 2015

A Visa/MasterCard theory of recessions

Statistical agencies employ data collectors who walk up and down aisles with hand-held computers gathering sticker prices for things like frozen french fries and bicycles. The data they collect gets amalgamated into an index and passed on to central bankers who use it as the basis for rate change decisions. It seems simple enough, but what happens if the source material has been corrupted? Might central bankers be reacting to mere shadows on the wall?

Here's how prices might go bad. Start with the U.S. and Canadian payments systems. For each credit card payment, a North American merchant must pay 1-2% in fees to the card networks Visa and MasterCard. Retailers in both countries have very different strategies for coping with this burden. In the U.S., retailers are permitted to offload network fees onto customers by asking them to pay a surcharge on each credit card payment. Because Canadian retailers are prohibited from surcharging customers, they react by marking up every sticker price in their store by a percent or two, the extra margin they collect sufficient to cover the card network fees. (Canadian retailers almost never offer cash discounts.) For a more complete explanation, see here.

This arcane difference in payments habits has the potential to result in a divergent evolution of prices, vastly different monetary policies, and an uncoupling of North American economic growth.

Consider what happens when the Visa and MasterCard networks decide to offer North American customers a universal 5% cash back reward. The networks fund this bonus by requiring merchants to submit a 5% fee on each card transaction. U.S. retailers cope with this levy by boosting the surcharge they apply on each card transaction to 5% or so, forcing the card-paying customer to bear the cost. Those Americans who pay with cash i.e. banknotes continue to get the sticker price, which stays constant. Without the ability to surcharge, Canadian retailers cope by boosting sticker prices by 5%, thereby indirectly passing the costs of the cash-back bonus onto the customer.

Marching up and down the aisles, U.S price collectorsdon't notice a thing. As a result, the U.S. consumer price index stays the same and the Fed doesn't lift a thumb. Canadian price collectors, however, find that prices have risen. Upon reception of this data, the Bank of Canada anxiously raises rates. This is because Bank officials believe that the rapidly rising price level indicates that the economy-wide rate of return (the natural rate of interest) has risen above the Bank's market rate, breeding inflation. A rate hike is necessary to bring the two rates back in lane, thus choking off the incipient inflation that seems to be developing. The natural rate hasn't budged, of course. All that has changed is the card networks' fee policy. Instead of bringing the market rate of interest in line with the natural rate, the Bank of Canada has been fooled into moving the market rate of interest above the natural rate.

If the card networks again increase the cash back reward, say to 10%, Canadian prices will rise even more. U.S. prices stay flat. The Bank of Canada once again confuses the effects a new cash-back policy with a rise in the natural rate of interest, tightening while the Fed stays pat.

Assuming that prices react rapidly and fluidly to central bank policy, then the Bank of Canada's tightening will simply drive consumer prices back down and restore equality between the natural rate of interest and the market rate. But if changes in monetary policy have effects on the real economy, then we've got problems. It could be that certain prices are sticky downward so that markets can't clear, the result being inventories of goods going unsold. Or perhaps the fact that debts are nominally denominated creates a Fisherian debt deflation. If so, then the Bank of Canada could end up unnecessarily driving Canada into a recession. The Federal Reserve, reacting to the very same set of stimuli, does not.

Now of course I'm exaggerating things. In real life such large increases in cash-back policy are unlikely. Nevertheless, we have seen a progressive increase in network fees over the years, enough to have probably inspired Canadian retailers to ratchet up sticker prices. As a result, Canadian CPI may be slightly over-stating actual inflation. On the U.S. side, consider that American retailers only recently gained the power to surcharge credit cards. As U.S. retailers roll out surcharge policies and reduce sticker prices, CPI will be pressured down. This may fool Fed officials into believing that the economy is slowing and draw them into an unnecessary rate cut when in realtiy all that has changed is credit card pricing habits. One wonders if the monetary authorities take into account these arcane features of our payment system when they set their monetary policies.

This answers a question I asked more than a year ago.


  1. But wouldn't this just miscategorize part of inflation as goods inflation instead of financial service inflation?

    1. Sorry, can you clarify what you mean by "this"?

  2. This comment has been removed by the author.

    1. Is there a similar issue with sales tax vs. VAT? A tax increase would presumably have different effects on the sticker price under each regime.

      I imagine this has been investigated thoroughly and that Central Banks act accordingly. Still, I wonder if it has any effect on cross-country comparisons of inflation rates?

      [first comment deleted due to typos.]

    2. Yes, they're similar ideas. My feeling is that the effect of tax changes on CPI is probably more widely understood than the effect of card network changes. Certainly more transparent and easier for a central banker to take into consideration.

  3. Sounds like another good reason for an electronic currency.

  4. A couple points:

    1. The ability to surcharge and the use of surcharges are not the same thing. Most major retailers in the U.S. do not use surcharges -- although you will see it at gas stations and smaller retailers.

    2. The change affects the price level, not the inflation rate. In other words, this should be a one-time change. Central bankers tend to adjust rates slowly over time, so it is unlikely that the BoC would react sufficiently strong to have the effect you describe.

    1. 1. Yes. My feeling is that the U.S. will take a while to adopt surcharging. Australia permitted it in the early 2000s and now I understand that the practice is widespread. I would have used Australia instead of the U.S. in my illustration, but U.S.-Canada seemed more tidy.

      2. Sure, although central bankers have been accused of reacting to one-time changes before (say oil shocks). If not, a series of interchange price changes as illustrated here might trick them into reacting.

      In the end I am sure the effects are small. But small differences seem to be important to central bankers. The Fed for instance seems to think that core PCE is a better measure to target than core CPI, despite they're being quite similar.

  5. Wouldn't credit card companies have an incentive to lower fees to give the illusion of deflation which would trigger expansionary monetary policy and increase the number of "swipes" by customers?
    I guess this would also lower interest rates which isn't great for the credit card companies either.