Cato Institute
1000 Massachusetts Ave, NW
Washington, DC 20001-5403
Phone (202) 842 0200
Fax (202) 842 3490
Contact Us

The Future of Money in the Information Age

Introduction: The Future of Money

James A. Dorn

Just as fiat money replaced specie-backed paper currencies, electronically initiated debits and credits will become the dominant payment modes, creating the potential for private money to compete with government-issued currencies.

--Jerry L. Jordan

Transition to a New Monetary Universe

Money is a social convention, a widely accepted medium of exchange, a store of value, and a unit of account. Sound money is essential for a smoothly functioning market system. Wide swings in the value of money distort the information contained in relative prices and misdirect the flow of resources. The wealth of the nation declines as a result. Moreover, the absence of monetary stability causes people to lose confidence in the monetary system and, at the same time, provides government with the incentive to impose wage and price controls, which further distort markets and impair individual freedom.

There is a certain inertia in the current U.S. fiat money regime: even though persistent inflation has eroded the value of the dollar over the past 50 years, so that a 1947 dollar is now worth only 14 cents, most people continue to hold the Federal Reserve System in high esteem. In the future, however, government fiat money may be placed on the endangered species list as people shift from paper currency to electronic cash (e-cash). Stored-value cards (``smart cards'' with an embedded micro chip that stores money in digital form) may become a customary circulating medium along with privately supplied digital cash stored in computer hard drives and used over the Internet to facilitate electronic commerce.

The transition from a paper-based monetary system to an electronic payments system will reduce transactions costs, expand markets, and empower individuals. The speed of that transition and the expected benefits, however, will depend on creating a legal infrastructure that penalizes failure and rewards success. The rules that govern the new monetary universe will have to be transparent, equally applied, and consistent with individual freedom if people are to have trust and confidence in cybermoney and cybercommerce.

The more basic issue, of course, is what type of monetary institutions are consistent with monetary freedom and monetary stability? The Greenspan Fed has done a good job of combating inflation, but what is to prevent a future Fed chairman from pursuing targets other than price stability and eroding the future value of money? High and variable inflation can lead to a controlled economy and destroy the price system. That is why it is so important to think clearly about alternative monetary regimes and to select those that offer the best protection for private property and personal freedom. The advent of private e-money and the end of the Fed's monopoly over currency will increase monetary freedom and could lead to a new monetary standard.

Thus far, the Fed is generally supportive of monetary innovation. Federal Reserve Board governor Edward W. Kelley Jr., for example, sees ``private-sector experimentation with new payment and banking products'' as ``a positive development.'' And he recognizes that ``direct competition between the Federal Reserve . . . and the private sector could well stifle the current climate of innovation'' (Kelley 1996: 9).

The papers in this volume examine the changing nature of money and banking in the information age; consider the implications of e-money for monetary control, taxation, and regulation (If money can be encrypted, can government control it, tax it, and regulate it?); and address the question of who should be allowed to issue e-money. Underpinning the entire discussion is the problem of privacy and the role of government in the new monetary universe.

Electronic Commerce and Monetary Evolution

The papers in Part I point to the evolutionary character of the payments system and consider how e-money may develop in light of new technology and changing domains of trust. The myriad implications of those changes for policy and freedom are touched upon.

In chapter 2, Lawrence H. White, a University of Georgia economist specializing in monetary history, traces how technological changes have affected the payments system, making it possible to move from what he calls ``analog currency'' (paper bank notes and coins) to digital currency. If issuers of digital currency were to pay interest and safeguard privacy, argues White, the public would have a strong incentive to shift from government fiat money to privately issued e-cash. Ending the government's currency monopoly, however, would not necessarily change the monetary standard: digital currency would be convertible into U.S. dollars, and those dollars would be fiat money. Moreover, according to White, the Federal Reserve could still control monetary aggregates by controlling the monetary base, which would consist solely of bank reserves.

For White, the most promising benefit of the transition to a secure and inexpensive electronic payments system is the potential it offers for offshore banking. He predicts that ``when commercial on-line networks and Internet sites begin offering offshore banking services, with zero or very small fees for transferring funds, an exodus of retail banking business will begin from the regulated onshore sector to the untaxed and unregulated offshore sector.''

William Melton, founder of CyberCash, focuses on the concept of electronic liquidity and the importance of trust in chapter 3. ``Liquidity,'' he writes, ``can only be produced from a domain of trust.'' Two domains are pertinent: ``a domain of actuarial trust'' (often found in a market system) and ``a domain of guaranteed trust'' (found in hierarchical structures). In the first domain, trust is generated by feedback from statistical tracking and in the second, by an ``external guarantor.'' Melton sees technological advances in cryptography creating greater trust and efficiency in the electronic payments system and enabling financial markets to provide greater liquidity. The increased liquidity, however, need not be inflationary--if it ``is provided under the tight feedback loops of the market.'' In other words, the information revolution will create more liquidity (trust) and more markets. Melton is therefore optimistic that we are entering ``a new age of plenty and opportunity.''

Bill Frezza, president of Wireless Computing Associates, is also optimistic. In chapter 4, he predicts an era of increased liberty as individuals use the Internet to globalize money and commerce and to end the government's monetary sovereignty. He envisions an enlarged private sphere in cyberspace, beyond the reach of government, in which ``sovereign individuals will have the tools to construct a practical realization of laissez-faire capitalism.'' At the center of that space, writes Frezza, ``will be new monetary institutions that must inherently rest on the consent of the participants.''

In the final chapter of Part I, Lawrence Gasman, director of telecommunications and technology studies at the Cato Institute, considers the potential of the Internet, or World Wide Web, within the confines of existing technology. He asks whether the Internet, which is based on ``a innovative combination of older technologies,'' is likely to end distance-based pricing and empower people to the extent claimed. Gasman expects Internet service providers to be able to charge by distance in the foreseeable future, and he expects a regulatory push in that direction. He agrees that the Web ``offers a powerful new tool for entrepreneurs,'' provides consumers with greater freedom of choice, and makes e-cash and electronic banking feasible. But he does not see the end of government interference and a world dominated by small traders in cyberspace. Reality dictates that ``the price of free commerce and free banking on the Net will be much the same as for freedom itself--namely, eternal vigilance.''

Financial Innovation, Regulation, and Taxation

Financial innovation depends on experimentation and the freedom to fail, as well as the right to profit from success. Markets are driven by individuals who are willing to take risks in the search for new opportunities and profit. In the process of discovery, privately enforced informal rules often emerge that later become codified and enforced by government; the market typically leads the process of innovation, and government follows. The question thus becomes, what is the role of government in financial innovation? If overzealous regulators restrict experimentation and make the emerging electronic marketplace too costly, the development of e-cash will be nipped in the bud.

The papers in Part II deal with regulation, taxation, and privacy as they relate to the financial services revolution. How the Congress, the Federal Reserve, and the Treasury, in particular, view the transition to electronic cash and commerce will shape the future of the electronic payments system. A laissez-faire attitude will foster innovation; a protectionist attitude will mean that special interests will determine the pace of innovation and who captures the rewards and bears the costs. The challenge for government will be to provide a legal framework that safeguards property rights and expands markets so that wealth is created rather than destroyed.

The early signals are encouraging: regulatory agencies are taking a wait-and-see approach to financial innovation in cyberspace, although there is considerable concern about the impact of e-money on tax collection and on criminal activity.

In chapter 6, Federal Reserve Board chairman Alan Greenspan draws a lesson from the success of self-regulation during the ``free-banking'' era in 19th-century America: ``If we wish to foster financial innovation, we must be careful not to impose rules that inhibit it.'' He emphasizes that, in the case of e-cash or the electronic payments system, ``the private sector will need the flexibility to experiment, without broad interference by government.''

Greenspan also draws on lessons learned from the Federal Reserve's role in developing the Automated Clearing House system to argue that government involvement in the design of new technology often deters private alternatives. The lesson for ``electronic money and banking . . . is that consumers and merchants, not government, will ultimately determine what new products are successful in the marketplace. Government action can retard progress, but almost certainly cannot ensure it.''

In chapter 7, Scott Cook, chairman of Intuit, examines the forces behind the financial services revolution. He begins by looking at the increased complexity consumers face when choosing financial instruments and the trend toward greater self-reliance. In his view, the Internet is ideally suited to deal with both issues. Another trend is the movement toward greater freedom in the provision of financial services as the industry is deregulated. That trend will allow the industry to serve consumers better as they deal with complexity and strive for greater autonomy in planning their financial future. Cook is therefore confident that ``we are entering a period of one or two decades of marvelous invention and creativity that will change the financial services universe.''

In chapter 8, Rosalind Fisher, executive vice president of VisaNet Services, sees an important role for Visa and its member banks in the electronic payments system. Visa's stored-value card, ``Visa Cash,'' had a successful trial at the 1996 summer Olympic Games in Atlanta and is undergoing other trials around the world. Visa is also working with its members to develop on-line electronic payments. Fisher is confident in the future of the new payments system but recognizes ``that premature government regulation--or the failure to modify existing regulations to accommodate evolving technologies--could chill or halt the delivery of new financial products to consumers.''

In chapter 9, Representative Michael N. Castle (R-DE), chairman of the House Subcommittee on Domestic and International Monetary Policy, summarizes the results of four hearings on ``The Future of Money,'' held during 1995-96. He concludes that the best way to avoid overregulation is for private industry to begin devising ``standards . . . for interoperability, privacy, security, financial responsibility, and especially consumer rights.'' If self-regulation is successful, notes Castle, the full promise of the new electronic payments technology will be realized.

The unanswered question is whether regulators will leave the cybermarket and its evolving electronic payments system alone. In chapter 10, R. Alton Gilbert, an economist with the Federal Reserve Bank of St. Louis, contends that the answer hinges on how regulators view the safety and soundness of the emerging electronic payments system. The issue he specifically addresses is whether ``nonbank firms whose liabilities are used or will be used for making payments'' should be treated as banks and subject to the same supervision and regulation. His interpretation of banking history tells him that market competition and self-regulation are important, but they are not sufficient to prevent crises in the payments system. What is needed is ``a central authority for preserving stability of a payments system.'' Thus, he concludes ``that all firms that offer liabilities used by the public for making payments should be required to obtain bank charters . . . be supervised and regulated as banks, and have access to the discount window to help them deal with occasional liquidity problems.''

On the question of taxation, Richard Rahn, president of Novecon, argues in chapter 11 that the new monetary universe offers an opportunity to adopt a low-rate consumption tax that will stimulate economic growth. If that opportunity is missed, warns Rahn, the elecronic payments system will be used to evade the onerous burden 12.5]of the present tax system. In a world of anonymous e-money, which can be transferred around the globe at the speed of light, governments everywhere will have to consider Rahn's case for tax reform, since ``the more the government tries to tax, regulate, control, and confiscate, the greater the incentive for business and investors to leave.'' The danger is that if the current tax system is retained, government will become even more intrusive as it tries to stop tax evasion. As Rahn notes, ``In the age of the cyberpayment, we cannot both keep the present income tax system and enforce it, and at the same time keep our liberty and privacy.''

David Chaum, founder and managing director of DigiCash, presents a way to build an electronic payments system in chapter 12 that will satisfy consumers' demand for privacy while protecting society. He wants to avoid a system of ``data fascism,'' in which every electronic transaction is traceable, but he also thinks that perfect anonymity is not desirable. Paper currency has the merit of allowing its users to remain anonymous, but the costs of using it are high relative to those of an electronic payments system. Chaum's research on blind-signature technology (i.e., the use of encryption to generate secure digital signatures) shows that e-cash can come very close to having the attributes of paper currency without the costs. Moreover, that technology allows users of e-cash to ``retroactively and irrefutably reveal the recipient of the funds.'' Thus, crimes associated with the use of paper currency--such as extortion, bribery, and tax evasion--``are no more likely than they are with checks today.'' Chaum's goal is to create ``a payments system that can be widely adopted and that will stimulate economic growth. . . . and act as a springboard for increasing individual freedom.'' He believes that goal is achievable once ``consumers realize that the use of electronic payments media does not have to compromise their privacy, but in fact can empower them to protect their own interests.''

Monetary Policy in the Information Age

The papers in Part III deal with the question of how e-money will affect the conduct of monetary policy. In particular, how will the Federal Reserve's ability to control money and the price level be affected by the transition to an electronic payments system?

In chapter 13, George Selgin, a monetary economist at the University of Georgia, argues against the conventional wisdom that financial innovation means the Federal Reserve needs more discretion. Instead, he contends that innovations such as e-money will provide individuals with more monetary freedom and make them less dependent on the central bank. With less to do, the Fed will not need as much discretionary power to conduct monetary policy. If e-money were to completely crowd out paper currency, the Fed would no longer have to be concerned about variations in the ratio of currency to deposits. Monetary policy then could be more easily directed to controlling the monetary base, argues Selgin. Thus, he considers e-money a friend of monetarists, who have long advocated rules in place of discretion.

Bert Ely, president of Ely & Company, argues in chapter 14 that e-money is unlikely to crowd out paper money because people do not trust the new payments technology. He also argues that e-money will not affect monetary policy. The latter conclusion rests on Ely's assumption that the Federal Reserve is passive in today's financial environment and merely supplies whatever currency and reserves the public and the banking system demand. According to Ely, the only effect e-money will have is to reduce the Fed's profit (seignorage) from issuing currency, insofar as e-money is substituted for central bank money.

In chapter 15, Jerry Jordan, president of the Federal Reserve Bank of Cleveland, and Edward Stevens, an economist at the bank, expect e-money to crowd out government fiat money and predict that financial innovation is likely to reduce the demand for bank reserves to near zero. Those changes, however, need not reduce the Fed's control over the money supply, according to Jordan and Stevens. That is because ``the reliability of monetary policy depends not so much on the amount [of central bank] money demanded as on the predictability of that amount.'' In their view, ``It is much too soon to say whether the predictability . . . will be reduced in any significant way.'' Moreover, they argue that as long as central bank liabilities are used to settle final payments of taxes and other obligations, the Federal Reserve will continue to ``determine the price level.''

A more fundamental question, which Jordan and Stevens only touch on, is whether a new monetary standard will emerge as people shift to e-money--that is, will people be willing to hold privately supplied e-money if it is not convertible into central bank money? Moreover, will such a monetary regime be stable? If the answer to both questions is yes, then government fiat monies and central banks may become relics of the 20th century.

In chapter 16, William Niskanen, chairman of the Cato Institute, comments on the preceding three chapters. He doubts whether

e-money will significantly reduce the public's demand for currency, so he does not expect e-money to have any significant effect on the ratio of currency to deposits or the money multiplier. He favors a monetary rule, but prefers a feedback rule that would target ``the nominal level of domestic final sales'' to a strict monetary base rule. Niskanen explains that ``for a central bank that uses such a recursive, error-correcting monetary policy, a reduction of the variance of the money multiplier is not very important.'' In sum, he discounts the effect e-money will have on monetary policy and contends that ``the regulatory implications of e-money seem more interesting and more important.''

The Future of Banking

The information age promises to create an electronic monetary system and expand monetary freedom. How far that freedom reaches and how it may affect the future of banking is the subject of Part IV.

In chapter 17, Sholom Rosen, vice president and head of emerging technology at Citibank, describes the progress Citibank has made in developing a secure electronic monetary system and the implications of that system for the future. He states that the new payments technology will allow ``EMS notes'' to ``be created on demand

in any currency.'' Moreover, the electronic monetary system will

provide both security and privacy, because it ``guarantees the traceability of every note without knowing the identity of the customer.'' Finally, the EMS--using so-called Trusted Agent technology--will provide protection for both buyers and sellers as they transact over the Internet, ensuring that goods are delivered and payments received. The implication of the new system, writes Rosen, is that ``for the first time . . . truly open spontaneous electronic commerce'' will be possible.

In chapter 18, Catherine England, an economist with the Graduate Business Institute at George Mason University, provides a useful overview of the nature of money and asks how e-money may affect the Fed's position as the sole supplier of currency. She argues that market forces are on the side of private suppliers of e-cash and that those forces will make a system of private competing currencies inherently stable. In the future, she predicts, ``What is `money' will be determined by what buyers and sellers accept and use as money rather than by government definitions.'' The disappearance of central banking, notes England, will not be a disaster because, as F. A. Hayek (1989: 103) wrote, ``The history of government management of money has, except for a few short happy periods, been one of incessant fraud and deception.''[1In Choice in Currency, Hayek (1976: 16) wrote, ``What is so dangerous and ought to be done away with is not governments' right to issue money but the exclusive right to do so and their power to force people to use it and to accept it a particular price.''] In particular, ``a study of about 30 currencies shows that there has not been a single case of a currency freely manipulated by its government or central bank since 1700 which enjoyed price stability for at least 30 years running'' (Bernholz 1990: 104).[2Bernholz is referring to the study by Michael Parkin and Robin Bade (1978).] That dismal record is why it is so important to consider alternatives to government fiat money.

In the final chapter, F. X. Browne and David Cronin, economists at the Central Bank of Ireland, reason that in the long run a system of laissez-faire banking could evolve as e-money and the model of share banking are widely accepted. They predict that electronic payments and financial innovations could allow individuals to hold all their assets in highly liquid and divisible mutual-fund shares that reflect current market values and, consequently, would represent economically viable exchange media. The resultant ``accounting system of exchange'' would eliminate the problem of monetary disequilibrium, which is associated with the present par-value ``monetary system of exchange.'' The inherent stability of this private alternative to government fiat money, Browne and Cronin argue, would end the need for banking regulation. Finally, they point out that, while nonbank providers of e-money will compete with banks, banks will probably continue to have a comparative advantage in managing risk in the new monetary universe.

Conclusion

Several policy implications flow from the papers in this volume:

Low-cost on-line banking and financial innovations will create greater opportunities to escape inefficient domestic financial regulations by moving banking activities offshore, which may create pressure to remove inefficient regulations at home (chapter 2).

A secure electronic monetary system will expand financial markets and increase liquidity (trust). As markets expand, the domain of actuarial trust will grow, thereby reducing the problem of moral hazard associated with the guaranteed domain of trust (chapter 3).

As the information revolution progresses and e-money becomes more widely accepted, there could be added pressure for tax reform, especially for a low-rate consumption tax. Global financial markets will exert even more influence on policymakers to pursue sound policy choices or face massive capital outflows (chapter 11).

As e-cash crowds out Federal Reserve notes, the Federal Reserve's case for discretion will weaken while the case for monetary rules will strengthen. The adoption of a rules-based monetary regime would reduce institutional uncertainty and provide a more stable monetary unit (chapter 13).

Finally, in the long run, the electronic payments system may evolve into a system of laissez-faire banking with competing private currencies based on the model of mutual-fund or share banking (chapters 18-19).

In the new monetary universe, people will benefit from more information and more freedom. The danger is that government may try to stifle that information and freedom by overregulation. The challenge is to develop an institutional infrastructure that provides transparent rules for the electronic payments system, safeguards the value of money, and protects individual freedom. There will then be better money and greater wealth as a result of the information revolution. The papers in this volume help lay the intellectual groundwork to meet that challenge.

References

Bernholz, P. (1990) ``The Importance of Reorganizing Money, Credit, and Banking When Decentralizing Economic Decisionmaking.'' In J.A. Dorn and Wang Xi (eds.) Economic Reform in China: Problems and Prospects: 93-123. Chicago: University of Chicago Press.

Jordan, J.L. (1995/96) ``Governments and Money.'' Cato Journal 15 (2-3) (Fall/Winter): 167-77.

Hayek, F.A. (1976) Choice in Currency: A Way to Stop Inflation. Occasional Paper 48. London: Institute of Economic Affairs.

Hayek, F.A. (1989) The Fatal Conceit: The Errors of Socialism. Vol. 1 of The Collected Works of F.A. Hayek. Edited by W. W. Bartley III. Chicago: University of Chicago Press.

Kelley, E.W. Jr. (1996) Speech given at the Digital Commerce Conference. Washington, D.C., 6 May.

Parkin, M., and Bade, R. (1978) ``Central Bank Laws and Monetary Policy: A Preliminary Investigation.'' In M.A. Porter (ed.) The Australian Monetary System in the 1970s: 24-39. Melbourne: Monash University.

The Future of Money Table of Contents