Laurence H Meyer: The future of money and of monetary policy
Remarks by Mr Laurence H Meyer, Member of the Board of Governors of the US Federal Reserve
System, at the Distinguished Lecture Program, Swarthmore College, Swarthmore, Pennsylvania,
5 December 2001.
The references for the speech can be found on the website of the Board of Governors of the
US Federal Reserve System.
* * *
Money and the payment system have evolved over time. The earliest forms of money were
commodities, such as cattle and grain, that came to be used as means of payment and stores of
value, two properties that effectively define money. Over time, precious metals, specifically silver and
gold, became dominant forms of payment. From the 1870s to World War I and, in some cases, into the
Great Depression, many nations backed their currencies with gold. Later, fiat money--currency and
coin issued by the government but not backed by any commodity--became the dominant form of
money, along with deposits issued by banks. What has driven this evolution of money, and what is the
future of money? This is the first set of questions that motivate this lecture. Money also provides a
metric for the measurement of prices. That is, once you have defined the unit of exchange, you can
measure the price of any other item in terms of that unit. Money is also obviously related to monetary
policy. Another theme of the lecture is the relationship between the nature of money, the scope for
changes in the overall level of prices, and constraints on or opportunities for discretionary monetary
policy.
The next step in the evolution of the nature and transfer of money appears to be the spread of
electronic forms of money and payment. In the United States, deposit money issued by private banks
grew rapidly in the late nineteenth and the twentieth centuries. From a historical perspective, a now
well-established form of electronic money is the bank deposit stored on the computers of the banking
industry. Ironically, the most widely used method by the general public for transferring this electronic
type of money is still the paper check, although large-value transactions between banks and between
some businesses are electronic.
In the early-to-mid-1990s, a new generation of technology created the possibility of storing monetary
value on a silicon chip embedded in a plastic card or in a personal computer. With these
developments, the focus of payments development shifted to electronic money--e-money--using
cardbased and computer-based products (often referred to as stored-value cards and network money,
respectively) that consumers might use as a general means of payment in both the physical and the
virtual worlds. What is driving the evolution toward electronic payments and perhaps toward new forms
of electronic money? How rapidly is the innovation catching on, and what will the payment system look
like in the future? How would the spread of e-money affect financial stability and the conduct and
effectiveness of monetary policy? This is a third set of questions that motivate my lecture.
In the past, money was often privately produced, though today note and coin production has generally
become a government monopoly. The development of e-money has generated a fascinating debate
about the possibility of reintroducing privately issued currency in the United States. What would be the
implications for the payment system and for the central bank of the reintroduction of what is in effect
private currency? Could the development of private money and private clearing balances make the
Fed obsolete? If so, what becomes of monetary policy, and how would the price level be determined?
These are the final themes that motivate my lecture.
The evolution of money
The range of commodities used over time as money is very wide; it includes cattle, grain, knives,
spades, shells, beads, bronze, silver, and gold. The oldest recorded use of money dates back
4,500 years to ancient Mesopotamia, now part of Iraq. About 3,500 years ago, cowrie shells from the
Indian Ocean were used as a means of payment in China. Passages in the Bible indicate that silver
was used as a means of payment in the time of Genesis.1 The first coins--lumps of "electrum," a
natural mixture of gold and silver--were introduced in Asia Minor in the seventh century B.C. in Lydia,
now part of Turkey.
Driving the evolution of money, from the earliest emergence of commodity money, has been the desire
to increase the efficiency of carrying out exchanges. In the absence of money, trade is accomplished
by barter, the direct exchange of commodities or services to the mutual advantage of both parties.
Such exchanges require a double coincidence of wants or multiple trades. If I have apples and want
grain, I have to find someone who has grain and wants apples. Alternatively, I can engage in a series
of intermediate trades that ultimately result in the exchange of apples for grain. In primitive societies
with a small range of goods, barter can work well enough, but as the range of goods expands, barter
becomes increasingly inconvenient and costly.
Several considerations have affected the evolution of commodity money itself--from cattle and grain
toward shells and then bronze and ultimately to silver and gold. Commodities are useful as a means of
payment and store of value if they were are less bulky in relation to their value, more durable, more
homogeneous, and more easily verified as to their worth than other commodities. These
considerations favored the use of the precious metals, for example, over cattle and grain, encouraged
the use of gold and silver rather than bronze and copper, and further affected the way that silver and
gold were used as money over time. Early commodity money, for example, was weighed, not counted,
including the early uses of silver and gold. The introduction of coins that were stamped with their
weight and purity allowed money to be counted and again reduced the costs associated with making
transactions. Silver became the dominant money throughout medieval times into the modern era.
Relative to silver, copper was too heavy and gold was too light when cast into coins of a size and
weight convenient for transactions.
The next important evolution was the introduction of "representative" paper money. Warehouses
accepted deposits of silver and gold and issued paper receipts. These paper receipts in turn began to
circulate as money, used as a means of payment and held as a store of value. The paper was fully
backed by the precious metals in the warehouse. Once again, efficiency was enhanced by the
convenience of carrying paper money as opposed to the bulkier silver or gold coins.
Owners of the warehouses soon learned that the holders of the paper receipts would not
simultaneously redeem the gold deposited with them. The warehouses could therefore lend the
gold-in turn, often converted into paper notes--holding a reserve of gold that allowed them to meet the
normal demands for redemption. This is the beginning of fractional reserve banking.
Seventeenth-century English goldsmiths are usually credited with this transition to modern banking,
though the first paper money was introduced in China in the seventh century, a thousand years before
the practice became widespread in Europe. Paper notes and early banking were introduced in Europe
in medieval times and further advanced by the great banking families of the Renaissance. The spread
of paper notes and fractional reserve banking opened up the potential for credit expansion to support
economic development but also introduced the possibility of runs and liquidity crises as well as the risk
of insolvency through the credit risk associated with the lending.
In the nineteenth century, many countries were on a bimetallic standard, allowing the minting of both
gold and silver coins. But by late in that century, many countries had moved to the gold standard, and
currency and bank reserves were backed exclusively by gold. Barry Eichengreen (1996) describes the
gold standard as "one of the great monetary accidents of modern times," owing to England's
"accidental adoption" of a de facto gold standard in 1717. Sir Isaac Newton was master of the mint at
the time and, according to Eichengreen, set too low a price for silver in terms of gold, inadvertently
causing silver coins to mostly disappear from circulation. As Britain emerged as the world's leading
financial and commercial power, the gold standard became the logical choice for many other countries
that sought to trade with and borrow from, or emulate, England, replacing silver or bimetallic
standards.
England officially adopted the gold standard in 1816. The United States moved to a de facto gold
standard in 1873 and officially adopted the gold standard in 1900. The international gold standard
refers to the period from the 1870s to World War I, during which time the major trading countries were
simultaneously on the gold standard. Though many countries went off the gold standard during World
War I, some returned to a form of gold standard in the 1920s. The final blow to the gold standard was
the Great Depression, by the end of which the gold standard was history.
Eichengreen argues that the emergence of the gold standard reflected the specific historical
conditions of the time. First, governments attached a high priority to currency and exchange rate
stability. Second, they sought a monetary regime that limited the ability of government to manipulate
the money supply or otherwise make policy on the basis of other considerations. But by World War I,
economic and political modernization was undermining the support for the gold standard. Fractional
reserve banking, according to Eichengreen, "exposed the gold standard's Achilles' heel." The threat
and, indeed, reality of bank runs created a vulnerability for the financial system and encouraged
governments to seek a lender of last resort to provide liquidity at times of distress. Such intervention
was, however, inconsistent with the gold standard.
The international gold standard involved adherence to certain "rules of the game." First, the national
unit of currency had to be defined in terms of a certain quantity of gold. Second, central banks had to
commit to buy and sell gold at that price. Third, gold could be freely coined, such coins represented a
significant part of the money in circulation, and other forms of money were convertible into gold at a
fixed price on demand. Fourth, gold could be freely imported and exported.2
With the collapse of the gold standard, countries moved to fiat money systems. Fiat money is
inconvertible, meaning that it is not convertible into nor backed by any commodity. It serves as legal
tender by decree, or fiat, of the government. Its value is based on trust--specifically that others will
accept it in payment for goods and services and that its value will remain relatively stable. This trust is
based, in part, on laws that make the fiat money "legal tender" in the payment of taxes and, in the
United States, also in the payment of private debts.3
Fiat money consists of both paper currency and metal coins the face value of which exceeds the value
of the metal content of the coins. The need to finance wars encouraged early efforts by governments
to issue fiat money. Early examples include the continentals issued by the American government
during the Revolutionary War, assignats issued during the French Revolution, and the greenbacks
issued during the Civil War. Most such issues of fiat money were followed by severe increases in
prices, as governments tapped to an ever greater degree the easiest--in some cases perhaps the
only--source of revenue. These experiences highlight the importance of control of the money supply
for achieving price stability.
Today, money consists of currency, coin, and transactions deposits (that is, checking accounts) at
depository institutions, including, in the United States, commercial banks, thrift institutions, and credit
unions.4 It is not clear when the first check was written. The earliest evidence of deposits that might be
subject to checks is from medieval Italy and Catalonia. But at that time, the depositor had to appear in
person to withdraw funds or to transfer them to the account of another customer. Checks did not come
into widespread use until the early sixteenth century in Holland and until the late eighteenth century in
England.
The payment system has evolved further in recent decades with the spread of credit cards and then
debit cards. Credit cards allow consumers to purchase all kinds of goods "on credit," making payment
to the credit-card company for a collection of purchases later by check. In effect, the use of credit
cards separates the purchase of goods from the ultimate settlement but increases the efficiency of
2
Bloomfield (1981) refers to the strict version of the gold standard described here as the "gold-coin standard." He notes that
some countries operated under a variant he calls the "gold-exchange standard." In this case, the monetary authorities held
their reserves in gold or in claims on currencies (foreign exchange) that were redeemable in gold. Instead of moving gold
around to settle payment imbalances, they stood ready to buy or sell these currencies at fixed exchange rates, which
enabled them to economize on gold and earn interest on the reserves. Gold coins either did not circulate at all or circulated
to only a limited extent in countries operating under a gold exchange standard.
3
Section 102 of the Coinage Act of 1965 provides in part: "All coins and currencies of the United States, regardless of when
coined or issued, shall be legal tender for all debts, public and private, public charges, taxes, duties, and dues." Thus when
you tender U.S. currency to your creditor, you have made a legal offer to pay your debts. However, private businesses are
not required to accept currency as a form of payment and may develop their own policies in this respect, unless state law
says otherwise. However, the government is required to accept currency in payment of taxes and for other public charges.
4
I am defining money "narrowly," to include only the means of payment, not broadly to include other highly liquid deposits.
BIS Review 100/2001 3
exchange. Debit cards allow the consumer to make a purchase from a checking account through an
electronic instruction to debit the account instead of by writing a check, another advance in efficiency.
Even more recently, electronic money has been introduced, still perhaps more in concept than in
practice, at least in the United States. I will return to the role of electronic money today and the
potential for the spread of electronic money in the future.
Money, monetary standards, and monetary policy
The nature of money determines some important properties of the economy, including the scope for
changes in the overall price level and the opportunity for discretionary monetary policy -- that is, for
control of the money supply in an effort to improve economic performance.
The basic relationship between money and prices is often described in terms of the "quantity theory of
money." In the long run, according to this proposition, the price level moves proportionately to the
money supply. As a result, the rate of inflation depends on the rate of money growth. Though this
proposition holds precisely only under restrictive conditions, it identifies in a more general sense an
essential link between money and prices. It is therefore useful in understanding the way changes in
the nature of money might affect the determination of the price level.5
Under commodity money systems, money is often privately produced, and the price level of
nonmoney goods in terms of the commodity money depends on the supply of commodity money relative
to the supplies of the non-money commodities. In a sense, there is no absolute price level of goods in
such an economy, only a set of relative prices. However, the relative prices of non-money goods in
terms of the commodity money become, in effect, a measure of money prices, as we would think of
that term today. The supply of commodity money, in turn, depends on technology and--particularly in
the case of precious metals--on the pace of discovery. Prices of non-money goods in terms of the
commodity money need not be constant, but there is no opportunity for discretionary monetary policy.
As states came at times to monopolize the issue of commodity money, such as gold or silver coins,
they often were tempted to debase the currency by reducing the proportion of silver or gold in the
coins in an attempt to realize "seignorage" or revenue from issuing money. Debasement of the
currency typically resulted in inflation--a rise in the price of non-money goods in proportion to the
debased currency, which, in effect, maintained the underlying relationship between the commodity,
gold or silver, and the price of other goods. These are the first experiences with significant inflation
induced by government's manipulation of money.
The next evolutionary step was representative paper money. As long as the relationship between the
commodity money and the amount of paper money backed by the commodity money is stable,
inflation will be determined by the available supply of commodity money. But the beginning of modern
banking, by breaking the strict link between the commodity money and the money supply, added an
element of flexibility to the money supply and further opened up the possibility for inflation.
During the international gold standard period, currency issue and coin production were linked to and
convertible into gold, so that a country's total domestic money supply was tied to the domestic supply
of gold. This situation did not guarantee a stable price level, but it did remove the risk of
government-induced inflation. The result--and an indeed an important motivation--was to constrain
and, in principle, eliminate the government's discretion regarding the supply of money. The gold
standard, in effect, put in place a rule that governed monetary policy.6
If a country ran a trade deficit that exceeded private capital inflows, it would, in principle, finance the
difference by shipping gold to other countries. Doing so reduced the money supply--and hence income
and prices--in the country with the balance of payments deficit and increased the money supplies,
incomes, and prices in the countries with balance of payments surpluses. As a result, the system had
a built-in tendency to move the deficit and surplus countries toward balance. In fact, drains on a
country's gold or foreign exchange reserves were typically countered by an increase in central bank's
discount rate. The effect on income and prices was, in this case, not due directly to changes in the
gold supply, but to the changes in interest rates that were implemented to limit the drain on gold.
However, principle and practice differed under the gold standard. Richard Cooper (1992) summarizes
the contrast in the following terms: "The idealized gold standard . . . conveys a sense of automaticity
and stability--a self-correcting mechanism with minimum human intervention, which ensures rough
stability of prices and balance in international payments. . . .The actual gold standard could hardly
have been further from this representation."
Cooper notes that economic growth during the late nineteenth century was respectable, but variability
in income growth was substantially greater under the gold standard than during the period after World
War II.7 But the gold standard was predominantly about price stability, so here we might give special
weight to evidence pertaining to that characteristic. Cooper notes that short-run variations in wholesale
prices were greater during the pre-war gold standard than during the period from 1949 to 1979. In
assessing economic performance under the gold standard, one must also look at possible trends in
prices. Here the story is more complicated. If one compares 1877 and 1913, for example, the price
level is essentially unchanged. But the period covers a sharp and extended decline in the price level
followed by an equally sharp and persistent increase. Prices from 1873 to 1896, for example,
decreased 53 percent; this decrease was followed by an increase of 56 percent from 1896 to 1913.
These swings can be explained, in large measure, by fluctuations in gold production driven by
discoveries of new deposits.
In the early post-World War II period, nations sought an alternative to the international gold standard to
govern exchange rates and international economic relations. At a conference at Bretton Woods, New
Hampshire, in 1944, participating governments agreed to maintain a fixed exchange rate
system-more precisely, an adjustable peg. Exchange rates were mostly stable but could be altered in discrete
amounts, under prescribed circumstances--allowing deviation from a fully rules-based system to one
with more discretion. In practice, the system was implemented by the commitment of the United States
to maintain a fixed relation between its currency and gold and other countries' agreement to fix their
exchange rates relative to the dollar, at rates agreed to at the conference.
Fixed exchange rate systems provide a degree of constraint on domestic monetary policies. Under
such a system, imbalances in payments were settled by flows of acceptable assets, typically gold or
dollars. Most countries, given limits on their international reserves, had to follow policies consistent
with supporting their fixed exchange rates--though, as noted above, they had the option of changing
the exchange rate. The United States, however, was in a unique position because it could print more
of the assets--dollars--acceptable for settling payment imbalances. As long as the United States was
prepared to convert dollars into gold, at a fixed exchange rate for official purposes, other countries
seemed willing to hold dollars. As dollars grew relative to the U.S. gold supply, the sustainability of this
system came into question. When the United States broke the link to gold in 1971, other major
countries no longer were willing to accept dollars at the fixed exchange rate. The adjustable peg
system broke down, and the world ended up, de facto, in a regime of floating exchange rates, with
exchange rates determined by supply and demand in the foreign exchange market.
Most countries were operating under fiat money systems by this time. The combination of fiat money
systems and floating exchange rates removed the earlier constraints on domestic monetary policies
for other countries and made price stability and other dimensions of domestic economic performance
dependent on the conduct of their domestic monetary policies. Central banks had to learn how to
exercise that discretion in support of the objectives usually dictated by their legislatures, almost always
including price stability and, in the case of the United States, price stability and full employment.8
There have been disappointments as well as successes with monetary policy around the world. Over
time, the number of independent central banks has increased significantly, and independence no
doubt enhances the ability of central banks to achieve price stability. There has also been an advance
in our understanding of how to conduct monetary policy to achieve stable rates of inflation, at least on
average over a period of years, and perhaps also to contribute, at the same time, to smoothing output
and employment growth. Over the last ten to fifteen years, coinciding with both an increased emphasis
on the price stability objective and the advances in our understanding about the conduct of policy,
inflation performance has been very good.
However, some countries today continue to impose constraints on discretionary monetary policy
through fixed exchange rate regimes, tying their inflation rates to inflation in the country to which their
exchange rate is pegged. This system does not eliminate the influence of discretion, but it makes
inflation in one country dependent on the discretionary monetary policy in some other country. A
currency board and dollarization are tighter versions of a fixed exchange rate regime--that is, fixed
exchange rate systems from which it is progressively more costly to exit.
The payments system today
The payment systems in use today rely on concepts developed in the eighteenth century and before
as well as on those developed in the twentieth century. Paper instruments are vital to commerce and
so are electronic systems. To understand the long-term incentive for the spread of electronic
payments and potentially new forms of money, one must appreciate the complexities and costs
associated with our current payment system.
As checks came into more widespread use, banks that accepted checks for deposit had to find ways
to exchange checks drawn on a variety of other banks and to receive appropriate value for those
checks--processes called "collection" and "settlement." First, banks sent messengers directly to other
banks to collect the money due to them and their customers, the direct presentment method of check
collection. Second, out-of-town banks would send checks to a correspondent bank, which in turn
would collect the check, the correspondent banking method. Both of these methods required
significant travel and could require the movement of large amounts of banknotes or gold.
According to banking lore, a third solution to the interbank check collection problem evolved at a
British pub. A London bank messenger stopped by for a pint (or two) and allegedly met another bank
messenger. They quickly discovered that they each had checks drawn on the other's bank and
decided to save time by exchanging them on the spot. More messengers joined the group. These
messengers found that they could not only centralize the exchange of checks, they could also net the
amounts of money that had to be exchanged among them to settle (pay) the checks they exchanged.
This arrangement, the clearinghouse method, was first adopted in the United States by the New York
Clearing House in the mid-nineteenth century, and it is still used by banks all over the world
today-although, generally speaking, the exchanges are not held at a drinking establishment. In fact, all three
methods of interbank check collection still are in use in the United States.
In the early twentieth century the creation of the Federal Reserve System helped to improve the
efficiency of the payment system in at least two important ways. First, the Fed set up a national
system of check-clearing, in which the Fed acts like a correspondent bank with an ability to collect
checks throughout the United States. This system improved the existing localized check clearing
system by facilitating the collection and settlement of interbank checks among banks scattered
throughout the country. Second, the Fed was able to act as a central repository for the reserves of the
banking system. Reserve balances held at the Fed are widely used as the settlement vehicle for
interbank check-clearing.
According to a new Fed survey, households, businesses, and government entities write approximately
50 billion checks each year. The costs of using these checks include processing by depositing and
receiving banks and by intermediaries, transportation, accounting, and resolving problems. The
estimated cost to the banking industry of operating the entire check clearing system range from
approximately 1⁄4 to 1 percent of GDP. In addition, fraud losses in connection with checks are
significant, perhaps in the tens of billions of dollars annually, and are growing rapidly. The level of
these costs provides an incentive to improve the efficiency of the check clearing process.9 These costs
have also encouraged innovation in substitutes for checks, that is, electronic payments, and may
foster the development of new payment instruments, such as electronic money. Of course, developing
and implementing electronic payment alternatives is expensive; however, electronic payment methods
tend to be characterized by high fixed investment costs but low marginal costs, so the average cost
per transaction should fall as use rises.
The process of innovation, driven by attempts to increase the efficiency of the payment system, is
continuing. Banks and technology providers are attempting to develop new payment methods, in many
cases building upon the underlying the automated clearing house (ACH), debit card, and credit card
networks to find more convenient and secure ways to make purchases, pay bills, settle debts, and
post credits, especially over the Internet.10 "On-line" banking involves electronic access to information
over the Internet about accounts and loans--including current balances and transactions history--as
well as providing the ability to carry out payment related transactions--including transfers among
accounts, receiving and paying bills, applying for bank credit cards, and reordering checks. Some
so-called virtual banks have been set up to service customers exclusively through electronic channels,
but an increasing number of traditional "bricks and mortar" banks see the Internet as another delivery
channel that improves convenience for some of their customers. Similarly, the emergence of e-money
reflects the attempt to develop new payment methods as a more efficient alternative to existing
electronic payment means.
The future of money: the spread of e-money
Many innovations to existing payment systems have been successful, but the question remains as to
how e-money, a fundamentally new payment system, has fared. As mentioned earlier, most types of
e-money take one of two forms: stored value cards and network e-money. Initially, many believed that
these innovations would allow more retail and smaller-value transactions to be made electronically,
paralleling the move to electronic funds transfer for large-value payments. Of course, substantial
investments were needed to provide the infrastructure for using these types of payment devices and to
ensure that enough consumers and merchants would use them to make the investments worthwhile.
In the end, despite optimistic predictions, this first generation of e-money products was not widely
adopted in the United States.
In general, stored-value cards have been successful in closed payment systems, where e-money was
the primary payment instrument accepted, and have failed in open payment systems, where
competing instruments were readily available. Examples of closed system successes include mass
transit systems, college campuses, and military bases. Two well-publicized open system e-money
experiments that fizzled (one at the 1996 Olympics in Atlanta and the other on the Upper West Side of
Manhattan in 1997 and 1998) accepted e-money at only limited locations and suffered operational
difficulties. Limited locations discouraged consumer use, while operational difficulties discouraged
merchant use. Both consumers and retailers were able to substitute other payment instruments, which
resulted ultimately in lack of either customer or retailer support for the product.
Possibly as a result of these experiences, new e-money plans target captive markets, including
corporate expense accounts, teenagers with allowances, and payroll for employees without bank
accounts, and use the existing, well-functioning credit card and debit card networks. The fundamental
e-money characteristic--that a liability is issued by an entity primarily for the purpose of making
payments--is retained. However, these new products are similar to a standard debit card issued by the
major networks in terms of technical implementation, institutional arrangements, value transfer,
recording of transactions, and currency denomination.
I should note, however, that it took years for ATMs and debit card networks to be widely used and
accepted within the United States. Ultimately these innovations in the payment system have proved
efficient and cost-effective for users. E-money may have a similar experience, with natural setbacks at
first, further evolutionary development, and eventually a growing acceptance from the general public.
E-money and financial stability
The spread of e-money could have significant implications for the size of central bank balance sheets,
for depository institutions (depending on which are allowed to provide network money), for financial
stability, and possibly for the implementation of monetary policy.
Let me begin with the implications of the spread of e-money for financial stability. One possible
problem is that those issui