Electronic Money and the Market Process
by Adam MikkelsenÊ

How Digital Developments are Opening New Frontiers for Liberalism

Approaching the twenty-first century, there is enormous hope for the dynamic market process continuing to be regarded as the only viable means of securing free and prosperous societies. In contrast to the predominantly collectivist political and economic ethos of 20-30 years ago, today's orthodoxy is that the dynamic market process is both the only system consistent with personal freedomand the one which delivers vastly superior economic outcomes. The past 20 years in particular have been marked by privatisations, financial deregulation and a retreat of the state from direct participation in economic life.

However, this movement over the last 20 years has been a response to the poor economic outcomes that resulted from heavy state intervention. Pragmatism, not principles, has driven reform, and in many ways attitudes of legislators towards the market and the role of the state have not changed. A regulatory framework has sprung up to take the place of the more direct intervention of the Keynesian past. The recent Asian economic turmoil, which has led to the imposition of currency controls and calls for increased government intervention in 'stabilising' the crisis, has also highlighted that philosophical attitudes towards the role of government may not have changed as much as some of us would have hoped.

However, although market hostile regulation may be increasing in some areas, there are also some extremely encouraging developments, based on Internet technology, which not only are based upon private, consensual and generalised legal rules, but also have the capacity fundamentally to alter the relationship of the individual to the state. Advances in technology, in particular computer and communication technology, have reduced the power of governments to control information, and have already contributed to the downfall of communist states. Today, Internet based technology is rapidly moving towards offering 'digital cash' on a personal and worldwide basis. Over the next 20-30 years this development will, I believe, undermine the monopoly supply of money by governments, and allow the public to choose between different private money suppliers, based around a legal framework not of discretionary government control, but of private contractual monetary obligations based on generalised rules.

Private money has long been a goal of a number of advocates of the free market, who have primarily viewed it as the means to control inflation (Hayek 1976/1990, Dowd 1988). However, until now, the introduction of private money would have required governments to agree voluntarily to relinquish their monopolies over money, which has been and will continue to be politically unrealistic. Digital cash offers the promise of ending this monopoly using market forces. Accordingly, the legal rules governing digital cash should, in all likelihood, be in best traditions of the Common Law.

This paper explores why the choices offered by the development of digital cash are so significant from a legal and constitutional point of view, and why the legal rules governing digital cash will be entirely consistent with the dynamic market process.

Financial innovation and legal relations

It is worthwhile to first put the prospect of private digital cash in the wider context of the general revolution occurring in global financial markets. Forty years ago, most countries operated on a system of fixed exchange rates and exchange controls. There were stringent legal restrictions on obtaining foreign currency, and moving money offshore was difficult. Not only did this system impact on the flow of goods, it impacted on personal liberty in a very direct way. In New Zealand and Australia, individuals who wanted to go on overseas business trips and needed to obtain foreign currency, had to prove to the government that their trip would be to the 'economic benefit' of the country (Hawke 1973: 135). Not only did such controls hinder the market, the market that did develop could not be called 'free' in any principled sense.

This system of controls and financial regulations began to break down following the collapse of the Bretton Woods exchange rate regime in the early 1970s. With the development of on screen electronic funds transfers between banks, the speed at which money is now able to flow between markets has also made it far easier and cheaper to move capital from place to place. Freedom in financial markets has also obviously been reliant upon legislative and regulatory changes. As governments began to run continuous budget deficits during the 1960s and 1970s they themselves became reliant upon capital markets in order to raise finance, and fixed exchange rates and restrictions on capital movements were incompatible with accessing these markets. Most countries have consequently moved to free up foreign investment and capital flows over the past 15 years, although there is a dangerous backlash beginning to emerge against financial freedom following the recent Asian economic turmoil.

Yet although increased freedom in financial markets has assisted in integrating international markets, Internet based digital cash has the potential to alter legal relations in a far more significant way. Although it is impossible to predict the exact form that digital cash will take, the current indications are that it will be based predominantly upon private contract law (Jordan and Stevens 1997). This has radical implications. Not only would it create a competitive market for the supply of money (which would, amongst other things severely limit the scope and effectiveness of governmental monetary policy), it would also affect governments' ability to tax individual income and expenditure. Furthermore, unlike today where central banks use discretionary power to control the supply of money, the legal rules relating to private digital cash would be generalised and outcome independent. In other words, digital cash would be governed by rules ideally compatible with the market process.

Nature of digital cash

In one sense, it is misleading to talk of digital cash or electronic money as a future development, as it is already used on a daily worldwide basis. Commercially, money (in the sense of national currency) is transferred between domestic and offshore financial institutions not by the physical transfer of cash or other assets, but by setting off money balances in electronic form. The relatively free global movement of money discussed above could not survive without payment being made electronically. Although the term 'electronic money' is used widely, this more properly describes national currencies stored and transferred in electronic form, so I will use the term 'digital cash' to draw the distinction between such national currencies and privately issued electronic currencies.

At a retail and individual level, advances in digital monetary systems have until now been restricted to Eft-Pos cards (which essentially operate as an electronic chequebook), the use of credit cards to purchase goods and services overseas and on the Internet, and stored value cash cards. Eft-Pos and credit cards are limited in that the customer must rely upon a intermediating bank in order to transact, and the money transferred under these systems are currencies issued by central banks. Most importantly, it is also practically impossible to purchase goods and services over the Internet without a credit card. This has obvious limitations for transactions between individuals who are not accredited card merchants, and means that small purchases are uneconomic.

The system also relies on the use of intermediating banking networks and the sale and purchase of foreign currencies to carry out international transactions. What is required is a more cash like payment system so that individuals and firms can make payments directly to each other anywhere in the world without requiring third party assistance. The development which will allow this, and will truly change the nature of the international monetary system, is the ability to transfer, directly and instantaneously from one individual to another, cash balances in digital form, issued by banks or other financial institutions.

At present, if you wish to buy books over the Internet, the relevant credit card company must mediate the transaction by transferring money between accounts and, where necessary, buying and selling foreign currencies. Although the effect that a buyer in one country can purchase goods in another over the Internet, the monetary side of the transaction is reliant upon cooperation between banks. Notwithstanding that the buying order is made over the Internet, and that the relevant banks set off balances against one another electronically, such a development is, in the words of Lawrence White, evolutionary rather than revolutionary. The essential nature of the transaction – deposit transfer – between the banks remains the same as if a physical cheque had been written and the balances set off in the books of the banks (White 1997: 16).

However, consider the position under a system involving the issue by private institutions of 'digital currency.' White (1997: 16) envisages such a system having the following features:

The currency balance information, an encoded string of digits, can be carried on a 'smart' plastic card with an implanted microchip, or kept on a computer hard drive. Like a travellers check, a digital currency balance is a floating claim that is not linked to any particular account. One cardholder can make a payment to another, without bank involvement, by placing both cards in a 'digital wallet' that writes down the card balance an one card and writes up the balance on the other by the same amount. Desktop electronic currency transfers can similarly be made by electronic mail.

Under this system, the above book buying transaction would involve the buyer, for instance, clicking on the 'buy' sign on the seller's Internet website, at which point an amount equivalent to the price of the book would be deducted from the buyer's digital cash wallet on his PC, and the same amount added to the seller's wallet on her PC. The seller could then use that money to buy further goods and services in the same way, redeem the cash into the asset or assets against which it is a claim, or transfer it instantly into a bank account anywhere in the world over the Internet. There is no need to purchase foreign currency and it does not require bank assistance.

The digital cash could also be transferred in the same way between two individuals in repayment of a debt. The only need for third party involvement anywhere in the process is the need for the institution which issued the cash to verify that it is genuine and has not been spent previously. Importantly, privacy is protected by a system of 'blind signatures' under which the institution can verify that it has issued the cash, but cannot tell to whom it was issued. There are currently an alliance of banks supporting trials on a similar system developed by Digicash, Inc, including Deutsche Bank, Credit Suisse and St George Bank in Australia ¹. Digital cash will probably begin to be used widely once a number of the larger banks have enough confidence in the encryption technology to market it to the general public and use of the Internet spreads further in high inflation countries.

It is important to realise that digital cash would be redeemable by the issuing bank or banks in question into certain assets (most probably currency issued by a central bank) at any stage. It would be a contractual claim issued by the bank to redeem the 'cash' upon demand. In this sense, so long as the cash did not have to be redeemed every time a transaction was made, it would function as private currency issued by the bank. It is probable that its initial stages, consumers would stick with the familiar and digital cash would be redeemable only into currency issued by national governments, most likely the US dollar. However, there is no reason why the digital cash could not be redeemable into any other assets. The most logical backing commodity today would not be a precious metal such as gold, but a 'basket' of financial instruments, such as long term fixed interest bonds and the like. It is also feasible that digital cash could be used in a manner similar to current and chequing accounts run by mutual funds whereby the digital cash would merely be the 'cashed up' or most liquid form of the assets held by the mutual and which could be spent at any time.

Legal features of digital cash

Certain legal features of a private digital cash system make it fundamentally more compatible with the market process than current monetary arrangements. A monopoly over the supply of money is principally required by governments in order to implement monetary policies that aim at particular outcomes – typically sustainable and non inflationary economic growth. However, at the point at which digital cash represented a reasonable proportion (say around 15%) of the total money supply, using monetary policy for these purposes would become impossible, because changes in monetary aggregates or interest rates would not affect the spending or investment patterns of those consumers not using the national currency. If monetary policy became ineffective, the whole justification for government having a monetary monopoly would fall away, and combined with the transactional and tax based incentives for consumers to use digital cash, the widespread use of digital cash would lead to money being privately supplied, as it was prior to the development of central banking earlier this century ².

The implications of this for the relationship between the individual and the state are enormous. Governmental monetary monopolies have become integral in the implementation of government policies and have profoundly assisted the growth of coercive governmental power. Removing this monopoly power would rob governments of a great deal of their power to control and distort economic affairs. Furthermore, irrespective of particular monetary policies adopted by any government, the monopoly issue of money is inconsistent with the free market, since it represents the supply of goods under a legal grant of monopoly. The economist's presumption against monopolies is that they impose costs on consumers not present in a competitive market. The legal objection to state monopolies, however, is that they both benefit the state at the expense of individuals, and impact on political freedom, since by limiting choice they restrict the opportunity for individuals to develop or maintain preferences contrary to those of the state.

A monopoly over money supply also allows government to finance itself by in effect 'printing' money, which although is politically useful in creating short term aggregate demand, is ultimately inflationary and reduces the value of the currency. This acts as a coercive taking of private property, similar to a tax, and is typically unconstrained by any Parliamentary or Constitutional process (Robertson 1996: 1). As Friedrich Hayek makes plain in Denationalisation of Money:

[A] government ought not, any more than a private person, to be able to take whatever it wants, but be strictly limited to the use of the means placed at its disposal by the representatives of the people, and to be unable to extend its resources beyond what the people have agreed to let it have. The modern expansion of government was largely assisted by the possibility of covering deficits by issuing money – usually on the pretence that it was creating employment (Hayek 1976/1990: 32-33).

It is unlikely that privately supplied currency would be inflationary, as there would be competitive pressures on suppliers to provide stable currencies, and consumers would be likely to use only those currencies which were both freely convertible and would maintain their purchasing power over time (Dowd 1993; White 1989). However, even if certain private currencies were inflationary, from a legal perspective, holding that currency in the face of inflation would involve consumer preference, not the exercise of coercive government power. (In fact, it is likely that some would make the deliberate decision to hold currencies with a higher risk of inflation, as they would be compensated for that risk by correspondingly higher interest rates.) Indeed, the supply of money would no longer be a constitutional issue, but merely one of a number of business risks or decisions an individual would face or make when holding money or making contracts.

The rules under which central banks operate involve the exercise of discretion, as opposed to generalised rules which are more consistent with the market process. Sayers (1957: 1) illustrates this in a definition of what constitutes central banking:

The essence of central banking is discretionary control of the monetary system É working to rule is the antithesis of central banking. A central bank is necessary only when the community decides that a discretionary element is desirable. The central banker is the man who exercises his discretion, not the machine that works according to rule.

Legal relations in a free market should be governed by general rules which limit, not promote, the exercise of government discretion. It could be argued that discretion is only used by central banks today in order to eliminate inflation and maintain the stability of the currency, which is positive for markets. However, although an increasing number of central banks today conduct monetary policy with the sole objective of keeping inflation low, they are still involved in setting interest rates and controlling the money supply in the pursuit of a particular outcome: namely to ensure that economic growth is kept at 'sustainable non-inflationary' levels. In other words, central banks operate and act on the basis of very limited information in order to achieve macro economic certain outcomes, by using discretionary power – ie they operate in a manner which is contrary to the requirements of the spontaneous order. It should also be remembered that legally, central banks retain the same capacity to create inflation as during the 1970s – only attitudes towards inflation have changed, not the capacity of governments to cause it.

Relationships under a digital cash system would also be altered by the speed and low cost at which digital cash could be moved from place to place. One of the advantages of digital cash is that transactions could take place without the need for banks to intermediate in international transactions. Instant transfer of money would not only encourage the development of a free worldwide market, by removing the present significant barriers to transacting, but also reduce the ability of governments to impose taxation and disclosure obligations on banks (such as withholding tax).

In addition, because a digital cash system would allow funds to be transferred from place to place quickly and cheaply, offshore banking would become directly available on a personal level for the first time. The obvious beneficiaries of this would be consumers in high inflation countries who would have access to stable private currencies, and consumers in countries where interest rate controls place effective restrictions on borrowing, or borrowing or deposits can only be made though state owned banks at set rates of interest. In the United States, consumers could also borrow more cheaply and earn higher rates of their deposits using offshore banks not subject to the FIDC insurance regime (White 1997: 16).

Although it is perhaps inevitable that certain private currencies would lose value or even collapse, it would not have the disastrous far reaching consequences which a similar event has today. Although the holders of cash or completely liquid investments denominated in a certain digital currency might lose their whole value, this would be relatively minor compared to the general wiping out of all claims within a country that have are a feature of major inflations or currency collapses. Under a private currency system, there could never occur the debacle that investors have seen occur in Russia over the past six months where the real value of all foreign investments has fallen dramatically with the collapse of the rouble. 'Competitive devaluation' would be impossible. Capital controls such as those imposed by Malaysia would also be completely ineffective in controlling the movement of currency in and out of national borders.

The tax implications of digital cash

Perhaps the most exciting aspect of digital cash is the potential for it significantly to reduce the ability of governments to collect tax. If individuals are paid in anonymous and encrypted digital cash, without the need for intermediary banks, declaring transactions conducted using digital cash to the revenue, and the income derived from them, becomes essentially voluntary. Unless government had access to all phone lines, and to the decrypted information contained on each hard drive of the computers in a particular jurisdiction, it would be difficult to tax income derived in digital cash, particularly income derived from assets held or services performed offshore. Rahn (1997: 85) gives the following example:

Assume you are a lawyer in New York doing work for a client in a jurisdiction without an income tax. You do your work in New York but send it via the Internet. The client agrees to pay you in electronic money. As your bills become due, your client sends the money to you over the Internet and it is downloaded into your computer. You in turn pay your bills by sending electronic cash from your computer and by loading up your smart card. And only you É decide what electronic and paper records to both create and keep.

Given the extent to which tax dollars are used to provide inefficient and sub-standard goods and services, and taking into account the disincentivising effect of taxation, reducing the capacity of the government to collect tax is extremely positive for the market process. Indeed, if the only change to legal relations caused by digital cash is to introduce competition between tax regimes, and allow individuals to choose between them by storing their assets and money offshore, digital cash would be hugely beneficial for the future of the free market.

The ease and potential anonymity of digital cash transfer does however carry with it the significant risk that governments will attempt to monitor digital cash transactions, justifying doing so on the basis of preventing money laundering or drug trafficking. This would be a far more intrusive and illiberal regime than at present, as it would mean that in order to monitor digital cashflows, governments would have access to private encryption codes and to the information contained on individuals' computers, with obvious consequences for privacy and to the detriment of the 'free' market. Alternatively, as is presently the case in New Zealand, tax authorities could simply make a unilateral assessment of an individual's income and impose tax on the basis of that assessment unless that individual was able to prove that he or she had not earned the income so assessed (Tax Administration Act 1994).

In relation to taxation and digital cash, we therefore face two choices – one is a society in which because of digital cash, government is more intrusive than at present, the other in which digital cash transactions can be conducted on a free and anonymous basis. I believe the second option is the only one which can succeed, for the simple reason that people would not choose to use digital cash if it subjected them to a higher degree of intrusiveness and disclosure than at present.

Conclusions

There is no reason in principle why money should not be supplied on the same basis as all other commodities in the market – competitively. The promise of a private digital cash system is that it will bring the benefits of competition and choice, namely lower costs and better performance, to an area where government has dominated supply for most of this century. Apart from the significant implications for the relationship of the individual to the state which digital cash promises, its other significant feature is that it is rooted in the tradition of the Common Law and the Law Merchant – a system whereby private, general rules and income independent rules allow individuals to make decisions on the basis of their own information. The choices brought by such a development bode well for the dynamic market process in the next century.

References

Dowd, Kevin 1988, Private Money: The Path to Monetary Stability, Hobart Paper 112, Institute of Economic Affairs, London.

Dowd, Kevin 1993, Laissez-Faire Banking, Routledge, London.

Hawke, G.R. 1973, Between Governments and Banks: A History of the Reserve Bank of New Zealand, ??? Wellington.

Hayek, F.A. 1976/1990, Denationalisation of Money: The Argument Refined, Hobart Paper Special 70, third edition, Institute of Economic Affairs, London.

Jordan and Stevens 1997, 'Money in the 21st Century,' in The Future of Money in the Information Age, Cato Institute, Washington.

Rahn, Richard 1997, 'The New Monetary Universe and Taxation' in The Future of Money in the Information Age, Cato Institute, Washington.

Robertson, Bernard 1996, 'The Currency and the Constitution: Lessons from a rather small place,' Oxford Journal of Legal Studies 16(1).

Sayers, R.S. 1957, Central Banking After Bagehot, Oxford University Press, Oxford.

White, Lawrence 1989, 'Depoliticising the Supply of Money: Constitution or Competition?' in Lawrence White, Chris Jones and Bryce Wilkinson, Do We Need a Reserve Bank?, Centre for Independent Studies, Sydney.

White, Lawrence 1997, 'The Technology Revolution and Monetary Evolution,' in The Future of Money in the Information Age, Cato Institute, Washington.

Endnotes
1. See BYTE magazine (January 1998).  'When will E-cash jingle in your pocket?'  Digicash's website is www.digicash.com

2. Govenments would still however retain the right to specify the currency in which taxes were to be paid and in which contracts were made, and wold thus be able to support their own currency.

Adam Mikkelsen is completing a PhD thesis at the University of Auckland on the constitutional implications of government supplied money. He works as a solicitor in Auckland, and is a graduate of the CIS's Liberty and Society program. A version of this paper was one of three winners of the 1998 Hayek essay competition offered by the Mont Pelerin Society, and was presented by him at the recent 50th anniversary conference of the Society in Washington DC.

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