The future of money.

Read our article in the Cayman Financial Review Magazine, eversion 

Rapidly evolving technology and the most recent and ongoing financial
crisis promise to significantly change the future of money. To look into
the crystal ball for clues to its future, we must first agree on what
money is. 
 

Money is a means of payment. But actually so is barter, swapping what you want for what you have that the seller wants.

Money’s central role in economic life and its huge contribution to the enormous increase in what we each produce results from dramatically reducing the cost of trading by eliminating the double coincidence of wants required by barter trade. To do so it must be universally, or at least very widely, accepted for payment.

Money is also a store of value, ie wealth. But so is any other durable good or financial asset. Money’s particular advantage as a store of value is its liquidity, the ability to use it immediately to pay for something. So while money is a highly convenient, low cost means of payment and a useful store of value, it is not unique in either of these uses.

The most distinguishing quality of money, the function performed by nothing else, is its use as the unit of account. Goods and services are priced in units of money allowing for an enormous simplification in stating, and thus comparing, the value of things we trade (the goods and services we produce including our wages).

Wealth and business activities (profit and loss) are accounted in units of money (dollars, euro etc). Decentralised information on the intensity of our desires for something and the costs of producing and delivering it are summarised in its price. And again, its utility as a unit of account depends on its universal, or at least widespread, use for that purpose.

When thinking about the future of money, these characteristics of money lead us to consider: a) how the value of money (ie its purchasing power) is determined and how that might change for better or worse in the future, and b) how payments of money are now made and might be made in the future.

Few things have been as misunderstood and mischaracterised as money. Money is not credit, for example, though they are both often involved in trade. Money is an asset of those holding it (and a liability of the supplier) while credit is a liability of the borrower (and an asset of the lender).

We think of credit as lending money, just as we think of trade as selling our property, output and labour services for money. But those are only the first half of the real transactions.

We borrow money to buy something else or invest in something else. Without money, credit would be more clearly seen as giving over the use of resources for a limited period of time (lending the car, the college tuition, the house) in exchange for the use of other resources. We don’t consume money. Money intermediates trade and lending.

As money is spent or lent it changes hands and thus circulates through the economy never being consumed. Economists speak of money’s velocity of circulation, but this must not be confused with the flow of production, income or spending.

Increasing the velocity of money’s circulation allows the same amount of money to buy more things but it does not increase the number of things available to buy and is more often associated with a decline in production, income or spending than an increase.

Inflation increases the cost of holding money (viewed both as a tax that reduces its purchasing power and as an increase in the opportunity cost of holding it because market interest rates are higher with inflation) and thus increases its velocity of circulation. This is true of all taxes on holding money (demurrage).

In hyperinflation the velocity of circulation increases enormously as the real value of money held falls (the inverse of velocity). The artificial scarcity of money and distorting effects of high inflation reduce actual output.

A recent extreme example was the hyperinflation in Zimbabwe in 2009. The central bank dropped 15 zeros from its currency and added 12 new ones in three years until it couldn’t afford the paper to print any more. Yet the real value of the entire stock of its currency held by the public at the end of 2009 valued in US dollars shrank to 64 cent before going out of existence. The velocity of its circulation became almost infinite.

However, the demand to hold money can also fall for the opposite reason of improved means of delivering it to make payments. If my monthly salary is automatically deposited in a money market mutual fund from which payments can be made electronically without holding actual money for more than a few seconds, my demand for money would drop to almost zero (velocity would increase greatly).

Clearly the most important existential quality of money is its value (its purchasing power) and the stability and/or predictability of that value over time. Will existing national currencies, the only serious monies currently available, be more or less stable in the future, ie will they reflect more or less inflation as measured in the behaviour of their value?

What policy, legal or market developments will influence the value of government currencies (inflation targeting mandates, gold or commodity basket standards, competing private currencies, bypassing money with technically more efficient barter)?

Closely related to the factors anchoring money’s value are the evolving payment technologies that are reducing the need to hold as much money for making the same or even more payments per unit of time. This and several following articles explore answers to these questions.

The future value of money

Before barter could be intermediated by “money”, both parties to the transaction had to trust the soundness and value of whatever played the role of money. Thus early monies were commodities with value other than their monetary role (copper, silver, gold).

In South Sudan, cattle still plays this role today. When gold and silver where minted into coins in order to standardise their weight and fineness, the public needed to trust that the issuing sovereign could be trusted to include the amount of precious metal that the coin claimed. Some cheated.

When redeemable paper currencies were issued, the public needed to trust the issuer to hold sufficient gold or silver to honour its redemption promise. Most ultimately failed to do so.

When President Nixon closed the gold window in 1971, thus ending the gold standard that had existed in one form or another for centuries, the fiat currencies that replaced it were no longer redeemable for anything but could be used to pay taxes or other obligations to the government in amounts stated in currency units.

The value of these paper fiat currencies depended on how their issuing central banks controlled their supply. All central banks have reduced the value of their currencies (inflation) by overissue, some only a little and some a lot.

With the development of commercial banks, those accepting a deposit of money in a bank in payment of obligations needed to trust the solvency of the bank and thus its ability to convert the deposit into central bank notes (or specie) on demand. Some failed.

The currencies issued by banks in the United States during the free banking era (1837-63) were redeemable for fixed amounts of gold or silver. Those accepting the bank notes of various banks needed to trust the soundness of the particular issuing bank and its ability to redeem them for the promised amount of gold or silver.

The bank notes of far away banks generally traded at a discount. Each bank’s notes represented the same unit of account, one US dollar redeemable for the same quantity of specie, and thus provided the essential basis for a monetary system. Today’s central bank currencies are free of default risk, but not of the erosion of their value (inflation).

The history of money has been rocky, but modern commerce and the enormous wealth it has created would not have been possible without it.

Trust in the value of money remains an essential aspect of its acceptance, use and utility. A credible anchor for the value of any currency in the future will be a critically important feature of its acceptance and effectiveness.

Such an anchor must provide a clear rule for the behaviour of its supply, such as Milton Friedman’s constant growth rate rule, an inflation targeting mandate, or redemption for gold, silver or a basket of commodities and/or goods.

National currencies

The currencies that 99.9 per cent of us use for all of those things that we use money for (payments, store of value and unit of account) are based on the money issued by national central banks.

For the United States, the US dollar, technically Federal Reserve notes, is issued by the Federal Reserve System of the United States. For the Cayman Islands, the Cayman dollar is issued by the Cayman Islands Monetary Authority.

For these central bank currencies the question of the future of their value is a question about the future behaviour of the issuing central banks. For those currencies like the Cayman dollar that are fixed to another currency, their value will depend on the behaviour of the central bank issuing the currency they are fixed to (for KY it is the USD).

Starting with the Bank of England in 1694, central bank monopolies on the issue of national currencies have had a very uneven history. Many if not most central banks were required to finance their governments at one time or another with the currencies they issued, often with very inflationary results.

During long periods when their currencies were redeemable for gold or silver, their control over its issue was constrained and disciplined by the market. Following the collapse of the gold standard as an anchor to monetary issue in the 1970s, the search for alternative sources of discipline to anchor monetary issue and value led to the wide spread adoption of “independent” central banks.

Modern laws give central banks the mandate (generally) to preserve the value of their currency (price stability) and protection from interference from the government in achieving that mandate. The Federal Reserve suffers from the dual mandate of price stability and full employment. Lending to the government is generally forbidden.

Over the last decade, inflation targeting has become very popular as an approach to providing the discipline of a rule but with the flexibility to judge the current economic situation. Because the effect on prices of changes in monetary policy only materialises one to two years later, monetary policy decisions taken today must aim to achieve an inflation target (generally 2 per cent) a year or more in the future.

This is not easy but it provides a relatively clear policy framework and anchor. The last two decades of inflation targeting (prior to the financial crisis of 2007-8) produced the ‘great moderation’ of stable prices and strong economic growth.

The great moderation came to an end in 2008 in part because of the failure of inflation-targeting regimes to adequately take into account the impact of monetary policy on asset prices (stock prices, real estate prices etc).

One direction that the future of central bank money might take is the refinement of the inflation-targeting framework to take better account of asset price behaviour. This, and some other lesson of the recent past that central banks will attempt to learn are explored in this issue by former Croatian National Bank Governor Marko Skreb.

A major challenge to the stability of the value of central bank money in the future comes from the large public sector deficits and debts that have accumulated in many developed countries and the pressure that is already building on central banks to finance (buy) some of it. See the discussion by former Federal Reserve Bank President Jerry L Jordan in this issue.

Another direction the future might take would be to return to the discipline of a redeemable currency. Gold has a relatively good history in this role and is well know, as are its weaknesses. It also has the virtue of simplicity.

Manuel Hinds, a former Finance Minister of El Salvador, makes a case for the return to gold in this issue. However, various commodity basket and broader index anchors are also possible. My own proposals of this type are considered in the next section and Robert Pringle, chairman of Central Banking Publications, presents a proposal for a valuation basket of equities in this issue.
International reserve currencies

Since the collapse of the gold standard, debate has raged between those favouring national currencies with market determined (floating) exchange rates and those favouring a single world currency, as was provided by the gold standard.

Where national central banks are unprepared to cooperate internationally for the benefit of global trade and stability, floating exchange rates are preferable (currency nationalism).

However, a single global currency would better promote global trade (in part by removing exchange rate uncertainty) and would impose stronger financial and monetary discipline on national governments.

Moreover, the dominance of the US dollar as the global unit of account and reserve currency carries risks that are now apparent. The risks to the US and to international holders of US dollars of the unwillingness of the United States to adapt its domestic monetary and fiscal policies to the needs of global stability are large and growing.

For some years I have proposed promoting the use of the IMF’s reserve currency, the Special Drawing Right (SDR), by replacing its current valuation basket of four currencies with a valuation basket of widely traded goods.

Like the Cayman dollar, the new Real SDR could be purchased from the IMF for prime financial assets at the price given by its valuation basket and the IMF would be required to redeem them at the same price for the same class of financial assets.

This proposal was discussed in issue 18 (first quarter of 2010) of the Cayman Financial Review http://www.compasscayman.com/cfr/2010/01/05/Do-we-need-a-new-global-currency-/ and more recently in “Real SDR Currency Board”, Central Banking Journal XXII.2 (2011).

Such a reserve currency, created by international agreement, has real promise as a supplement to, or even a replacement of, the US dollar and euro as an international reserve currency and as the anchor (peg) of many national currencies.

Means of payment

The biggest changes in the future of money will be the means by which it can be used to make payments. The old bank letters of credit used by travellers in Charles Dickens day, and the money orders, and Travellers Cheques of the previous generation have given way to credit and debit cards, which are now ubiquitous, but sufficiently expensive for the merchants that accept them that a new generation of high tech and generally internet based payment vehicles have been and will be developed to further reduce the cost and increase the convenience of making payments.

Paypal is the most established of the new payment vehicles, but many more are coming. Paypal, and similar systems bypass the interoperative networks developed by the debit/credit card issues. They are closed systems transferring balances only between participants.

This reduces their usefulness to those in the closed system, but also reduces their cost. A Paypal account may be funded from your credit card account or your bank account, all on-line. The beginning (cash in) and end points (cash out) are the traditional bank money system. Actual cash is never involved.

One of the most exciting areas of technical advances in making payments is the use of mobile phones rather than the internet. The pioneering mobile phone payment systems in the Philippines and Kenya have developed very rapidly and service a larger part of the population than do banks.

I have reported on these developments in Kenya in the Dailycaller: http://dailycaller.com/2010/04/10/kenya-owes-monetary-advances-to-imf-world-bank/ (see The Technology of Money in this edition).

These systems use existing national currencies, but provide cheaper and easier means of delivering (paying) it than existed before. Unlike purely internet based payment systems like Paypal, mobile phone systems have established agents (the equivalent of a bank teller window) for receiving and paying out cash (cash in and cash out points).

Thus they connect the cash world with the deposit world in the way banks do, but to a much wider audience and at much lower cost bring such services to the unbanked.

While each is a closed system, they have been made interoperative (payments between systems) in most countries, meaning that a payment made on the phone of one telecom company can be received on the phone of another telecom company or payment service provider, just as voice communications can.

In the United States, and most other countries, payment systems are all private except for the central banks’ interbank settlement systems (Fedwire in the US and TARGET in Europe). The natural monopoly inherent in the core, so called base money of national central banks as a unit of account, does not exist for payment systems.

Thus the development of new and improved means of payment benefits from the competitive innovative drive of private entrepreneurs. Paypal, for example, opened its sophisticated code to other developers in 2009 who quickly generated thousands of systems using Paypal’s platform, such as the twitter based, Twitpay (https://twitpay.com/). Most will fail but a few will transform the means of payment as we now know them.

Cash (bank notes) must be delivered face to face (transferred hand to hand). Its use to make a payment only requires the willingness of the recipient to accept it, which depends on his judgment that it is genuine (not counterfeit) and his trust that its value will be preserved until he spends it himself.

All more sophisticated means of payment require the build up of a network of users (individuals and firms) that are willing to accept and use them. If the online merchant you wish to pay does not display its acceptance of payments from Paypal (next to the Visa, Am Ex logos), you can’t use Paypal or any other such service.

To establish the trust needed for any payment instrument and system, the legal rights and obligations of the participants must be clearly established. The recipient of a check (bank draft) cannot be sure of payment until the check has been returned to the bank of the signing payer.

The recipient of Paypal funds has an immediate and final claim on Paypal for the national currency amount of the payment. The private developers of these systems have a life or death incentive to “get it right”, not likely to be found among regulators.

Trust, the willingness to accept payment from a particular system or instrument, is an essential feature of any means of payment. If the currency being transferred is not (ultimately) the US dollar, the euro or your national currency, the challenge of finding anyone willing to accept it is enormously greater. This is the almost insurmountable challenge faced by all issuers of private currencies.

Private money

Those championing a return to the gold standard or the right to deal in private gold backed currencies, which Americans have been able to do again since 1977, are generally motivated by the search for a more secure anchor to the value of the money they use.

Thus e-gold (now liquidated – at a profit to its participants and replaced by the Global Standard System) delivers a digital currency redeemable for a fixed amount of gold, or national currencies. Its founder, Douglas Jackson, shares his views on private money in this issue.

The value of Ven, the virtual currency used by about 20,000 “Hub Culture” participants also has a well-defined anchor (the current market value of a basket of currencies, commodities and carbon futures), as does Terra (the Trade Reference Currency – TRC).

Like frequent flier club credits encashable for airline tickets and other goods, or Facebook credits, which Facebook describes as “a virtual currency you can use to buy virtual goods in any games or apps of the Facebook platform that accept payments”, this class of private monies are linked to interest groups or subsidiary social or political purposes.

Ven ties its value, in part, to carbon futures making it a “green” currency and is part of a social network. Stan Stalnaker, the Founding Director of Hub Culture, for which Ven is the virtual currency, also offers his views on the future of money in this issue.

Like my Real SDR, the Terra strives to provide a global unit of account and means of payment (ie money) with a relatively stable real value (derived from its valuation basket). Unlike my proposal, Terra is backed by physical holdings of the items in its valuation basket and charges a fee to cover the storage and operational cost (demurrage).

Once issued in exchange for one or more of the items in the basket, Terra circulates among its participating members like national currencies but within its closed system of members. The demurrage charges of 3.5 per cent to 4 per cent per year are high but necessary to cover storage and administrative costs.

The redemption (cash out) fee of 2 per cent is also used as a deterrent to frequent redemptions.

The demurrage charge reduces the demand to hold Terra, ie increases its velocity of circulation. The increases and decreases in the inventories backing Terra would tend to have a countercyclical (stabilising) effect on prices and economic activity. Some have also claimed that the more rapid velocity of circulation would also stimulate additional spending.

However, the demurrage charge would raise velocity to a new rate as a one-time event. Unless the demurrage charge is systematically varied over the business cycle it would have no countercyclical effect, which is what central banks try to do by varying the growth in the money supply (rather than by influencing its demand/velocity).

Jordon MacLeod, a co-founder and partner of Cornerstone Global Associates, expresses a contrary view in this issue.

In the mid 1970s, Friedrich Hayek, the Nobel Prize winning economist, argued that the only hope of containing the propensity of central banks to over issue, and thus inflate, their monopoly currencies was to introduce competition.

His competitive currencies proposal was really aimed at allowing citizens to use the national currencies of other countries when their own misbehaved, a right that now exists in most countries1.

However, his proposal has contributed to interest in the creation of private competing currencies.

Much of the drive for private money is an almost religious search for independence from government, for anonymity, and/or for a more communal order. Many of the so-called private currencies are really credit or barter trading arrangements that technology and the Internet make more efficient.

Examples are Local Exchange Trading Systems (LETS) such as Ithica (New York) HOURS http://www.paulglover.org/hours.html/ and Bay Bucks, http://www.baybucks.org/, used in Grand Traverse, Michigan, both of which actually issue currency notes as a way of granting credit to their members.

In the words of Paul Glover, founder of Ithica HOURS, “We regard Ithaca’s HOURS as real money, backed by real people, real time, real skills and tools. Dollars, by contrast, are funny money, backed no longer by gold or silver but by less than nothing – $8.4 trillion of national debt.”

In this issue, Chris Cook, with Nordic Enterprise Trust, discusses the replacement of much of money as a means of payment (but not a unit of account) with modern technology enhanced, closed group, credit exchanges.

With the exception of WIR, almost all private credit/barter arrangements have had a relatively short life. The term WIR was derived from the word “Wirtschaftsring”, or “economic circle” and also means “we” in German. WIR was launched in Switzerland in 1934 at the height of the great depression to provide credit to its members. It is purely a book keeping system with no currency notes of any sort.

WIR is now a licensed bank and in fact was never much different than any other mutual bank or cooperative bank (Credit Unions and the Savings and Loan Associations in the US that used to be owned by their depositors). WIR credits were denominated in Swiss francs, and thus were never meant to introduce a private competing unit of account.

In Thomas H Greco Jr’s book The End of Money and the Future of Civilization, he states that:

“The credit clearing exchange is the key element that enables a community to develop a sustainable economy under local control and to maintain a high standard of living and quality of life…. The attraction [of these credit clearing exchanges] has been mainly ideological.

Complementary currency and exchange has been seen as a means for achieving social justice, economic equity, local self-determination, and environmental restoration.”

“Bitcoin”, on the other hand, represents a very different animal. It is explicitly a private money in the fullest sense of being its own unit of account. Its value is anchored to nothing but the demand for it by those holding it (and a very well defined rule for increasing its supply).

It is also meant to preserve the anonymity of transactors. It is an example of an application of P2P technology to produce totally decentralised electronic money (no central record of where it is).

According to The Economist (21 October, 2011): Bitcoin “plummeted from a peak of around $33 per unit in June to just $2.51…. Only six eateries worldwide (three in New York and three in Germany)” accept it (as do a few dozen other enterprises). Without a well-defined anchor to its value bitcoin and other private monies have little prospect of success.

Bank deposits denominated in national currencies are included in official statistics of money (M1, M2 etc), and deposits in national currencies with other payment service providers such as Paypal should be included as well.

They are widely accepted in payment for goods and obligations because they are ultimately claims on the currency of a central bank in which the obligation being paid is denominated. Truly private currencies, those anchored in (and redeemable in) something other than national currencies (gold, defined baskets, faith) have an uphill road to broad acceptance because they are based on a unit of account not widely used and thus not (yet) convenient.

It is more promising to anchor national currencies (those issued by central banks) to gold, SDRs or some other valuation basket, as the mains of gaining wide spread use and acceptance of such valuation units – an essential feature of anything wishing to service as money.

As noted above, however, technology and the ingenuity of private, competitive entrepreneurs will almost certainly create new and better ways to make payments. Some of them will surprise us. A century ago, no one imagined mobile phone payments, in part, because no one imagined mobile phones.

These payments will almost certainly be settled at the end of the chain with national central bank money, hopefully anchored to something with predictable and stable value.

Endnotes

1 I debated Hayek on his competitive currencies proposals at a meeting of the Mont Pelerin Society in 1976 in St Andrews Scotland. I argued that he undervalued the role and importance of an agreed and universally (or at least widely) accepted unit of account.

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