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by Lawrence H. White
University of Georgia
When hearing or reading excited discussions of "the new payment technologies" and "digital money" it is well to maintain some historical perspective. What exactly is new, and what difference will it make? Is the coming change in the payments system revolutionary, or better understood as evolutionary? Will changes in the way money is paid from one party to another bring about changes in the character of money itself?
Digital money--spendable balances represented solely by digits on a bank's balance sheet--is not new. Banking historians have found that merchants in Genoa, Italy, were making payments by transfering bank account balances back in 1200 AD. It doesn't really matter whether the digits on the bank's balance sheet are displayed in ink or in pixels.
What has been changing over the centuries is the usual method of authorizing the transfer of balances from one account to another. In 1200, when Alice wanted to pay Bob by deposit transfer, one or both of them would have to meet in person with a banker to authorize the transfer orally. Paper checks--authorization by written order--came along later, first appearing in the 1300s and becoming common in the 1600s. Remote, paperless, and instantaneously executed authorization of funds transfer, in the form of "wiring" money from one account to another, has been around at the wholesale level since the mid-1900s, following the introduction of the electric telegraph. Wire transfer today accounts for the vast majority--more than six-sevenths--of the dollar volume of payments in the United States. (Cash is the most common method by number of transactions per day, but the estimated average value of a cash transaction is tiny, $10, compared to that of a wire transfer, $4 million.) What is called electronic funds transfer or EFT, wherein an individual accesses the payment system by means of a debit card reader or a personal computer, basically brings the wiring of money down to the level of the retail transaction.
What makes EFT significant is that it considerably lowers the cost of wiring money. The most obvious result to be expected is a reduction in the frequency of check-writing. Debit cards are now proliferating widely, bill-paying by personal computer is finally catching on, and deposit transfer via the Internet appears to be coming soon. People who today receive glossy catalogs, order merchandise by telephone, and pay by reading a credit card number to an operator, may in a few years find it more convenient to shop on-line by personal computer, and pay on-line by clicking an on-screen "buy" button to authorize a deposit transfer to the seller's account. (On-line payment by credit card is already available at many commercial web sites today.) But these are evolutionary rather than revolutionary changes, and superficial rather than profound. What happens behind the scences--deposit transfer--remains the same.
A second form of digital money--an alternative to the deposit-transfer method of payment--has recently appeared on the horizon. Developments in cryptography are said to be bringing us what we can call "digital currency". The currency balance information, an encoded string of digits, can be carried on a "smart" plastic card with an implanted microchip, or kept on a computer hard drive. Like a traveler's check, a digital currency balance is a floating claim on a bank or other financial institution that is not linked to any particular account. One cardholder can make a payment to another without bank involvement, by placing both cards in a "digital wallet" that writes down the card balance on one card and writes up the balance on the other by the same amount. Desktop electronic currency transfers can similarly be made by electronic mail. A card's digital currency balance can be "topped up" by placing it in an ATM (a PC's balance by getting on-line with the bank) and downloading funds from one's account. Like paper currency and coins (which we can conveniently call "analog currency"), digital currency balances are circulating bearer media. If personal information is omitted from the balance transfer information (unlike current practice in debit- and credit-card transactions), the bearer can remain anonymous. An issuing bank need only know the total of its outstanding currency liabilities, not who holds them at any moment.
First Union, NationsBank, and other banks have already begun issuing a prototype "digital currency" in the form of prepaid "cash cards" whose balances can be spent down. (Residual balances can be redeemed or applied to the purchase of a new card.) As I understand the technology, however, the balances Alice pays to Bob cannot be added to Bob's card. They cannot be respent without bank involvement, but must be deposited by Bob, and thereby (directly or indirectly via the clearing system) presented to the issuing bank for verification and addition to Bob's deposit balances. Balances on prepaid cards (and on PC's and smart cards that share this feature) are consequently more like digital cashier's checks than like circulating currency.
What is new in true digital currency is not the creation of anonymous bearer claims against private banks. Private banknotes, paper-borne bearer claims issued by banks in round denominations, have been the predominant form of currency throughout history when and where governments do not seize a monopoly of paper currency issue. They continue to form the common currency today in Scotland, Northern Ireland, and Hong Kong, where local commercial banks have never completely lost their right of issue.
The incentive for banks to offer digital currency is clear: float. If digital currency balances pay zero interest, as analog currency traditionally has, the bank receives an interest-free loan from customers holding its currency balances. I imagine that personal computers and even smart cards could be programmed to pay interest on digital currency balances, augmenting the unspent balance each day by a pre-specified percentage. If such programming can be developed and cheaply copied to PCs and smart cards, competition will force the banks that issue digital currency to pay interest on it, presumably at a rate similar to what they pay on bank deposits, leaving the banks with a spread just sufficient to cover the costs of issuing digital currency. Interest on digital currency would make small-denomination currency interest-bearing for the first time in history. Such a development, combined with anonymity, would enhance the prospects for the public's turning away from government-issued notes and coins. The only remaining sellers who would continue to accept analog currency would be those whose transaction volume is too small to justify an investment in the hardware necessary to receive digital currency payments or electronic deposit transfers. As the hardware becomes cheaper and card use more common, the set of such sellers will increasingly shrink. Once it falls below critical mass, and consumers no longer routinely carry cash, the use of analog currency could practically disappear.
Suppose that analog currency does disappear from common circulation. Does this usher in a world without money, as some writers have suggested? No. Rather, it "merely" undoes the current government monopoly of currency. It returns us to a world where the commonly seen money is privately issued, as it was in sophisticated economies 150 years ago where gold coin was seldom seen outside bank vaults despite being the ultimate money of redemption for deposits and banknotes. Payments continue to be money payments, transfers of deposits and currency. Bank-issued monies continue to be claims to an ultimate or "base" money. In the current U.S. monetary system base money comes in two forms: Federal Reserve Notes and commercial bank clearing deposits on the books of the Fed. Eliminating the first (by the public voluntarily swapping its holdings with banks in exchange for bank-issued money) would not eliminate the second. In fact the total stock of base money need not change, as banks would swap the Federal Reserve Notes turned in by the public for Fed deposit claims (still indispensible for settling net flows of funds between banks). Bank deposits at the Fed would constitute the entire stock of base money.
The transition from analog to digital currency therefore does not change the monetary standard: the base money remains a fiat money, and bank-issued money remains a redeemable claim to fiat money. It is possible that the disappearance of Federal Reserve notes will make the unanchored nature of the fiat dollar standard more obvious to the public, but a change in the standard will not automatically follow. A switch to some kind of commodity standard will require a public debate and deliberate public decision.
Do electronic funds transfer and the private issue of digital currency undermine the central bank's ability to control the total quantity of money in the economy? No. (In fact, as my colleague George Selgin argues, it may even make the Fed's job easier.) Electronic funds transfer merely moves money from one holder to another; it does not itself change the aggregate quantity. The quantity of transaction balances or digital currency a bank can prudently create is naturally limited by the bank's contractual obligation (without which the public would not accept bank-issued money to begin with) to convert its liabilities on demand into scarce reserve money (analog currency or its account balance at the clearinghouse). Thus even with banks "creating their own money" the Fed has undiminished control over the aggregate quantity of money (whether measured as M1, M2, or whatever) via its undiminished control over the quantity of base money. If the Fed mistakenly thought that digital currency undermined its monetary control, it could of course impose the same reserve requirements against outstanding digital currency liabilities that it now imposes against deposit balances. (I do not know what reserve requirements are currently imposed against cash card balances.)
So what real difference will digital currency and desktop EFT make? What strikes me as the most exciting potential development to come from the new payment technologies is that, as they lower the cost of wiring money from $20 to 2 cents or less per transaction, they give ordinary small savers affordable access to offshore banking. With direct deposit of paychecks, and with analog currency available at ATMs whenever we want it, many of us no longer need to visit our bank in person. Why not keep your account with a reputable bank (perhaps a branch of a major Swiss bank) in the Bahamas or Cayman Islands? Such an account is perfectly legal for U.S. citizens (though the offshore branch of a U.S. bank is prohibited from directly doing business with American citizens or firms). Offshore banks pay higher interest on deposits (and charge lower interest on loans) than domestic banks because they are free from the taxes on deposit balances that the U.S. government levies in the form of reserve requirements, deposit "insurance premiums," and taxes on bank earnings. Big-money players have enjoyed the advantages of offshore banking for years. Small firms and individuals do not find it worth accessing the offshore banking market today because the current expense of wiring money back and forth more than consumes the extra interest earned on small sums of money. Cheap desktop electronic funds transfer will make offshore banking a smart move for small savers. If an offshore bank were linked into an onshore clearinghouse (and an onshore ATM network for providing analog currency, as long as analog currency survives), it could also attract transaction account customers. Individuals concerned about privacy might find an offshore foreign bank attractive for its lesser propensity to surrender its records to domestic authorities.
When commercial online networks and Internet sites begin offering offshore banking services, with zero or very small fees for transfering funds, an exodus of retail banking business will move from the regulated onshore sector to the untaxed and unregulated offshore sector. The depositors left behind will be those traditionalists who like to do their banking business in person (many households are not yet online; and some people still refuse to use ATMs), and those who think that FDIC insurance is worth its price--despite the fact that uninsured offshore bank deposits have proven safe throughout the postwar era.
Prepared for the Cato Institute's 14th Annual Monetary Conference, May 23, 1996, Washington, D.C.