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Cato Policy Report, July/August 1996

The Future of Money in the Information Age

The Cato Institute's 14th Annual Monetary Conference, "The Future of Money in the Information Age," was held in Washington on May 23. Economists, bankers, entrepreneurs, and Federal Reserve Board officers discussed how electronic cash and other new technologies may change monetary activities and policy. Speakers included Lawrence H. White, professor of economics at the University of Georgia; Richard Rahn, president and CEO of Novecon Ltd.; Rosalind Fisher, executive vice president of VisaNet Services for Visa U.S.A.; William Melton, founder and CEO of CyberCash; David Chaum, founder and managing director of DigiCash; Bill Frezza, president of Wireless Computing Associates; and Scott Cook, cofounder and chairman of Intuit. Excerpts from their presentations follow.

Lawrence H. White: Suppose that analog currency (coins and paper money) does disappear from common circulation. Will that usher in a world without money, as some writers have suggested? No. Rather, it will "merely" undo the current government monopoly of currency. It will return 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 bank notes.

What real difference will digital currency and desktop electronic funds transfer (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 automated teller machines (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 do 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 EFT 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 survived), 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 transferring funds, there will be an exodus of retail banking business 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 the Federal Deposit Insurance Corporation is worth its price--despite the fact that uninsured offshore bank deposits have proven safe throughout the postwar era.

Richard Rahn: The electronic age, with virtually instantaneous international financial transactions and with encrypted confidential smart cards substituting for money, will make the taxation of capital transactions, interest, and dividends increasingly problematic. In an age in which most people can transfer money and pay bills with an ordinary telephone, enforcing taxation of those types of transactions will become virtually impossible. The cost of trying to tax them may well exceed the revenue collected and certainly will exact a price in terms of lost economic efficiency and lost privacy rights that exceeds the benefits of their continued taxation.

Government authorities cannot stop that worldwide revolution, because too many knowledgeable people are part of it. Censorship and regulation will not work, because progress in developing the means of evasion will always be far ahead of those who are trying to restrict it. In the same way that most totalitarian governments have largely given up trying to control the flow of information, because technology has made it an impossible task, governments will need to realize that the old central bank monopolies on the issuance of money will also go the way of the buggy whip.

Government officials have two choices: to redesign their tax and monetary systems to reflect technological reality or to try to create a system in which every investment and every expenditure every person makes throughout his life are known. In the new world of monetary freedom there is no middle ground. Either the government will know everything, or the government will only know what is voluntarily revealed. An all-knowing government is doomed to fail, practically and politically, and attempts to impose a "Big Brother" government could impoverish the nation and trample our liberties.

Most Americans are not aware of the broad powers that the government already has to pry into and control their monetary affairs. Many regulations have been enacted as part of the war on drugs and a general attempt to control "money laundering." The Treasury and other government departments have been holding meetings to determine the nature and form of regulation that they will attempt to impose on what they refer to as "cyberpayments." On September 23, 1994, President Clinton signed the Money Laundering Suppression Act of 1994. That act increases the federal government's oversight of money-transmitting businesses that engage in check cashing, currency exchange, money order and traveler's check sales, and money transmitting and remittance services.

The danger is very real, but the battle for financial freedom is not yet lost. To win that battle, advocates of liberty will of necessity need to be involved with tax reform. The abolition of the income tax and its replacement with a low-rate noninvasive tax will take away much of the rationale for income and expenditure monitoring by the government.

In the age of the cyberpayment, we cannot both keep the present income tax system and enforce it and keep our liberty and privacy. Let us all work together to get rid of the income tax rather than rid ourselves of liberty.

Rosalind L. Fisher: Visa and its member financial institutions are playing--and must continue to play--a central role in the introduction and use of electronic consumer payment services. I say "central role" for two different but equally compelling reasons.

First, Visa and its member banks have a solid track record of developing an array of payment products and services that meet consumer needs, and we are confident of our ability to continue to do so. Second, the integrity of the payment system, and public confidence in it, could be at risk if so-called electronic money becomes nothing more than zeros and ones--digital signals--without the backing and involvement of regulated financial institutions. The integrity of the payment system and public confidence in it demand that regulated financial institutions be central players. But even as we work to ensure such involvement, we caution 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.

Some electronic payment services may be offered through entities that are not subject to the same supervision and regulation as Visa's members. Their customers will not have the protection of the bank supervisory system. Furthermore, to the extent that those entities, as a result of not being regulated by bank supervisors, enjoy a competitive advantage over traditional financial institutions, they may worsen the disintermediation of traditional depositories. For that reason and because of the importance to the world economy of developing electronic payment systems and preventing abuse in those systems, it is significant that a recent report by the European Union's Working Group on EU Payment Systems proposed that only banks be allowed to issue stored-value cards.

Visa also believes that providing new payment products and services through regulated and supervised financial institutions ensures significant safeguards that are not otherwise available. As stored-value cards become an important medium of exchange, policymakers must be cognizant of the potential economic consequences of loss of public confidence in major unregulated, uninsured issuers. Law enforcement officials combating criminal activities such as tax evasion, counterfeiting, and money laundering should consider the problems that could result from the development of stored-value card systems that, unlike Visa's, may not generate a well-defined audit trail and from systems whose record keeping is not subject to periodic supervision and examination. Accordingly, we believe lawmakers should carefully examine the risks that attend participation of those other entities in the payment system.

On the other hand, in view of the highly regulated environment in which our members operate and the numerous safeguards that are already in place with respect to depository institutions, we are concerned that additional regulation in this area will stifle the innovations that are being developed. At the extreme, subjecting new payment products to government regulation could result in their premature death.

William Melton: In the consumer world, all that matters is liquidity--reliable, convenient, liquidity. Liquidity (the speed with which a marker is accepted as a valid medium of exchange) has a strong psychological component; indeed, its principal element is trust. Liquidity can only be produced from domains of trust, of which there are two kinds: the domain of actuarial trust and the domain of guaranteed trust.

Life insurance is an example of the former. Because they rely on actuarial tables, life insurance companies can trust that they will have a certain investment horizon for your policy, depending primarily on your age. Another example is a major grocery chain that is willing to accept checks from strangers because actuarial experience has shown that less than one-half of 1 percent of those checks will go bad.

We are more familiar with the domain of guaranteed trust. The government, the bank, or some other strong guarantor says, "Trust me, I guarantee it!" Behind any guarantor there may be another guarantor--behind your bank stands the FDIC, and behind the FDIC is the perceived strength of the government. Thus guaranteed trust domains quickly become very hierarchical.

As a national and, in fact, an international economy we are moving and must move toward actuarial trust. Indeed, modern financial markets spring from the sharing of risk and are actuarial by nature. Even the largest guarantors (governments) are subject to the statistical evaluations of those actuarial domains. Whereas the guaranteed domain of trust is compatible with hierarchical environments, the actuarial domain of trust is frequently found in a market economy.

Relying on an actuarial domain of trust, aggressive banks now routinely issue liquidity to customers whom they have never seen, on a nationwide basis. With the help of massive databases, sophisticated scoring techniques, and carefully delineated actuarial domains, banks issue billions of dollars of liquidity based solely on actuarial trust.

But a funny thing has happened on the way to this great outpouring of liquidity. The cost of distribution (that is, the cost of getting the liquidity to the consumer) is greater than that of evaluating and granting the credit (or liquidity). By today's economics, it might cost $50 to $70 (including advertising and mailings) to acquire a new bank liquidity customer. At the same time, using advanced actuarial techniques it might cost less than $10 to evaluate and complete the granting of the credit.

To solve the problem of high distribution costs, aggressive players have begun to rely on existing natural groupings (e.g., your United Airlines Visa card). Those groupings already support distribution infrastructures for their own purposes. In the banking world those are known as "affinity" or "co-branding" efforts.

If chains of trust are the primary ingredient of liquidity, then the technology of digital signatures and digital certificates is indeed a breakthrough that allows maintenance of ever more subtle, more complex, and yet still reliable chains and domains of trust. The economic impact is to provide greater liquidity. Yet that additional liquidity is provided under the tight feedback loops of the market and thus is, on the whole, noninflationary.

The challenge of the marketplace and the newer forms of electronic liquidity is to continually lower transactions costs, continually increase convenience, and thereby enable new markets heretofore not possible. With strong actuarial feedback it is also the job of the market to match the supply of the new forms of liquidity with an equivalent supply of goods and services from both old and new markets.

I am extremely optimistic about the enabling power of increasing efficiency and convenience in payments systems and in the granting of liquidity. I am doubly optimistic about the power of the marketplace that is being born on the Internet, a marketplace where geography has largely evaporated and time is measured in baud rates. I believe that those combined efficiencies can bring society a new age of plenty and opportunity. We live in exciting times.

David Chaum: There are two different scenarios for electronic cash. One is what we might call a fully traceable world--others might call it Clipper cash or data fascism. Making ordinary consumer payments totally traceable by government would curtail all kinds of activities, peaceful and not so peaceful.

One way to do it--familiar from science fiction--would be to require the consumer to identify himself by some kind of biometric, like a fingerprint or retina scan. Once identified, the consumer could access his account and conduct transactions. Of course, there would be central records of all transactions, and a customer could be locked out of the system at any point.

Another way is a little trickier: to create a chip that is in effect a portable bank officer. Like a Clipper Chip, it would be a little black box that everyone would have to carry with him in order to access his financial accounts and records. The consumer would have no way of knowing just what was on the chip; it might be sending out encrypted messages revealing his transactions to all kinds of parties. It might even be programmed to discriminate against certain people or to enforce arbitrary rules. The consumer's lingering doubt about what's on that chip would have a chilling effect on society. I hope neither of those systems is implemented in the United States.

Another scenario would involve anonymous transactions. Of course, we already have anonymous transactions--using paper bank notes. Many people like paper dollars, but those dollars are very expensive. Perhaps 2 to 3 percent of the gross national product is tied up in maintaining the bank note payment system. Also, the paper dollar system makes possible counterfeiting, extortion, bribery, tax evasion, money laundering, and other criminal activities.

Some people think we have to strike a balance between the anonymous and fully traceable systems. But I think we can instead develop a system that offers the best of both worlds. We would use the line-signature payment technology that is being launched by Deutsche Bank and other major European banks and that we have on chip cards and in electronic malls. Under such a system, instead of receiving digital money from your bank, you would create randomly on your own computer serial numbers that could be hidden in a layer of encryption that only your own computer could unlock. Then you would submit money forms to your bank to be validated, remove the layer of encryption, and no one would know who you were when you spent that money. You would know whom you were paying, and you could always retroactively reveal the recipient of the funds. Thus extortion, bribery, and black-market trading would be no more likely with electronic cash than they are with checks because the recipient could always be traced by the payer and because the money would have to be deposited into a bank to be verified as valid. Each person's total revenue would be known--and subject to taxation--but not how he spent his money or his total wealth.

Bill A. Frezza: The Internet will not merely make our existing forms of commerce more efficient; it will also support the emergence of self-organizing, supranational communities whose economic intercourse can be based on the principles of laissez-faire capitalism.

It will never be possible to transport wheat or steel across cyberspace, and real economies will always continue to produce and consume wheat and steel. But any product of man's mind can be communicated as a stream of digital bits. And it is exactly this sector of our economy--the information industries broadly defined--that is growing the fastest and producing the wealth on which the value of money will someday be based.

The pressing question, then, is, How might a political economy based on exchanging intangibles in cyberspace differ from a political economy based on exchanging wheat or steel in the real world?

First and foremost, privacy in cyberspace will not be an abstract political right based on the vagaries of geography, government policy, or cultural norms. In the future, electronic privacy will be an absolute algorithmic certainty. The day will inevitably come when the amount of effort required to breach the shield of privacy provided by low-cost, widely available encryption will exceed the value of such an attack by so many orders of magnitude that it will not be economically feasible to base public policy on such invasions. The governments of the world will have to live with the fact that they will be impotent to pry into many private economic affairs.

Second, cyberspace differs from our everyday world in that coercive force cannot be projected across a network. That is a discomfiting revelation to most legislators, who like to pretend that their power rests on the consent of the governed rather than the barrel of a gun. Sooner or later, however, any authority that asserts sovereignty over actions that take place entirely within cyberspace must resort to acts of physical coercion or threats thereof.

That, however, requires that the target be identified and located. It will always be possible to identify and locate Fortune 500 companies, whose vast visible assets make them conspicuously vulnerable. But it is going to get very difficult to keep track of the growing number of individuals who are rapidly learning to ply their trades on the Internet.

In practice, that means that ordinary people will be able to create and exchange wealth away from the prying eyes and grasping hands of sovereign powers. Imagine the consequences if a significant fraction of the world's most productive people engaged in unrestrained commerce within an economic system inherently immune from government scrutiny. The wealth produced--that is, the underlying products of their creative output upon which the value of money will be based--may never exist in the physical world. And since that wealth may not have to be exchanged for government fiat currency in order to be useful, there may be scant opportunity to seize it.

That possibility is going to be treated as a grave threat by most national governments. A battle for cyberspace most certainly lies ahead, and you can expect entrenched bureaucrats to do everything they can to demonize the new technology by associating it with pornographers, child molesters, and drug-money launderers. Imagine what would happen if the productive efforts of millions were invisible to the Internal Revenue Service, gone from the GNP statistics, blind to the balance of trade, and immune to social or industrial policy mandates.

Cyberspace, which promises to shield individuals from the ravages of coercive force and allow them to conduct their affairs in secure anonymity, will bring forth a burst of creative human genius not seen since the last time a new world was discovered. If Atlas Shrugged were written today, imagine how it might end.

Scott Cook: Financial services is perhaps the largest industry whose product is already digital. The largest consumers of mainframe computing power in the world have always been financial institutions. Wealth is not stored physically; it's stored as bits on mainframe disk drives and transferred electronically. What's interesting is that, although the back end of financial institutions is wonderfully automated, the front end--consumer interface--is not.

In the billing cycle in the United States, by far the largest cost is postage: first class stamps, one each way. The gas company and the phone company already have on a computer all the information that appears on your bill. But to bill you they have to translate that digital product into ink on dead trees and then have it hand carried to your home. If you are a Quicken user, the information on your bill gets translated back into digital form and a check gets printed out, put in an envelope, and carried back to the biller and financial institution where it is rekeyed into the computer; then the check is physically moved around and is ultimately returned to your home.

Clearly, that is ridiculous, but payment systems are first and foremost social conventions. Like languages, they are methods of communication among large groups of people and they have great inertia. Just as language does not change rapidly, neither do other mass-oriented social conventions, including payment systems.

So perhaps for change we should look, not just to new systems, but also to existing systems. If you can take a payment system that is already in use and modify it, tweak it, so that it can deliver the new benefits that are sought, it will probably be the preferred vehicle for new benefits.

I would point to the modifications being made to the credit card system to allow people to secure online credit card transactions as an example of how a system that's already in place and widely accepted can be used. Once the modified system is in place, I think it will become the predominant system for monetary transfer. It won't solve all of the problems, but existing systems are being further modified to handle new things such as microtransactions.

Let me close by saying that I think perhaps the biggest benefits of electronic commerce have yet to be seen. The current system will, of course, improve. People will be able to use their current financial products and services more wisely and more conveniently. More exciting is the probability of the invention of new kinds of financial services that have never been thought of. I wish I knew what they will be.

This article originally appeared in the July/August 1996 edition of Cato Policy Report.