Subscribe to BrookesNews’ Bulletin
Electronic money and the money supply: another fallacy emerges
Dr Frank Shostak
Many economists and financial markets commentators hold that in de-regulated markets whenever a central bank tries to impose control, markets create a new form of money, thereby bypassing central bank supervision. The latest development in this regard is the emergence of a new electronic means of payments that experts maintain is likely to displace the existent fiat money, currently controlled by the central bank and the government. This displacement will usher in a new era of free banking where competition between various banks’ electronic moneys will finally put to rest the menace of inflation.
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. 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 sellers account. Some commentators hold that banks and other financial service companies could issue competing name brands of electronic money stored on smart cards. Each brand in turn will be based either on a fiat money base, 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. The envisaged rise in the use of electronic money, it is held, would contribute to the lowering of the demand for the government fiat money and eventually to its total replacement.
Does it make any sense? Can electronic money replace fiat paper money? It seems that this way of thinking ignores the essence of what money is and how it did emerge.
To establish the essence of money we have to ascertain how the money-economy came about. Money emerged as a result of the fact that barter could not support the market economy. The distinguishing characteristic of money is that it is the general medium of exchange. It has evolved 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.
In short, money is the thing that all other goods and services are traded for. Furthermore, it also implies that money must emerge as a commodity. An object couldn’t be used as money, unless at the moment when its use as money begins it already possesses an objective exchange value based on some other use. In short 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 them. 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. Money is demanded because the benefit it offers is its purchasing power i.e. its price. Consequently for something to be accepted as money, it must have a pre-existing purchasing power, a price.
This price could have only emerged as a result of the fact that an object that becomes money must previously have had an exchange value established in barter. This exchange value, prior to its becoming money, was on account of other benefits that the object offered to human beings. 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 by decree, 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 all this 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. The idea that anybody could print their own money is preposterous. Why would anyone accept notes printed by Mr Jones or by a famous movie star? This is, however, implied by the view which endorses the issuance of electronic money based on paper notes issued by banks and financial enterprises. Moreover, the whole idea that electronic money could somehow replace fiat money is not defendable. In similarity to demand deposits, electronic money can function only as long as individuals know that they can convert it into fiat money i.e. cash on demand.
Without a frame of reference i.e. 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.
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 however, could have argued that by a decree government could enforce electronic money and displace the current paper standard. This however, would not work. Electronic money is just a device of storing information regarding the amount of money. It cannot acquire any independent purchasing power, it cannot become money itself. It functions in the same way as cheques, 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. Whilst this new technology would permit the electronic "notes" to circulate much longer, sooner or later they would still be returned to the issuer for redemption.
The mere fact that people would hold less currency notes 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. As 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, then it would be the end of the division of labour and the market economy.
Dr Shostak is a former professor of economics who now works in the private sector
BrookesNews.Com
Monday 28 May 2007