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Washington’s Seizure of Sunk Capital: Part II

Wednesday, June 29, 2011

The importance of the issues of political opportunism, free riding, the commons, and constitutional bargains are well-known to everyone, except the Supreme Court. This must change.

Efforts to persuade Congress to delay implementation of the Durbin amendment have failed, and on June 29 the Federal Reserve Board will meet to discuss, and probably finalize, its rules. There is no reason to expect much change from the version published for comment last December—significant issues upon which comment was sought were unanswerable then, and remain so, and the FRB is largely flying in a fog with non-functional instruments.

The law applies when a customer uses his debit card, and instructs the FRB to limit the “interchange fee” levied by the bank that issued the card to an amount “reasonable and proportional to the cost incurred by the issuer with respect to the transaction.” The nature of this reasonableness is then defined as including only “the incremental cost incurred by an issuer for the role of the issuer in the authorization, clearance, or settlement of a particular electronic debit transaction,” to the exclusion of other costs, such as capital investment or general overhead. A rough analogy would be to require that a restaurant charge only for the cost of the food, with no add-on to pay for its oven or refrigerator.

Soon after the law’s passage, the TCF National Bank in Minneapolis filed for an injunction. It lost at trial and is now appealing to the Eighth Circuit. Once the FRB issues the final rule, and assuming it maintains roughly its present shape and scope, additional appeals are certain.

The fundamental need of any polity is to solve the problems of free riding, exploitation of sunk effort and capital, and the opportunistic behavior that characterize the human species.

At first thought, one is skeptical about the chances of these attacks because the opponents of the law are playing on a rigged wheel. The courts have pulled back from anything that looks like second-guessing the Congress on economic regulation. Led by “conservative” justices such as Scalia and Thomas, a statute stands as constitutional if it has a “rational basis,” which means, since there is no requirement for Congress ever to give explanations for its actions, if there is any conceivable state of facts on which the law might make sense. Only last week, the Court said (per Scalia), “we have held for many years (logically or not) that the ‘liberties’ protected by Substantive Due Process do not include economic liberties.”

It is not possible for Congress to fail this “rational basis” test, given the ability of bright Justice Department lawyers to think up possible justifications when they are unconstrained by the petty concerns of the real world. Nonetheless, there is hope for the appellants, for two reasons.

First, an asterisk is attached to the rule that economic liberties get no protection. A hefty line of Supreme Court precedent says that Congress cannot constitutionally impose rate regulation that deprives a business of a just and reasonable rate of return on its investment. This is the doctrine that TCF Bank is invoking in the Eighth Circuit, arguing that Durbin’s requirement that interchange fees not be based on anything except incremental costs violates it. The government has countered with a series of arguments as to why these cases are inapplicable, and the outcome is indeterminate.

The Supreme Court spends its time as the interpreter of murky statutes, guardian of the right to watch porn, and defender against the dreadful prospect that someone might display a cross on public property.

The second reason for hope by the appellants is that the litigation will be over a rule issued by the FRB, not directly over a statute, and, while courts may not ask the legislature to explain itself, they most certainly require that agencies do so. The Administrative Procedure Act of 1946 (APA) requires that every rule be accompanied by an explanatory statement of basis and purpose, and the Courts of Appeal are charged with tossing out anything found to be “arbitrary and capricious.”

The rule proposed by the FRB, with its quixotic interference into the practices of the Electronic Funds Transfer industry, would, were it based on some broad and general delegation to the FRB, fail this test. The D.C. Circuit regularly reams the FCC for far more venial transgressions of rationality, and any court would brand as “arbitrary” the requirements imposed pursuant to Durbin.

Nor, in a review of administrative action, could the FRB fall back on the suggestion that some other hypothetical state of facts that might exist in some universe might support its decision. Such weaselry is precluded by the APA and by half a century of law and practice, which require an agency to explicitly set forth and live by the facts and conclusions on which it is acting.

Nor, while the courts are sometimes a bit wishy-washy on this, can an agency simply declare that the moon is made of green cheese and reason from that premise. As the D.C. Circuit declared 40 years ago:

Review would be a relatively futile exercise in formalism if no inquiry were permissible into the existence or nonexistence of the condition which the Commission advances as the predicate for its regulatory action. A regulation perfectly reasonable and appropriate in the face of a given problem may be highly capricious if that problem does not exist.

Confronted with this lack of congruity between the standards governing judicial review of a rule versus those applicable to a statute, a sensible FRB might dodge the bullet. It would say that Congress told it to set a price cap at incremental cost and that is what it is doing, that it has no idea what the impact on anything will be, and that if the appellate court thinks this is arbitrary it should complain to Congress. It could tell the court to sort out the interplay between the conflicting requirements of the Durbin amendment and the APA.

These are grievous deficiencies, and in the world of administrative law, as opposed to that of hands-off non-review of economic liberties constitutional issues, they would be mortal.

However, this is not possible. Other parts of the law that have received less publicity, such as a requirement that multiple networks be available and a dispensation from price caps for additional costs of implementing fraud prevention measures, do not lend themselves to such a blunt approach. In any case, no agency staff likes to admit to irrationality, and the FRB’s instinct, as demonstrated by its December proposal, is to put a happy face of pseudo-rationality on its proposals.

If the final Statement of Basis and Purpose continues this effort, it is will inevitably be entangled in errors, inconsistencies, and uncertainties, perhaps to the extent that a court reverses it. In its initial notice, “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.” Proessor Todd Zywicki, in “Durbin’s Innovation Killer,” took particular aim at its potential “to destroy innovation in the payment card industry, harming consumers and the economy and promoting continued reliance on inferior substitutes such as checks.”

These are grievous deficiencies, and in the world of administrative law, as opposed to that of hands-off non-review of economic liberties constitutional issues, they would be mortal.

The D.C. Circuit regularly reams the FCC for far more venial transgressions of rationality, and any court would brand as ‘arbitrary’ the requirements imposed pursuant to Durbin.

So even a court willing to uphold the law on the grounds that there could, somehow, be a rational basis for it might pause when the expert agency responsible for implementation admits it cannot answer any of the crucial questions about the impact of the rule, and really has no justification for its action except for Congress’s desire to take from A to benefit B without concern for the collateral damage to the economic system or anyone else in it. To classify this as a “rational basis” might be too much even for a supine SCOTUS.

Besides, the Scalia statement quoted above is actually false. In theory, economic liberties are indeed protected by Substantive Due Process principles; the Court simply will presume the rationality of the law. This distinction may seem useless, but it could count in this litigation because SCOTUS has never directly confronted (or at least has never admitted to confronting) a “the moon is green cheese” law of the Durbin amendment’s nature. And it has, in more respectable days (1972), recognized the inseparability of all rights:

Property does not have rights. People have rights. The right to enjoy property without unlawful deprivation, no less than the right to speak or the right to travel, is, in truth, a "personal" right, whether the "property" in question be a welfare check, a home, or a savings account. In fact, a fundamental interdependence exists between the personal right to liberty and the personal right in property. Neither could have meaning without the other. That rights in property are basic civil rights has long been recognized.

To any judge looking at this mess of conflicting dictates, TCF National Bank’s focus on the requirement of a reasonable rate of return on invested capital is going to look pretty interesting. It addresses the essence of the problem, which is the legislative appropriation of sunk capital, and a court can easily ignore the government’s silly distinction between utilities and everyone else, because utilities are simply one variety of sunk capital. The rate-of-return approach would also provide some check on legislative rapacity while providing reasonable guidance to appellate courts.

So the appellants’ chances are a bit better than an initial look might indicate.

The case has a broader political/philosophical level, too. The Supreme Court seems determined to ignore the rise of the special interest state and all the attendant problems of demosclerosis. It persists in reassuring everyone that it has no intention of refighting the battles of the late 19th and early 20th centuries, but it abdicates on the great issues of the 21st, spending its time as the interpreter of murky statutes, guardian of the right to watch porn, and defender against the dreadful prospect that someone might display a cross on public property.

Even a court willing to uphold the law on the grounds that there could, somehow, be a rational basis for it might pause when the agency responsible for implementation admits it cannot answer any of the crucial questions about the impact of the rule.

Yet the fundamental need of any polity is to solve the problems of free riding, exploitation of sunk effort and capital, and the opportunistic behavior that characterize the human species. (“If men were angels,” etc.) The fundamental way to achieve this is through constitutions, which are agreements at a high level on rules of the game so as to keep people from opportunistic behavior in particular instances. So a constitutional jurisprudence that rejects as unworthy any effort to prevent particularistic depredation of economic interests, and that tells the aggrieved to put together their own opportunistic coalitions, exacerbates the fundamental problems.

In the context of Durbin, is it really sensible public policy to tell the banks to become even better organized and more aggressive in their dealings with Congress? Usually, they are quite well-organized enough, and it would be far better if they stood down rather than stepped up their lobbying efforts.

The importance of these issues of political opportunism, free riding, the commons, and constitutional bargains are well-known to everyone, except the Supreme Court. Examine the literature of political science, economics, and, to a lesser extent, law, and one finds literally thousands of articles on “collective action” or “prisoner’s dilemma,” or “constitutional interest” versus “action interest,” or “the tragedy of the commons.” As William Poundstone said in the introduction to Prisoner’s Dilemma: “[This] is one of the great ideas of the twentieth century, simple enough for anyone to grasp and of fundamental importance,” and the fundamental tools needed to construct a 21st-century law of economic liberties are at hand.

It is of crucial importance that the SCOTUS grasp that the courts must have a role in solving our current political problems, which basically arise from conflicting efforts of various groups to make everything into a national commons, and then loot it.

In his penetrating Bradley Lecture two years ago, Michael Greve highlighted the role of the courts, and especially the Supreme Court, as guardians of democracy—real democracy, not a serial ochlocracy of shifting mobs of 51 percent, each of which gets to loot the other 49 percent on any given issue:

"Democracy" (full stop, period) is just a slogan. If it means an unstructured, undisciplined, exploitative interest group free-for-all—our politics, that is to say—it is an unpalatable alternative to juristocracy. On the other hand, if democracy means a structured, institutionally cabined and constitutionally disciplined form of government—a republican form of government, as we used to say—it is emphatically worth having. By constitutional design, though, that form of government assigns a prominent role to the Supreme Court. It collapsed because the Court abandoned that role, and it cannot and will not restore itself. Thus, the appeal to democracy has to be coupled with a credible judicial re-commitment to the Court's constitutionally envisioned role of protecting a transparent, responsible politics.

Amen.

James V. DeLong is vice president and senior analyst at the Convergence Law Institute. He is a former research director of the Administrative Conference of the United States, and the author of New Wine for a New Bottle: Judicial Review in the Regulatory State.

FURTHER READING: DeLong’s preceding article is “Washington’s Seizure of Sunk Capital.” He has also recently written “Protecting Property on the Internet,” “Eminent Domain (at a Price)” and, along with co-author Garland T. McCoy Jr., “Tea Party Tech Policy.” Todd Zywicki  wrote a related article titled “Durbin’s Innovation Killer.”

Image by Rob Green / Bergman Group.

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