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The Electronic Money Myth


Tags Money and BanksMoney and BankingValue and Exchange

06/23/2000Frank Shostak

"Electronic money is merely a device for storing information concerning debits and credits. It cannot acquire independent purchasing power; it cannot become money itself."

Many economists and financial commentators believe that in the unregulated market of the internet economy, new forms of money can be created that bypass central-bank and government supervision. The latest development is the emergence of a new electronic means of payment. Experts maintain it will displace the existent fiat money. This displacement will usher in a new era of free banking, it is claimed, where competition between banks' electronic moneys will finally put to rest the menace of inflation.

Unfortunately, this is a pipe dream. Electronic money will not replace fiat paper money. The belief that it can stems from a failure to understand the nature and function of money and how it emerges on the market.

Electronic money, or digital money, takes the form of a "smart" card, containing a microchip that the user pre-programs with a specific dollar amount [See David Friedman and Kerry Lynn Macintosh "Technology and the Case for Free Banking" unpublished paper]. To make a purchase, the card is swiped through a special card reader, which automatically deducts the amount of the purchase from the stored value on the card and credits the amount to seller's account.

Some commentators believe that banks and other financial service companies can issue competing name brands of electronic money stored on smart cards. Each brand, in turn, will be based either on fiat money, or on banks issuing their own notes, which will serve as a base for the electronic money.

Each issuer would manage the quantity of its electronic money in order to keep its value stable relative to the base money. Ultimately competition would force unstable moneys out of the market (a claim advanced by Kerry Lynn Macintosh in "How to Encourage Global Electronic Commerce:The Case for Private Currencies on the Internet," Harvard Journal of Law & Technology, 11). They suppose that a rise in the use of electronic money would contribute to the lowering of the demand for the government fiat money and eventually to its total replacement.

To see where this view goes wrong, let's first see how money comes about. Money emerges out of barter conditions to permit more complex forms of trade and economic calculation. The distinguishing characteristic of money is that it is the general medium of exchange, evolved from private enterprise from the most marketable commodity. On this Mises wrote,

There would be an inevitable tendency for the less marketable of the series of goods used as media of exchange to be one by one rejected until at last only a single commodity remained, which was universally employed as a medium of exchange; in a word, money. (The Theory of Money and Credit, pp. 32-33)

In short, money is the thing for which all other goods and services are traded. Furthermore, money must emerge as a commodity. An object cannot be used as money unless it already possesses an objective exchange value based on some other use. The object must have a pre-existing price for it to be accepted as money.

Why? Demand for a good arises from its perceived benefit. For instance people demand food because of the nourishment it offers. With regard to money, people demand it not for direct use in consumption, but in order to exchange it for other goods and services. Money is not useful in itself, but because it has an exchange value, it is exchangeable in terms of other goods and services.

The benefit money offers is its purchasing power, i.e. its price in terms of goods and services. Consequently for something to be accepted as money, it must have a pre-existing purchasing power: a price. This price could have only emerged if it had an exchange value established in barter.

Once a thing becomes accepted as the medium of exchange, it will continue to be accepted even if its non-monetary usefulness disappears. The reason for this acceptance is that people now possess previous information about its purchasing power. This in turn enables them to form the demand for money.

In short the key to the acceptance is the knowledge of the previous purchasing power. It is this fact that made it possible for governments to abolish the convertibility of paper money into gold, thereby paving the way for the introduction of the paper standard. Again the crux here is that an object must have an established purchasing power for it to be accepted as general medium of exchange, i.e. money.

In today's monetary system, the core of the money supply is no longer gold, but coins and notes issued by governments and central banks. Consequently coins and notes constitute the standard money we know as cash that are employed in transactions. Notwithstanding, it is the historical link to gold that makes paper money acceptable in exchange.


Why competitive moneys cannot replace government money

The fact that an object must have a pre-exiting price before it becomes money precludes the possibility that money in a free market could be issued by just anybody. In fact, the idea that anybody can print his own money, and for that money to be accepted in exchange, is preposterous. Why would anyone accept notes printed by Mr Jones or even by a famous movie star? This possibility, however, is implied by the view which endorses the issuance of electronic money based on paper notes issued by banks or private entrepreneurs.

Moreover, the whole idea that electronic money could somehow replace fiat money is not defendable. Electronic money can function only as long as individuals know that they can convert it into fiat money, i.e. cash on demand (see, e.g., Lawrence H. White "The Technology Revolution And Monetary Evolution," Cato Institute's 14th annual monetary conference, May 23, 1996).

Without a frame of reference or a yardstick, the introduction of new forms of settling transactions is not possible. This frame of reference cannot be something arbitrary--as in the case of banks issuing their own notes. Rather, it must be established in accordance with a criterion that everybody would accept as valid. On this Rothbard wrote,

Just as in nature there is a great variety of skills and resources, so there is a variety in the marketability of goods. Some goods are more widely demanded than others, some are more divisible into smaller units without loss of value, some more durable over long periods of time, some more transportable over large distances. All of these advantages make for greater marketability. It is clear that in every society, the most marketable goods will be gradually selected as the media for exchange. As they are more and more selected as media, the demand for them increases because of this use, and so they become even more marketable. The result is a reinforcing spiral: more marketability causes wider use as a medium which causes more marketability, etc. Eventually, one or two commodities are used as general media-in almost all exchanges-and these are called money. (from Murray N. Rothbard, What Has Government Done to Our Money?

It was through a prolonged process of selection that people had settled on gold as the most marketable commodity. Gold therefore had become the frame of reference for various forms of payments. Gold formed the basis for the value of today's fiat money.

Besides, electronic money is not a new form of money that replaces previous forms, but rather a new way of employing existent money in transactions. Because electronic money is not real money but merely a different way of employing existent fiat money obviously, it cannot replace it.

One could argue that a government decree could enforce electronic money and displace the current paper standard. This would not work, however. Electronic money is merely a device of storing information concerning debits and credits. It cannot acquire any independent purchasing power; it cannot become money itself. It functions in the same way as checks, which cannot acquire an independent purchasing power from money.

Even the latest technological breakthrough that allows electronic money holders to transfer value directly from one card to another won’t do the trick. While this new technology would permit the electronic "notes" to circulate much longer, possibly providing certain efficiency gains, sooner or later they will still be returned to the issuer for redemption.

The mere fact that people would hold less currency in their pockets and to a greater extent employ electronic money doesn't imply a fall in the demand for fiat money, as some commentators have suggested (see, e.g., George Selgin "E-Money: Friend or Foe of Monetarism?" Cato Institute's 14th annual monetary conference, May 23, 1996).

So long as people exchange goods and services with each other, there will be a demand for money. A new way of employing money doesn't mean that it will be replaced or that there will be a fall in demand for it. Besides, should this disappearance in demand really occur, it would be the end of the division of labour and the market economy.

In their recent paper David Friedman and Kerry Macintosh argue that the new technology would make it possible to implement sophisticated barter. This in turn would completely remove the need for money ("Technology and the case for free banking," unpublished paper).

However, why should the essence of barter be altered on account of a new technology? How could a professor of economics make his living if food producers were not interested in directly exchanging their goods for lectures in economics? This new technology does not resolve this issue, any more than technology alone can create a new form of money to replace existing fiat moneys. For the duration, or until we have serious efforts at far-reaching monetary reform, the most new technology can offer is new forms of efficiency in payment and record keeping. But it will not alter the essence of money itself.


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