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Sunday, November 1, 1998

A New Monetary Universe

Market-Driven Money Would Put the Individual at the Center of a New Monetary Universe

Electronic money (e-money) offers the possibility of privatizing the currency and making government fiat money disappear. Competition and falling processing costs will prompt e-money issuers to pay interest to users, and as people choose to hold that money rather than non-interest-bearing paper money issued by central banks, there will be a radical change in economic affairs.

Even central bankers are forecasting the demise of paper currency. Jerry L. Jordan, president of the Federal Reserve Bank of Cleveland, predicts that “Just as fiat money replaced specie-backed paper currencies, electronically initiated debits and credits will become the dominant payment modes, creating the potential for private money to compete with government-issued currencies.”1 And University of Georgia economist Lawrence H. White forecasts, “When commercial on-line networks and Internet sites begin offering offshore banking services, with zero or very small fees for transferring funds, an exodus of retail banking business will begin from the regulated onshore sector to the untaxed and unregulated offshore sector.”2

The transition from the old monetary universe, with government at its center, to a new monetary universe, with the private market at its center, will be a slow process of evolution rather than revolution.3 Because of habit and the network effects of paper currency, it will take time for people to adjust to new ideas and new technology and to accept digital cash (in the form of portable “smart cards” as well as Internet accounts) as a new medium of exchange.4 Thus, the current monetary system will not disappear overnight.

Transition to a New Monetary Universe

The convenience of e-money, its anonymity, and its positive yield will make it increasingly attractive as a medium of exchange in the information age. So, as banks find ways to further reduce their reserves and clearing balances at the Federal Reserve, the net effect will be to reduce the demand for central bank money (the monetary base). The Fed will then have to reduce the supply of base money to prevent inflation. In the process, the Fed will suffer losses. (Seigniorage, by which the Fed currently profits through issuing currency for interest-bearing government bonds, would become negative.) If the public and banks continue to move out of non-interest-bearing government fiat money (in the form of currency in circulation and deposits at the Fed) and into e-money, the central bank will eventually go out of business.5

The market will fill the void and provide a new monetary standard as people demand sound money. Private entrepreneurs will have an incentive to maintain the value of their currencies or be forced out of business; consumers will unload bad monies and switch to monies with reliable purchasing power.6 A market-driven monetary regime will then emerge in which the monetary unit would be fixed in value by making it convertible into a basket of commodities or, more likely, into mutual fund shares.7 Market forces will ensure that the supply of money will respond to changes in demand without experiencing the disrupting effects of monetary disequilibrium that occur under the current fiat money regime, in which money has no guaranteed value.8

The Flexibility to Experiment

In the choice of monetary institutions, F. A. Hayek wrote, “selection by evolution is prevented by government monopolies that make competitive experimentation impossible.”9 Thus, the key to whether a new monetary regime evolves is competition—that is, the freedom to experiment. Will private, profit-seeking entrepreneurs, operating within the spontaneous market process, be allowed to discover a new monetary universe or will government planners and regulators attempt to block that process by protecting the status quo? Ultimately, the answer to that question may be that the forces of technology and competition will make it impossible to prevent private-sector suppliers of e-money from breaking the government’s monopoly on currency.

Financial innovation depends on the freedom to fail, as well as the right to profit from success. Markets are driven by individuals who are willing to take risks in search of new opportunities and profit. In the process, privately sanctioned informal rules often emerge that later become codified and enforced by government; the market typically leads the process of innovation, and government follows. Misguided government intervention would cause more problems than it cures. If overzealous regulators restrict experimentation and make the emerging electronic marketplace too costly, they will severely hamper the development of e-money.

How the Congress, Federal Reserve, and Treasury, in particular, view the transition to electronic cash and commerce will shape the future of the electronic payments system. A laissez-faire attitude will foster innovation; a protectionist attitude will mean that special interests will determine the pace of innovation. The challenge for government will be to provide a legal framework that safeguards property rights and expands markets so that wealth is created rather than destroyed. As Federal Reserve Board chairman Alan Greenspan has noted, “If we wish to foster financial innovation, we must be careful not to impose rules that inhibit it. . . .The private sector will need the flexibility to experiment, without broad interference by the government.”10

Private entrepreneurs, such as David Chaum of DigiCash, are already developing the technology needed to ensure privacy and security in the electronic payments system. Chaum, a pioneer in developing blind-signature technology (the use of encryption to generate secure digital signatures), is confident that the new technology will allow electronic cash to come very close to having the attributes of paper currency without the costs. Moreover, that technology will allow users of e-cash to “retroactively and irrefutably reveal the recipient of the funds.” Thus, crimes associated with the use of paper currency—such as extortion and bribery—“are no more likely than they are with checks today.” His goal is to create “a payments system that can be widely adopted and that will stimulate economic growth . . . and act as a springboard for increasing individual freedom.” Chaum believes that goal is achievable once “consumers realize that the use of electronic payments media does not have to compromise their privacy, but in fact can empower them to protect their own interests.”11

Monetary Freedom and Individual Sovereignty

In the new monetary universe, the individual—not the state—will stand at the center. Market-driven money, not politicized government fiat money, will be the standard of value. Bill Frezza, president of Wireless Computing Associates, envisions an enlarged private space in which “sovereign individuals will have the tools to construct a practical realization of laissez-faire capitalism.” At the center of that space, “will be new monetary institutions that must inherently rest on the consent of the participants.”12 In the new monetary universe, people will benefit from greater competition, more information, and more freedom.

The danger, of course, is that government may try to stifle competition, control information, and constrain freedom. Special-interest groups that benefit from a paper-based monetary system should not be allowed to maintain what Milton Friedman has called the “tyranny of the status quo.” The challenge is to develop an institutional framework that provides transparent rules for the electronic payments system, safeguards the value of money, and protects individual freedom. Then we will have better money, greater wealth, and more liberty as a result of the information revolution.


  1. Jerry L. Jordan, “Governments and Money,” Cato Journal, Fall/Winter 1995/96, p. 176.
  2. Lawrence H. White, “The Technology Revolution and Monetary Evolution,” in James A. Dorn, ed., The Future of Money in the Information Age (Washington, D.C.: Cato Institute, 1997), p. 20.
  3. Ibid., pp. 15–16.
  4. Lawrence H. White, “Thoughts on the Economics of ‘Digital Currency’,” Extropy, 2nd–3rd Quarter 1995, p. 18.
  5. A more detailed scenario of this transition process is found in Kevin Dowd, “Monetary Policy in the 21st Century: An Impossible Task?” Cato Journal, Winter 1998, pp. 327–31.
  6. For a fuller discussion of why private enterprise will produce money of superior purchasing power, see F. A. Hayek, “Toward a Free-Market Monetary System,” in James A. Dorn and Anna J. Schwartz, eds., The Search for Stable Money (Chicago: University of Chicago Press, 1987), p. 383. Also, more generally, see Hayek, Denationalisation of Money—The Argument Refined, 2d (extended) ed., Hobart Paper 70 (London: Institute of Economic Affairs, 1978).
  7. In this “defined-value” monetary regime, the monetary unit would be defined by a basket of goods and services. Banknotes and bank accounts denominated in the unit would be maintained at their defined values by redeemability in equivalent amounts of some convenient redemption medium, perhaps mutual fund shares. Kevin Dowd has proposed a convertibility rule that is designed “to achieve price stability by pegging the prices of index-based financial derivatives.” See Dowd, “Monetary Policy,” p. 330, especially footnote 6.
  8. For an excellent discussion of how to avoid monetary disequilibrium, see part four of Leland B. Yeager, The Fluttering Veil: Essays on Monetary Disequilibrium (Indianapolis: Liberty Fund, 1997), edited and with an introduction by George Selgin. Also see F. X. Browne and David Cronin, “Payment Technologies, Financial Innovation, and Laissez-Faire Banking: A Further Discussion of the Issues,” in The Future of Money, chap. 19. They explain how a laissez-faire banking system based on electronic payments and deposits held in the form of highly liquid and divisible mutual fund shares that are “marked to market” and used as exchange media could eliminate the problem of monetary disequilibrium.
  9. F. A. Hayek, The Fatal Conceit: The Errors of Socialism, vol. 1 of The Collected Works of F. A. Hayek, edited by W. W. Bartley III (Chicago: University of Chicago Press, 1989), p. 103.
  10. Alan Greenspan, “Fostering Financial Innovation: The Role of Government,” in The Future of Money, p. 48.
  11. David Chaum, “Privacy and Social Protection in Electronic Payment Systems,” in The Future of Money, p. 94.
  12. Bill Frezza, “The Internet and the End of Monetary Sovereignty,” in The Future of Money, p. 33.

  • James A. Dorn is vice president for monetary studies, editor of the Cato Journal, senior fellow, and director of Cato’s annual monetary conference.