Competitive Payments Systems and the Author(s): Lawrence H. White Source: The American Economic Review , Sep., 1984, Vol. 74, No. 4 (Sep., 1984), pp. 699- 712 Published by: American Economic Association Stable URL: http://www.jstor.com/stable/1805134

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This content downloaded from 132.174.255.116 on Wed, 30 Sep 2020 15:22:04 UTC All use subject to https://about.jstor.org/terms Competitive Payments Systems and the Unit of Account

By LAWRENCE H. WHITE*

Recent competitive innovations in pay- account to the . It ment mechanisms, particularly the checkable specifically examines the plausibility of com- mutual fund, seem to have petition divorcing the unit in which blurred the edges of the category of are specified (the unit of account) from the properly called "money." These innovations medium in which payment is typically made. have coincided with new attempts by econ- The argument concludes that a payments omists to reconstruct monetary theory and system not based on into an policy using competitive models. Several outside should not be expected to authors have conceived of competitive pay- arise in the absence of government interven- ments systems seemingly devoid of any out- tion. side currency, base money, or standard medium of exchange.' The unit of account I. inCashless Competitive Payments Systems: these systems is evidently not a common A Brief Survey currency unit established outside the - ing industry. Yet it can be argued that the A. Black use of a common unit of account in de- centralized economic calculation presup- The belief that unrestricted poses a general medium of exchange. would produce a payments mechanism de- Lance Girton and Don Roper have re- void of outside money is expressed already cently written: "One observes that most con- in the title of Fischer Black's 1970 article, tractual obligations are specified in terms of "Banking and Rates in a the units in which the medium of exchange is Without Money: The Effects of Uncon- measured. Further research should provide trolled Banking." Black claims that in the more insight into why contracts are specified world he imagines "money in the usual sense in units in which the medium of exchange is would not exist" (p. 9). Initially he assumes measured" (1981, p. 20). This paper attempts that no currency is used; later he allows for to provide some insight into this question. currency, but supposes that its nominal By examining whether the above-mentioned quantity will be purely demand-determined, cashless competitive payments systems are so that it does not serve as an outside money coherent and operational, it explores the forming a base for bank liabilities.2 Pay- fundamental relationship of the unit of ments are made by transfer of this currency and bank liabilities. No mention is made of the redeemability of bank liabilities for this *Assistant Professor of Economics, New York Uni- versity, 269 Mercer St., New York, NY 10003. I am currency or any basic physical monetary as- indebted for discussion and comments to Robert set produced outside the banking industry. I Greenfield, Leland Yeager, Fischer Black, Joseph will for brevity's sake refer to such an Salerno, members of the colloquium on Austrian eco- as "outside currency" or "." nomics at New York University, and an anonymous referee. Research support from the U.S. Choice in Cur- What serves as the unit of account? Black rency Commission (a private foundation) is gratefully cannot say "the currency unit," for that is acknowledged. Responsibility for the views expressed is supposed to be subsidiary to the unit in mine alone. which bank liabilities are denominated. In- 'Fischer Black (1970), Eugene Fama (1980; 1982), Robert Hall (1981; 1982a,b), Robert Greenfield and stead he says: " may be priced in Leland Yeager (1983). At the other extreme, F. A. Hayek (1978) and Benjamin Klein (1974) have con- 2Currency in this world is supposed to be issued by ceived of a great multiplicity of parallel base monies and the government, but only on request of the , in standards. Criticism of the latter models is left implicit exchange for reduction of government with the in what follows. banks. For criticism, see fn. 16 below.

699

This content downloaded from 132.174.255.116 on Wed, 30 Sep 2020 15:22:04 UTC All use subject to https://about.jstor.org/terms 700 THE AMERICAN ECONOMIC REVIEW SEPTEMBER 1984 terms of a unit of account that does not change prices.3 The problem here is not that fluctuate in very much, and means of the unit of account is divorced from the payment may be priced in terms of the same medium of exchange, but that it is totally unit of account" (1970, p. 14). The unit of abstract, divorced from any traded good. account in Black's world is clearly not an Such an abstract unit of account, as Don outside currency unit as it is in our world. It Patinkin indicates (1965, p. 16), can have is instead apparently a unit of a distinct no operational significance for market par- numeraire (or bundle of com- ticipants. It can be meaningful only to a modities) that does not itself serve as the Walrasian auctioneer or other outside ob- means of payment. This is indicated by the server. remark that the means of payment is to be priced in terms of the unit of account rather B. Fama than the unit of account being defined in terms of the means of payment. Thus Black's Black's article went uncited in the litera- system divorces the unit of account from the ture for a decade, until the appearance of characteristic units of the system's exchange Eugene Fama's "Banking in the Theory of media. Finance."4 Fama, like Black, considers out- It is not at all clear in terms of what side money inessential to the competitive numeraire commodity the unit of account payments mechanism he hypothesizes. He would be defined in Black's world, or how posits a "pure system of ex- that numeraire would be selected. He con- change" (p. 42) in which the function of ducts a thought experiment in which the banks is to operate "a system of accounts in means of payment successively assumes five which transfers of wealth are carried out forms: 1) ; 2) shares of common ; with bookkeeping entries" (p. 39). This 3) corporate bonds; 4) corporate bonds method of wealth transfer is asserted to be certified by "banks"; 5) pure bank liabilities. "entirely different" in relevant respects from The passage quoted above appears in his the use of cash. Fama claims that the trans- discussion of the second stage. There it was actions industry in the world he examines clear that the hypothesized unit of account can dispense entirely with cash: "An ac- was not the characteristic unit of the hy- counting system works through bookkeeping pothesized means of payment (a share of a entries, debits and , which do not re- stock portfolio). At no later state is this quire any physical medium or the concept of divorce mended. money" (p. 39). This means that in Fama's The logic of Black's construction receives world, as in Black's, bank liabilities need not fuller criticism below. But the following curi- constitute claims to cash: ""In a pure ous feature of Black's exposition deserves accounting system of exchange, the notion of mention here. He speaks of " the " a physical medium or temporary abode of of a medium-of-exchange unit and " the dol- disappears" (p. 42). lar price" of a commodity, with "the dollar" Unlike Black, Fama is explicit in stipulat- clearly intended to designate the unit of ing that the unit of account in his world account. He suggests that transactors in his should be thought of as the unit of a com- system may use these "dollar" prices for the modity that plays no medium-of-exchange purpose of computing a commodity's price role: "it could well be tons of fresh cut in terms of the medium of exchange. Yet beef or barrels of crude oil" (p. 43). He there is nothing called "" actually explicitly recognizes that bank "deposits"- being traded against the in the which would be heterogeneous, being essen- system, hence no mechanism for registering the prices of those commodities in terms of 3I am indebted to Robert Greenfield for this point. dollars. There are no dollar prices estab- 4This result of a search through the literature (by lished on markets logically or temporally Fama) was personally reported to me by Bob Hall. It prior to establishment of medium-of-ex- evidently excludes self-citations by Black.

This content downloaded from 132.174.255.116 on Wed, 30 Sep 2020 15:22:04 UTC All use subject to https://about.jstor.org/terms VOL. 74 NO. 4 WHITE: COMPETITIVE PA YMENTS SYSTEMS 701 tially shares in various mutual funds and not Banks taking on such an obligation have an claims to a common currency-are not a demand to hold currency as re- suitable candidate for numeraire. serves against redemption out- Prices of commodities are stated in terms flows.5 Limitation of the quantity of reserve of the numeraire. Fama recognizes that an currency available to the banks then limits of this sort "is basically non-mone- the quantity of deposits that banks can pru- tary." There is no question of price-level dently create. Fama states that banks would determination: since there is no money com- indeed "inventory currency on behalf of de- modity trading against other goods, there is positors" (1980, p. 50), but at the same time no money . There are only numer- implicitly denies that the banks of an unreg- aire or relative prices to be determined. The ulated system would hold any non-interest- determination of relative prices is apparently bearing reserves. Yet a bank's vault cash to be thought of as a performance of the should be considered the primary component Walrasian auctioneer. Fama speaks of the of its reserves where its deposits are convert- system posing "a standard problem concern- ible in the usual sense of constituting sight ing the existence of a stable general equi- claims to predetermined quantities of cur- librium in a non-" (1980, rency.6 By "convertibility," Fama must mean p. 44). only that the banks act in the manner of Like Black, Fama leaves the particular mutual funds. Bank liabilities numeraire commodity ("some real good") in his analysis are not claims to outside and its method of selection both unspecified. currency, as they are today, but are on the This is of no concern so long as we take the order of shares in a mutual fund's portfolio auctioneer construct seriously. The auction- of interest-bearing assets. These funds (or eer's choice of a numeraire is of no conse- Fama's "banks") stand ready to liquidate quence. But Fama implicitly slips out of this their shares (his "deposits") on demand by construct. He suggests that agents in his selling the assets to which the deposits con- world face genuine calculational problems, stitute a claim and then turning over the and that they deal with one another in de- proceeds to the shareholder ("depositor"). centralized markets rather than with the Fama is explicit in a more recent paper that auctioneer alone. He says of the accounting this is what he envisions. He states that in his system of exchange, for instance, that "its world: "Deposits are just claims against other efficiency is improved when all prices are claims (securities, , etc.)" (1982, p. 6). stated in units of a common numeraire" That is, they are not redeemable claims to (1980, p. 43). outside currency. Fama's propositions that After analyzing banking in a nonmonetary "deposits issued competitively should not be setting, Fama introduces currency in the form called money" and that " the concept of of "a non-interest-bearing fiat currency pro- duced monopolistically by the government" (1980, p. 50). The unit in which currency is 5See Ernst Baltensperger (1980, pp. 4-6). In the measured may then serve as the economy's competitive banking system of Scotland prior to 1844, to give a historical example, banks held positive quanti- numeraire. The real value of a currency unit ties of specie as reserves against redemptions of liabili- in terms of is determined ties despite the absence of reserve requirements and in familiar fashion, as a determinate demand despite the fact, consistent with Fama's hypothesis of for real currency balances confronts a fixed how a competitive system would operate, that the banks nominal stock of currency. settled claims among themselves by transfer of readily marketable interest-bearing assets, namely Exchequer Fama suggests that banks in the world bills. On this episode, see my 1984 book, ch. 2. with currency provide a "currency convert- 6By "predetermined" I do not mean that ibility service" for their customers. But it is interest rates never vary, but that rates are contractually unclear whether he means "convertibility" in set before the period to which they apply. They are not calculated afterwards based on portfolio performance, the usual sense of an obligation to redeem as in the case of mutual fund shares. For further discus- deposits on demand for outside currency. sion, see Section IIIA below.

This content downloaded from 132.174.255.116 on Wed, 30 Sep 2020 15:22:04 UTC All use subject to https://about.jstor.org/terms 702 THE AMERICAN ECONOMIC REVIEW SEPTEMBER 1984 money plays no role in the transactions plicitly relies on for tying the value of the services accessed through deposits" (1982, unit-of-account dollar to the specified com- p. 7) both rest on deposits not being claims modity bundle. Only the commodity bundle to outside currency. The significance of the is to be for dollar obligations. difference between such assets and deposits This means that all holders of contractual in the usual sense is explored below. claims to receive dollars (or of obligations to It is clear from the "parable" with which pay dollars) are entitled to demand (or make) Fama concludes his earlier article (1980, pp. payment in the physical commodities defin- 55-56) that he regards the existence of out- ing the dollar. Any sufficiently wide diver- side money as unnecessary for the operation gence between the market price of the stan- of an accounting system of exchange. Out- dard commodity bundle and one dollar will side money is to him simply one commodity trigger demands by creditors to receive com- that, if it exists, may serve as numeraire; modities rather than paper dollars (or de- however, there is no need for it to exist. Steel liveries by debtors of commodities in place ingots or spaceship permits may as well serve of paper dollars). Transactors choosing to as numeraire. This result is arguably not true contract in ANCAP dollars would be expos- of any plausible world. There are compelling ing themselves to the risk of being forced to reasons, discussed below, for outside money deliver, or to accept delivery of, physical to exist and to serve as the unit of account. bundles of the standard commodities. Every transactor would be taking on bank-like obli- C. Hall gations. It is natural to doubt that many transactors would voluntarily do so. An In two recent papers Robert Hall, search- ANCAP obligation seems to be clearly ing for monetary policies consistent with sta- dominated for both creditor and debtor by ble prices and full deregulation of banking an obligation indexed to the ANCAP bundle and financial markets, has questioned the but contractually payable in a common necessity and desirability of associating the medium of exchange, that is, explicitly ruling unit of account with a medium-of-exchange out the commodity-delivery possibility, given currency unit. Citing Fama (1980), Hall that a common medium of exchange is by states: "It is possible to define the monetary definition more readily accepted than other unit [the unit of account] as one unit of a commodities. The creditor would rather re- resource called currency, but this is only one ceive, and the debtor rather pay, readily of many different definitions" (1981, p. 4). In spendable money than a bundle of commodi- general the unit is simply "a certain amount ties of equal market value. It is less implausi- of some resource" specified by government; ble to suppose that specialized bank-like in- the resource need not be currency. As an stitutions might issue ANCAP-redeemable example of a noncurrency monetary unit, obligations. The question that then arises, to Hall proposes "defining" the dollar in terms be answered below, is whether such obliga- of a composite-commodity unit called the tions would gain currency in an unregulated ANCAP, consisting of specified physical environment. quantities of ammonium nitrate, , aluminum, and plywood. Beyond defining D. Greenfield and Yeager the dollar in such a way, government is to play no role in the payments industry. A recent paper by Robert Greenfield and The ANCAP unit was chosen by Hall for Leland Yeager attempts to elaborate more its stable purchasing power over the last explicitly the possible operation of a compet- thirty years. Presumably this stability was itive mutual-funds-type payments system de- measured in terms of some price . An void of outside money. They attribute the obvious question therefore arises: why does inspiration behind the cashless competitive Hall not suggest defining the dollar directly payments system to the three authors whose in terms of the commodity bundle making works I have just surveyed. In Greenfield up the price index he desires to stabilize? and Yeager's view of that world, bank-like The answer lies in the mechanism he im- mutual funds would develop and operate a

This content downloaded from 132.174.255.116 on Wed, 30 Sep 2020 15:22:04 UTC All use subject to https://about.jstor.org/terms VOL. 74 NO. 4 WHITE: COMPETITIVE PA YMENTS SYSTEMS 703 sophisticated barter system (pp. 305-08). The rally quoted in the units of the solitary item unit of account would be an arbitrarily cho- (or set of items, identically denominated be- sen numeraire bundle of commodities; the cause secondary members of the set are means of payment would be primarily shares claims to a primary member) whose payment of ownership in mutual fund portfolios. They will routinely be accepted in exchange. explicitly affirm both the nonexistence of any To mount a critique of cashless payments outside money in which funds' liabilities are systems, one must give reasons for the emer- redeemable and the divorce of the unit of gence and prevalence of outside money as a account from these media of exchange. generally accepted medium of exchange and Greenfield and Yeager do not examine the unit of account. The reasons given here delve question of whether such a system could back to the origins of money. emerge or survive under competitive condi- tions. They do consider whether the system's A. The Origin of unit of account "has operational meaning" and whether " the level of prices expressed in The classic invisible hand explanation of that unit is determinate" (p. 313). In both the emergence of money from an initial state cases, they find in the affirmative. But this of barter was give by Carl Menger (1982). merely means that they find the concept of Under barter, each agent, attempting to keeping track of relative prices by use of a transform his initial endowment into his de- numeraire unit not incoherent or self-con- sired final consumption bundle through di- tradictory. It remains to be considered rect exchange, confronts the problem of find- whether economic agents in an unregulated ing a second agent who both offers for sale world without a central auctioneer would be what the first wishes to buy and is willing to likely to converge on use of a unit of account accept in payment what the first has to sell. that is not a unit of outside currency. The typical agent can achieve his goal more economically if, instead of searching for this II. Competitive Payments Systems rare or even nonexistent match, he exchanges in Evolutionary Perspective his endowment for more widely acceptable commodities that he may in turn readily In past and present monetary systems of exchange for the goods he ultimately wishes our world, the generally accepted media of to consume. Accordingly he accumulates a exchange have been and are units of outside trading inventory of highly saleable items. money and inside-money claims to outside These allow him to economize on search money. Inside money is naturally denom- by raising the probability that he may, inated in units of the cash to which it is a in any given number of samplings among claim, as each or bank deposit is a sellers, make desired purchases. In this situa- claim to a particular number of units of tion the superior saleability of certain items outside money. The distinguishing feature of becomes self-reinforcing: the knowledge that outside money is that it does not constitute a other traders will accept an item with high redeemable claim to any physical asset. probability raises its acceptability to each Whatever may be the bookkeeping conven- particular . A network of traders will tions with regard to the issue of , therefore converge on one or a small number as a form of outside money it is not in actual of items as general media of exchange. Their fact a contractual debt liability of any agent supreme saleability then distinguishes these or institution. The world has known both items from all other commodities. They have commodity outside money- and spontaneously become money.7 Historically provide the most familiar example- gold and silver emerged as money in eco- and fiat outside money. The latter typically originated as issued inside money whose redeemability was suspended after it 7For a modem version of this theory, see Robert Jones (1976). See also (1971, pp. had gained currency. In all cases the outside 30-34). Menger defines "saleability" more or less as the monetary unit naturally functions as the unit narrowness of the effective bid-ask spread, but construes of account. This is because prices are natu- this broadly to include spatial and temporal dimensions.

This content downloaded from 132.174.255.116 on Wed, 30 Sep 2020 15:22:04 UTC All use subject to https://about.jstor.org/terms 704 THE AMERICAN ECONOMIC REVIEW SEPTEMBER 1984

nomically advanced nations through this due to the lower of determining its true process. bullion content. The ease of is It should be readily apparent by extension still further enhanced by the institution of of this perspective on the origin of money names in minting: once a 's prod- that a unit of account emerges together with ucts are trusted to be of the weight and and wedded to a medium of exchange. A stated on their face, its coins may seller pursues his self-interest by posting pass by tale. Transactors may then forego prices in terms of the media of exchange he weighing and assaying each piece of is routinely willing to accept. This practice tendered in payment. The demand for read- economizes on time spent in negotiation over ily authenticated pieces of gold will therefore what commodities are acceptable in payment give rise to a market in minting services. and at what rate of exchange. More ini- Each mint strives to maintain a reputation portantly, it economizes on the information for uniformly high quality, lest it lose necessary for the buyer's and the seller's customers to its rivals by imposing higher economic calculation. Posting prices in terms authentication costs.8 In competitive equi- of a numeraire commodity not routinely librium, the mintage fee will be just sufficient accepted in payment, by contrast, would to earn each minter the normal rate of return force buyer and seller to know and agree on . Self-interest will lead all mints upon the numeraire price of the payment in an economy to denominate coins in terms media due. This numeraire price of the pay- of a unit of standard weight and fineness. A ment medium would naturally be subject to mint doing otherwise would inconvenience fluctuation, so that updated information its customers. The precise definition of the would be necessary. A non-exchange-medium unit is itself unimportant; it may be based on numeraire commodity would furthermore be preexisting custom in measuring the bullion subject to greater bid-ask spreads in barter content of uncoined gold, or it may be against other commodities, as by hypothesis adopted from the coinage of an early reputa- it is less saleable, than the medium of ex- ble mint. This unit then serves as the unit of change. It would therefore serve less well as a account. tool of economic calculation. Competitive private minting industries It is worth emphasizing, as Menger em- have been comparatively rare historically. phasized with respect to the genesis of a Governments have typically monopolized the general medium of exchange, that a collec- supply of minting services. In a noncompeti- tive decision is in no way necessary for the tive situation, where debased government- emergence of a clearly defined common unit issued coins circulate, the bullion content of of account. This point seems to have escaped an earlier full-weight may continue to those authors who consider monetary units serve as unit of account though no existing to be the creatures of government proclama- coin measures up to that content. This is the tions. phenomenon of "ghost money," which is sometimes misleadingly cited as an example B. Coinage of divorce between the unit of account and

The evolution of monetary institutions 8For examples of this process at work in the United does not, of course, stop with the emergence States, where some three dozen private mints operated of commodity money. One may trace out in the gold rush regions of the nineteenth century, see further steps that take place in an unregu- Donald Kagin (1981). Black (1972, p. 811) inaccurately identifies privately minted coins as a form of inside lated competitive environment. Supposing money. Armen Alchian's (1977) account of the selection that gold has emerged as primary money, the of a commodity money relies solely on economization of next logical step is economization of the authentication costs. In my view, this explains the emer- costs of using the metal in transactions gence of standardized forms of money, but as far as the origin of money itself goes is subsidiary to economiza- accomplished by the institution of coinage. tion of search costs through holding of highly saleable Coined metal enjoys greater acceptability commodities. Easy authentication is simply one among than uncoined metal (for example, gold dust) several contributing to ready saleability.

This content downloaded from 132.174.255.116 on Wed, 30 Sep 2020 15:22:04 UTC All use subject to https://about.jstor.org/terms VOL. 74 NO. 4 WHITE: COMPETITIVE PA YMENTS SYSTEMS 705 the medium of exchange.9 theIn essential fact, naturethe ofunit the transaction. of account and the medium of exchange both -claims to bank specie transfer- continue to be quantities of gold. The unit- able without bank intervention and payable of-account value of any particular coin in to the bearer on demand-similarly emerge circulation is a question of its weight and as a means of payment.'0 Banknotes natu- fineness, not of variable market exchange rally find the greatest acceptance when rates. The unit of account and medium of denominated as round multiples of the specie exchange have not become distinct commod- unit that has previously become the standard ities, only distinct quantities of the same unit of account. Money users find each form commodity. The informational difficulties of redeemable claim to bank specie more posed by a non-payment-medium numeraire, economical to use for many purposes than whose exchange value may vary in terms of actual specie. Bankers are recompensed for payment media, do not arise. The minor providing these instruments by the interest inconvenience that does arise may be attrib- they earn on assets corresponding to the uted to the absence of competitive condi- fraction of their liabilities not matched by tions. Under competitive conditions, a de- specie on their balance sheets, or (in the case basing mint would find that money users of deposits) by direct fees for the transfer reject its products in favor of full-weight service. In an unregulated system, the banks coins. pay competitive rates of interest on their deposits. Due to the costliness of doing so, C. Bank Liabilities they are unlikely to pay interest on their notes." The emergence of precious as mon- An invisible hand process can be shown ey, and subsequently of coins as their com- (see my book, pp. 19-22) to account for the mon form, comes about in a free economy as emergence of an interbank clearinghouse in a the undesigned outcome of decentralized competitive banking system. Briefly, each pursuit of self-interest. The genesis of inside member of a pair of banks profitably en- monies may be similarly explained. Bank hances the moneyness of its notes and de- liabilities originate as claims to specie de- posits relative to specie by agreeing to accept posited with bankers (hence the term de- one another's notes and deposits at face value posits; Fama's use of this term to denote as tendered by customers for deposit or money market fund shares is misleading). In repayment. Mutual acceptance of liabilities medieval Italy the first bankers were money is naturally accompanied by an arrangement changers; in London they were goldsmiths. for periodic settlement of the claims each Claims to specie assume a monetary char- bank collects against the other. The potential acter when bankers discover profit in the gains from these pairwise arrangements are business of effecting the payments one de- not exhausted until all banking companies in positor wishes to make to another by direct a region belong to a single clearinghouse transfer of bank balances from the one to the system. other. Checks are today the common means Members of the clearinghouse will, in the of signalling the bank to perform a transfer absence of regulation, be able to economize of balances, but the emergence of paperless on specie transhipments by settling balances electronic means would do nothing to change partly through the transfer of highly market- able interest-bearing assets. Specie redeem- 90n "ghost monies," see Carlo Cipolla (1956, ch. 4). ability remains essential to the economical The misleading claim that these represent abstract units functioning of the mutual acceptance ar- of account is made by Patinkin (p. 15). While it is true that a ghost money unit had no exact counterpart among existing coins, each of these coins bore a fixed value 10On the early history of European banking, see relationship to the unit based on relative bullion con- Raymond de Roover (1956, ch. 5). tent. For purposes of pricing and calculation, the situa- "1See my book (pp. 8-9). Fama (1982, pp. 14-15) tion was similar in kind to that prevailing today in the comes to the same conclusion for currency that is not a Italian monetary system, where no one- coin or note claim to outside money. Note that today's traveler's circulates. checks do not bear interest.

This content downloaded from 132.174.255.116 on Wed, 30 Sep 2020 15:22:04 UTC All use subject to https://about.jstor.org/terms 706 THE AMERICAN ECONOMIC REVIEW SEPTEMBER 1984 rangement, however, as the means by which services may continue to be competitive, but all bank liabilities have their value fixed in the nominal quantity of money is now scaled terms of the unit of account. The acceptance to determination of the mone- of their notes at fixed par values spares banks' tary base. customers-and the banks themselves-ex- Note what happens to the unit of account change risk and calculational inconvenience, in the transition to fiat money. At no point and is therefore integral to the function of does it cease to be defined in units of the acceptance arrangements in enhancing the basic outside-money medium of exchange. moneyness of the participating banks' liabil- The status of basic medium of exchange, ities. however, passes from specie alone to a strad- A competitive banking system of the fol- dle between specie and a redeemable central lowing sort thus emerges in the absence of bank currency denominated in specie units regulation. The stock of exchange media con- (dollars, pounds sterling, etc.), then to the sists of specie in the hands of the public plus no-longer-redeemable central bank currency numerous of redeemable banknotes (still bearing the same name) alone. In this plus transferable bank deposits. The self- way the economy arrives at a situation in interest of issuers insures that notes circulate which a noncommodity outside money has at par, that is, at unit-of-account values fully positive exchange value. Paper money is able equal to the number of specie units to which to function as the basic medium of exchange they are claims."2 Transferable deposits bear because it previously functioned as a sec- a competitive rate of interest, subject to com- ondary medium of exchange.`4 petitive charges for transfer services. The nominal quantities of specie, notes, and III. Cashless Competitive Payments transferable deposits held by the public are Systems: Critique determined not by any central bank regula- tion of the , but by the real In light of the evolution of money and demand to hold those assets divided by the banking, the problem confronting models of purchasing power of specie. Each bank's noncurrency-based payments systems is clear. holdings of specie reserves are determined byTheir applicability for modeling current in- its equating at the margin the cost of fore- stitutions or predicting future arrangements gone interest to the benefit of reduced risk of awaits a coherent account of how a cashless illiquidity. Total specie reserves are simply a system is consistent with or might emerge summation of these holdings across banks.13 from the currency-based payments systems The transition from a specie-based com- the world has known. This is not to deny petitive banking system to a fiat-currency- that such models may serve to illuminate the based system is most readily made in two monetary institutions of our world by con- steps: government creation of a central bank, trast to the abstraction of a world without whose specie-redeemable liabilities displace outside money. This is a use to which specie as a commercial bank reserve asset; Greenfield and Yeager deliberately put their and suspension of redeemability for central model. It is a role Fama may also have in bank liabilities. The supply of banking mind, as he later introduces outside currency to his model after first abstracting from it. In a way, the models play this role in the pres- 12That banknotes fell below par when they crossed ent discussion: I hope to illuminate the im- state borders-reflecting risk and transportation costs portance of the causal-genetic processes be- of accomplishing redemption-in the American "free banking" era was due to the legal prohibition on inter- hind monetary institutions, particularly the state branch banking. In the freer Scottish system, no unit of account, by contrast to models seem- such inconvenience was experienced. ingly inconsistent with these processes. 13This system is spelled out in my book (ch. 1). The statement of marginal conditions in the text assumes 14This historical account may explain the fact that equal marginal operating costs of holding various assets. intrinsically useless fiat money has positive value more The basic paradigm of bank optimization is set forth by plausibly than the overlapping generations model of fiat Baltensperger. money. For that model, see Neil Wallace (1980).

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A. The Disappearance of Demand Deposits fund shares need not lie entirely above the deposit . Risk-diversifying port- Could a monetary system based on outside folio owners might therefore not divest them- currency (specie or fiat currency) sponta- selves entirely of demand deposits even given neously evolve into a cashless competitive a higher mean yield on mutual funds. It is payments system of the sort envisioned by true that the characteristic pledge of money Black, Fama, and Greenfield-Yeager? Three market mutual funds to maintain a fixed steps are necessary to make the transition: share price, or rather the policy of investing 1) disappearance of redeemable inside mon- exclusively in short-term highly reputable ey; 2) disappearance of outside money; and securities so that the pledge can be kept, 3) redefinition of the unit of account in terms makes fund shares akin to demand deposits of a numeraire other than outside money. in having near-zero risk of negative nominal This section considers the first of these steps. yield over any period. The difference be- For expositional convenience it focuses on tween predetermined and postdetermined demand deposits, though in the past bank- yields-between debt and equity-nonethe- notes have also been important as inside less remains. The historical fact is that de- money. The term inside money here denotes posit banking did not naturally grow up on ready claims to outside currency. These are an equity basis." distinct from shares in a managed portfolio The more important reason why demand of assets. deposits would survive even under unregu- Fama envisions a world in which "compet- lated competition is that the payments sys- itive unregulated banks provide a wide tem they provide is, given the conditions that variety of portfolios agains which depositors lead to the emergence of money, less costly. can hold claims" (1982, p. 15). Bank deposits This cost differential is suggested by the fact no longer constitute claims to cash, in other that a checkable money market fund today words, but are instead akin to transferable typically imposes a $500 minimum on checks shares in mutual funds and hence "can be written against shares in the fund. The com- tailored to have the characteristics of any parative costliness of check writing against form of marketable wealth" (Fama, 1980, p. money market funds in their present form 43). Fama unfortunately fails to show that arises from the fact that checks written the outcome of unregulated competition against a fund require it either 1) to incur the would be the total domination of interest- transactions costs of selling securities plus bearing demand deposits by mutual fund the cost of transmitting the receipts to the shares. In fact this outcome is unlikely, even payee, or 2), what is presumably less costly apart from the question of which can provide and the method actually used, to draw against payments services more efficiently. Demand a demand deposit with a commercial bank deposits, being ready debt claims, are poten- held as one of the fund's assets.'6 In the tially superior to mutual fund shares, which latter case, it is evident that effecting a pay- are equity claims, in at least one respect. The ment by writing a check against a fund, value of a deposit may be contractually which in turn draws down its demand de- guaranteed to increase over time at a prean- posit, must be more costly than directly nounced rate of interest. Its unit-of-account value at a future date is certain so long as the bank continues to honor its obligation to redeem its deposits on demand. No such "5Though there was medieval banking in which bank deposits were treated as equity claims, this treatment contractual guarantee may be made with re- was devised to evade church and state prohibitions spect to an equity claim. A mutual fund is against the payment of interest on debt. Again see de obligated to pay out after the fact its actual Roover (pp. 201-02). earnings, so that the yield on fund shares 16A11 funds whose prospectuses I have examined hold a small percentage of their assets (less than 1 percent) in cannot be predetermined. In the absence of the form of a demand deposit with a commercial bank deposit rate ceiling regulation, the range of for the purpose of honoring redemption checks (and anticipated possible returns from holding purchasing securities).

This content downloaded from 132.174.255.116 on Wed, 30 Sep 2020 15:22:04 UTC All use subject to https://about.jstor.org/terms 708 THE AMERICAN ECONOMIC REVIEW SEPTEMBER 1984 effecting the payment by writing a check an interbank mechanism. The ana- against the payer's own demand deposit. In lytical question in this case-why money- the present world the checkable money transfer and cash-inventory services should market fund rides piggyback upon the bank- be jointly produced with deposits at lower ing system. cost than with mutual fund shares-awaits The check writing feature of money market further research. But it seems clear that the mutual funds relies on a money-transfer sys- major impetus to the use of mutual funds for tem for the obvious reason that sellers of check writing purposes, a use negligible be- commodities generally wish to be paid in fore 1974, has been Regulation Q's prohibi- money and not in other assets. Checks writ- tion of competitive interest rates on check- ten on a money market fund are generally able bank deposits. With this ceiling largely acceptable in payment only because to the lifted, the rationale for joining money-tranfer recipient they represent a transfer of inside services to mutual funds has largely disap- money, that is, of cash-redeemable bank de- peared."7 posits. Its unique acceptability as a routine In a model competitive payments system means of payment is, as we have seen, an devoid of cash or genuine demand deposits, essential conferred on money by payments effected via check writing against the Mengerian convergence process that en- fund shares obviously do not work by trans- genders money. Every form of marketable fers of money. Instead a check written against wealth could serve generally as a medium of Fund A in favor of a customer of Fund B is exchange only in a world where all forms of supposed to occasion a transfer of nonmone- wealth begin and remain equally marketable. tary assets from Fund A to Fund B via a Outside a Walrasian general equilibrium set- clearing arrangement (Greenfield-Yeager, p. ting, this is difficult to imagine. 307). These two funds must have previously There are no obstacles in principle to the entered a mutual acceptance arrangement of spontaneous emergence of an interfund the sort (described earlier) arising in a free clearing system that does not rely on trans- banking system. The clearing mechanism has fers of inside money. If mutual funds really to be slightly different, however, in the fol- could provide payments services efficiently, it lowing respect. Fund B, in accepting checks would be natural to expect money market written on Fund A, does not possess a claim funds in the present system, unless prevented to Fund A's vault cash of a specific quantity. by law, to begin announcing bilateral or Instead Fund B possesses a claim to Fund multilateral arrangements to permit check A's assets of a specific value. Checks are writing in any amount for purposes of trans- written, and interbank clearing balances ferring wealth to accounts in participating computed in units of account, as at present. funds. By this device, each participating fund But a check no longer transfers a claim to so would enhance the spendability and hence many physical units of outside currency; it desirability of its shares relative to nonpar- instead transfers ownership of earning assets ticipating shares and demand deposits. As with a market value of so much. The inter- yet this has not happened. At present, money fund clearing arrangement has to specify market funds rarely allow check writing for unlimitedly small amounts, even for transfer of shares to another customer of the same 17Two caveats are in order. 1) The 1982 Garn-St. fund. This is difficult to reconcile with the Germain Act authorizing Super NOW accounts (check- ing accounts with no legal interest ceiling) denies these idea that fund shares are so routinely accept- accounts to business firms, leaving firms a reason for able that they could dominate inside money using money market fund or sweep accounts for check as a means of payment. writing. 2) So long as demand deposits are in effect This argument does not rule out mutual taxed by the imposition of reserve requirements, there remains a rationale for hybrid accounts. The reason why funds developing a money-transfer system money market mutual funds (like banks) do not price and allowing cash withdrawals, or what their money-transfer services explicitly may be found in would be identical, banks offering checkable the taxation of explicit interest but nontaxation of mutual fund accounts with direct access to gratuitous services.

This content downloaded from 132.174.255.116 on Wed, 30 Sep 2020 15:22:04 UTC All use subject to https://about.jstor.org/terms VOL. 74 NO. 4 WHITE: COMPETITIVE PAYMENTS SYSTEMS 709 what types of assets are acceptable in settle- shares are indeed not perfect substitutes ment of adverse balances. So does an whose supplies may with any obvious sense interbank clearing arrangement if it is to be aggregated, and while outside currency economize on physical transfers of non-inter- and demand deposits are also not perfect est bearing currency, of course, but this does substitutes, demand deposits (and bank- not reduce its reliance on cash redeemability notes) may sensibly be aggregated with out- as the means by which the unit-of-account side currency held by the nonbank public in value of bank liabilities is fixed and their a measure of the quantity of money. The general acceptability maintained. econometric use of this aggregate is a sep- An apparent disadvantage of bank de- arate question. 2) The supply of demand posits in the form of ready claims to prede- deposits will likely be important in the termined quantities of currency, in contrast determination of the price level for a closed to fund shares, is the possibility that a bank economy with a competitive unregulated might become insolvent and thereby unable banking system. Even if the determination of to honor all the claims presented to it for the price level in that economy is most ap- redemption. (Illiquidity is no greater prob- propriately modeled in terms of the supply lem for a bank than for a mutual fund that and demand for outside money alone, de- allows check writing and cash withdrawals.) mand deposits are presumably a close sub- A mutual fund cannot become insolvent: as stitute on the demand side. 3) The concept of it issues no liabilities in the strict sense, but money clearly does play a role in the transac- only equities, it cannot have liabilities in tions services made available through de- excess of its assets. A money market fund mand deposits. 4) A bank using the clearing can legally break its pledge to maintain a mechanism of an unregulated banking sys- fixed share price if a sharp fall in the value of tem holds claims against the cash reserves of its assets makes a reduction necessary. A other banks, not against their portfolios.'9 bank lacks the flexibility to reduce its deposit liabilities in a similar way without going into B. The Disappearance of Outside Money bankruptcy. In a laissez-faire monetary sys- tem, bank deposits would not be govemment Might outside money disappear with the insured. Depositor fears of might evolution of competitive payments mecha- be adequately addressed, however, by high nisms? This boils down to the question of the capital-asset ratios, by private deposit in- disappearance of outside currency. In the surance, by forms of organization giving the present American banking system, the de- bank's stockholders extended personal liabil- posits of member banks with the Federal ity for its , or by some other means.18 Reserve may be regarded as a form of out- Hence it is not obvious that checkable mutu- side money (though they are claims to Federal al funds would dominate demand deposits Reserve notes, their quantity is not regulated on grounds of lesser risk. The debt form of by the existing quantity of those notes). This deposits does insulate depositors from shar- form of outside money is an artifact of regu- ing in portfolio losses that leave equity posi- lation, however; in an unregulated banking tive. system with a private clearing mechanism The difference between demand deposits and no central bank, outside currency (say, and fund shares, and the plausible nondisap- specie or fiat currency) would be the only pearance of the former under freely competi- form of outside money. tive conditions, requires the revision of The authors whose models have been con- several propositions put forth by Fama (1982, sidered here all recognize that currency will pp. 2-8). 1) While outside currency and fund continue in use so long as manual transfer of

18Unlimited liability was a feature of the Scottish free 190nly the last of these sentences rectifies an incor- banking system. Depositors' losses due to bank in- rect statement Fama makes about a banking system. solvencies were completely negligible, as failures were The others contrast a banking system to his characteri- rare and the losses fell upon shareholders. zation of a payments system operated by mutual funds.

This content downloaded from 132.174.255.116 on Wed, 30 Sep 2020 15:22:04 UTC All use subject to https://about.jstor.org/terms 710 THE AMERICAN ECONOMIC REVIEW SEPTEMBER 1984 currency remains the least costly method for numeraire. The bondholder nonetheless re- accomplishing certain transactions. Not only ceives payment in commodities or equities. is currency 1) more convenient to use in In general he will wish to sell these rather small payments, but 2) its acceptance, unlike than hold his wealth in their form, so that he acceptance of personal checks, entails no risk will prefer bonds whose coupon payments that the payer's funds may be insufficient, are made in the most readily saleable form of and 3) its use leaves behind no possibly property. In our world the most saleable incriminating records of payment. These property is money; in the cashless world it is authors all think it coherent, however, to supposed to be shares in mutual fund suppose that all currency is inside currency. portfolios. But this, as I have noted, creates a Pieces of such currency would be akin to circularity problem. Hence one of two out- banknotes, except that they would constitute comes is possible: either bondholders are claims against the portfolios of the issuing saddled with relatively high transactions costs funds rather than claims to cash.20 in unloading payment property, or bond Cashlessness has an important implica- portfolio shares are not the dominant means tion. Bonds in the cashless world cannot be of payment. In the latter case, say where what they are in our world, claims to future shares in a mutual fund portfolio of common streams of money payments. They must were instead the dominant means of rather be claims to future payments of com- payment, the numeraire value of exchange- modities or to other financial assets. These medium holdings would clearly be subject to other financial assets must be equities or significant fluctuation. shares in a mutual fund portfolio of equities, The natural question to ask from an evolu- as it would be circular for bonds to be exclu- tionary perspective is whether there is any sively claims to other bonds, either directly plausible reason for outside currency to dis- or indirectly via money market fund shares appear in a payments system freed from in bond portfolios. The present value of anticompetitive regulation. I have explained bonds in the cashless world must then be the above that the emergence of particular com- discounted value of the commodities or equi- modities as money is not wholly accidental, ties to be received in future payments. This but a consequence of their superior saleabil- clearly would make bond pricing much more ity. Black (1970, p. 14) hypothesizes the use difficult than it is in our world were the of shares of a portfolio of as future payments to be defined in units of the money, that is, as a generally accepted commodities or equities to be paid. Green- medium of exchange. There are good rea- field and Yeager understandably suggest that sons, however, to doubt that such an item the quantity of payment property (as they would ever become the most saleable in an call it, p. 313) to be received would be economy. The primary reason is that the specified, like all other contractual payments, institution of common stock is unlikely to in numeraire value units rather than in the arise in a premonetary economy because the physical own-units of the property. Coupon division of labor it presupposes would not payments would proceed in commodities or exist there. Even were stock shares to emerge equities of specified worth in terms of the in a barter economy, it is difficult to conceive of their being more saleable than the most widely saleable of commodities. Arising in 20Fama (1982, pp. 9-11) and Greenfield-Yeager (pp. an already monetized economy (this is Black's 307-08) clearly envision currency issued exclusively by scenario), shares of stock are from the outset mutual funds. Black (1970, pp. 13-14) introduces government-issued currency, but erroneously believes routinely sold against money and not against that the nominal quantity of this currency will be endog- any other good. They lack the saleability enously determined. He apparently fails to see or denies of money. And this inferior saleability is that an excess of supply of government currency at a self-reinforcing: no trader routinely accepts given level of prices will be worked off through a rise in shares of stock or shares of a portfolio of prices, not through retirement of the excess currency. In another paper (1972), Black advances a doctrine of the stocks when he cannot expect to be able to passivity of outside money. spend them easily. Each trader finds the use

This content downloaded from 132.174.255.116 on Wed, 30 Sep 2020 15:22:04 UTC All use subject to https://about.jstor.org/terms VOL. 74 NO. 4 WHITE: COMPETITIVE PA YMENTS SYSTEMS 711 of shares an inefficient medium of exchange base-year price index. There is no tendency due to high information and search costs. for spot prices to be indexed in this way, The "inefficiencies" of commodity money however. Indeed the perpetuation of non- cited by Black would exceed the inefficiencies indexed spot prices is presupposed by index- of common stock money only in a world in ing, which uses current nominal prices to which common stock approached the sale- compute the current-dollar equivalent of a ability of commodity money. constant-dollar sum. For analogous reasons it should be ap- The unit of account sticks with the medium parent that a commodity of exchange even through the transition from system, in which the basic money is redeem- commodity-based to fiat currency. A his- able for a basket of nonmonetary commodi- torical example is instructive here. In the ties, would not arise spontaneously in an suspension period of the Napoleonic Wars, unregulated setting. A claim to a basket of 1797-1819 in Britain, Bank of England notes commodities would not originally emerge as and deposits became the basic outside mon- money, since in a barter setting it would be ey.2' Gold coins ceased to circulate. The less saleable then the most saleable of its unit of account, the sterling, stuck components. Nor would it supplant the origi- with the actual medium of exchange rather nal monetary commodity. This is not to deny, than with a now-abstract gold definition. however, that one money (say, silver or The pounds-sterling price of gold fluctuated domestic fiat currency) may be sponta- rather than the pounds-sterling price of Bank neously supplanted by another (say, gold or of England notes. Commodity prices rose foreign fiat currency) in a region where both with the expansion of Bank of England notes have been circulating internally, or where and deposits, while the unit-of-account value external with neighboring regions is of a banknote or deposit remained fixed. conducted in their different money. A switch may come about because the transactions IV. Conclusion conducted in the second money grow in rela- tive importance, or because the first money In a decentralized and unregulated econ- experiences an exogenously caused ongoing omy in which all property is not equally relative decline in purchasing power. saleable, outside money emerges as most the saleable commodity and persists as a general C. The Divorce of the Unit of Account medium of exchange. Inside monies arise from the Medium of Exchange and persist on the basis of their convertibil- ity into outside money. The characteristic For reasons already suggested, a unit of unit of outside money naturally defines the account emerges wedded to a general medium unit of account, as prices are natually posted of exchange. Prices are universally posted in by traders in terms of the item sellers will the characteristic units of a medium or set of routinely accept in payment. media that sellers are routinely prepared to In a Walrasian world where the auctioneer accept in exchange. This process is self-rein- renders all commodities equally saleable, and forcing: a buyer or seller who communicated therefore equally suitable for use in indirect bid or ask offers in nonstandard units would exchange, payment in any commodity could impose calculation costs on potential trading be accepted indifferently. Tatonnement may partners. For this reason the unit of account proceed without outside money. Any com- remains wedded to the medium of exchange. modity or bundle of commodities could serve In an inflationary environment it is cer- as unit of account, the auctioneer's choice of tainly possible for a unit of stable purchasing a unit of account being unconstrained by power to dispace the depreciating currency any economic considerations. The payments unit as the unit of account voluntarily adopted in contracts calling for payments at 21Technically they were not fiat money since resump- future dates. An example of a stable unit tion at a later data was both anticipated and realized. In would be the "constant dollar" defined by a von Mises' (p. 483) terminology they were money.

This content downloaded from 132.174.255.116 on Wed, 30 Sep 2020 15:22:04 UTC All use subject to https://about.jstor.org/terms 712 THE AMERICAN ECONOMIC REVIEW SEPTEMBER 1984 system appropriate for such a world, how- Laissez Faire Approach to Monetary Sta- ever, is inappropriate in the present world of bility," Journal of Money, Credit and decentralized trade involving goods of un- Banking, August 1983, 15, 302-15. equal marketability. The convenience of Hall, Robert E., "The Government and the traders in the present world dictates outside Monetary Unit," mimeo., 1981. money whose units define the unit of account. , (1982a) "Explorations in the Gold Deregulation of the payments system in the Standard and Related Policies for Stabiliz- present world does not imply disappearance ing the Dollar," in his : Causes of outside money, nor divorce of the unit and Effects, Chicago: University of Chica- of account from the basic outside-money go Press, 1982. medium of exchange. , (1982b) "Monetary Trends in the and the United Kingdom: A REFERENCES Review from the Perspective of New De- velopments in ," Alchian, Armen, "Why Money?," Journal of Journal of Economic Literature, December Money, Credit and Banking, February 1982, 20, 1552-56. 1977, 9, 133-40. Hayek, F. A., Denationalisation of Money, 2d Baltensperger, Ernst, "Alternative Approaches ed., London: Institute of Economic Affairs, to the Theory of the Banking Firm," Jour- 1978. nal of Monetary Economics, January 1980, Jones, Robert A., "The Origin and Develop- 6, 1-37. ment of Media of Exchange," Journal of Black, Fischer, "Banking and Interest Rates in , November 1976, 84, a World Without Money: The Effects of 757-75. Uncontrolled Banking," Journal of Bank Kagin, Donald H., Private Gold Coins and Pat- Research, Autumn 1970, 1, 9-20. terns of the United States, New York: Arco ,"Active and Passive Publishing, 1981. in a Neoclassical Model," Journal of Fi- Klein, Benjamin, "The Competitive Supply of nance, September 1972, 27, 801-14. Money," Journal of Money, Credit and Cipolla, Carlo M., Money, Prices, and Civiliza- Banking, November 1974, 6, 423-53. tion in the Mediterranean World: Fifth to Menger, Carl, "On the Origin of Money," Seventeenth Century, Princeton: Princeton Economic Journal, June 1982, 2, 239-55. University Press, 1956. Patinkin, Don, Money, Interest, and Prices, 2d de Roover, Raymond, Business, Banking, and ed., New York: Harper & Row, 1965. Economic Thought in Late Medieval and von Mises, Ludwig, The Theory of Money and Early Modern Europe, Chicago: University Credit, rev. ed., Irvington-on-Hudson: of Chicago Press, 1956. Foundation for Economic Education, Fama, Eugene F., "Banking in the Theory of 1971. Finance," Journal of Monetary Economics, Wallace, Neil, "The Overlapping Generations January 1980, 6, 39-57. Model of Fiat Money," in John H. Kare- , "Fiduciary Currency and Commod- ken and Neil Wallace, eds., Models of ity Standards," mimeo., January 1982. Monetary , Minneapolis: Federal Girton, Lance and Roper, Don, "Theory and Reserve Bank of Minneapolis, 1980. Implications of ," White, Lawrence H., Free Banking in Britain: Journal of Money, Credit and Banking, Theory, Experience, and Debate, 1800- February 1981, 13, 12-30. 1845, Cambridge: Cambridge University Greenfield, Robert L. and Yeager, Leland B., "A Press, 1984.

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