Money: the ultimate privatization

Richard W. Rahn

A glimpse into the near future reveals that the concept of money as we now know will be radically altered. Future "money" will be produced increasingly not by governments but by private companies, helping to fuel privatization in other sectors of national economies. The privatization of money is occurring not so much as the result of explicit governmental privatization efforts, but because technological advances are forcing it.

Technological advances in electronic banking and commerce threaten to all but replace the existing system of paper currency. They ultimately will revolutionize the manner in which monetary exchange transactions are conducted by individuals and financial institutions. And, consequently, they will enhance privatization at the expense of governmental financial and tax systems.

Tangible money is useful only as a means to facilitate trade and investment. New technologies will enable people to acquire goods without handling cash, a troublesome, non-earning asset. In the future, trade will be executed by instantaneous and simultaneous debiting and crediting to and from liquid wealth accounts, held by both banking and non-banking institutions. Electronic digital payments technology will enable property rights claims on real assets, such as stock and bond funds, or gold, to be utilized as the medium of exchange for virtually all transactions. In sum, when businesses or individuals wish to purchase a good or service, they will provide — directly or indirectly — an electronic instruction to their bank or other financial intermediary. The instruction will state that an amount equal to the nominal value of the purchase should be transferred immediately to the account of the seller of the good or service.

Accordingly, there will be no loss of interest earned, nor will there be any need for a traditional wholesale inter-bank clearing system. The buyer and seller will have transferred wealth instantaneously, without risk of non-payment. By avoiding the use of government-produced fiat money, with all of its uncertainty and instability, some of the problems of inflation and payments insecurity will disappear.

Conventional money will disappear because it is costly and cumbersome. Paper currency and coins can easily be lost or stolen and are bulky to transport and time-consuming to use in business transactions. Such currency requires merchants to keep a monetary "inventory" in order to make changes. When used to buy merchandise from vending machines, for instance, costly coin and bill handling mechanisms must be installed. These mechanisms are subject to frequent mechanical breakdown and theft from both employees and others. All of this inventory of currency and coins is at risk and does not earn its owners any material return.

Paper currency also is subject to counterfeiting. With advanced copying technology, counterfeiting becomes easier. Despite anti-counterfeiting measures, technology-proficient counterfeiters continue to find ways to develop "passable" currency.

Bank checking accounts are also cumbersome and time-consuming to use. On average, it costs the US banking system approximately $1.50 to process each check. According to the American Bankers Association, an estimated total of 65 billion checks were processed in 1996, for a total cost of $97.5 billion, more than the total profits of the entire US banking system.1

Electronic payments, whether made with smart cards, debit cards, credit cards, or directly from computer to computer, eliminate most of these problems and greatly reduce costs. An electronic payment, by being virtually instantaneous, also eliminates the distinction between credit and debit transfers.

We are now entering an era when people will not have to endure episodes of sustained inflation, which is generally caused by governments' desire to spend the people's money for their own purposes. People can have a choice of monies, both government - and privately - issued, which will enable them to escape from monetary instability. If a government's Central Bank, such as the US Federal Reserve Bank, engages in inflationary monetary policy, users of its money will switch to a different currency or will hold other assets.

People will still use government money to pay taxes and for the receipt of payments from government. But, for private transactions, they will increasingly move away from government money. Governments that produce money with a stable value (little or no inflation) will find that their money may be used as a unit of account and medium of settlement, although it may not be used as a store of value or a medium of exchange.

There are a series of technological and regulatory changes underway that will eventually make privately issued digital (electronic) money the norm. These changes will alleviate the many problems experienced with conventional central bank-issued money, particularly with paper currency and coins.

Growing use of cards

Over the past several decades, credit cards have become popular in the developed, high-income countries. More recently, debit cards that deduct funds from one's checking account have become popular. Credit and debit cards have a magnetic stripe on the back, which is machine readable, but the magnetic stripe is rather limited in the amount of data it contains. But, because of the necessary telephone hookup and the lack of anonymity, and the impracticality for payment of small purchases, credit and debit cards will never become universal payment mechanisms.

There is a technology that can overcome the limitations of credit and debit cards — the "smart card." The smart card resembles a credit or debit card, but it contains a computer microchip, which processes a considerable amount of information. Monetary value can be downloaded into the card and stored, and then deducted in increments as purchases are made.

The machine that adds and subtracts information into the card chip is known as a smart card reader/writer. These are small and inexpensive and can be easily installed in ATM machines, PCs and telephones. When you use a smart card as a "cash purse," you will download the money from your bank account into the card similar to the way you withdraw cash from an ATM machine. Each time you make a purchase from the card, the amount of the purchase is deducted from the value of the card and deposited in the merchant's computer through a reader/writer. Payments also can be made directly from a computer. In the same way that money is downloaded from a bank account into a smart card, it can be downloaded directly to the hard drive of a PC. The "money" on the hard drive can be sent to someone else's PC and then to that person's bank account. All of these transactions can be secured by utilizing virtually unbreakable public key encryption.

As a result of these new technologies — all already operational — it is possible to send "money" from one point to another point on the globe extraordinarily fast and anonymously. These fund transfers can be sent in an encrypted format that, for all practical purposes, is unbreakable and totally secure from any criminal or government.

Detecting crime

We are entering an age when governments will not be able to trace the money transactions of those who wish anonymity. Previously, this had been true for cash transactions only. Because cash is difficult to hide, it is easily detected. New technologies will force governments to change their tax systems and the techniques they use to detect criminal activity. The question is whether they will engage in constructive change by reducing taxes on capital and their attempts at financial intrusion, or resort to destructive change by criminalizing activities of a significant portion of their populations.

The government monopoly on money is a recent occurrence. In the US, this monopoly dates to 1913 with the creation of the Federal Reserve system. Until that year, private banks also issued currency, which were private, dollar-denominated bank notes. Before creation of the Federal Reserve, the government defined the dollar in terms of the amount of gold and/or silver needed to acquire one dollar.

Governments favour the monopoly on money issuance because, to the extent that they are able to produce currency for less cost than its face value, they receive a profit known as seigniorage. In addition, because the currency itself is a debt owed by the government to the holder, with no interest accruing on this debt, the government receives an interest-free loan.

Private companies also seek ways to profit from the issuance of money substitutes. The American Express Company makes substantial profits from the issuance of traveler's checks. When you purchase a traveler's check, you are giving the American Express Company an interest-free loan until you cash the check. The smart card used as a cash purse provides the same profit opportunity — an interest-free float — to the issuer, as does the traveler's check.

As a result, banks and other issuers of smart cards have an enormous incentive to issue large numbers of smart cards and encourage people to hold money balances on them. In essence, smart card issuers reduce the public's demand for government-issued currency, shifting the profits from the government to the private sector.

Falling transaction costs

Competition among private financial institutions and others to obtain profits from money issuance, or from providing money substitutes, is driving down the cost of transactions and eroding the central banks' "market share" and control of the functions of money. As we enter the digital age, private competitors of Central Banks will be in an increasingly advantageous situation, despite legal tender laws.

If you could avoid holding any (non-interest-bearing) currency or coin, and still have the same, or greater, ease and ability to spend, you would probably choose to do so. Further, if you could keep your assets in a form in which they receive higher rather than lower rates of return commensurate with the level of risk, you probably would choose to do so. Finally, if you could take liquid assets, such as your stock portfolio and illiquid assets, such as your home, and turn part of their value into money only at the moment you wish to purchase some other good or service, you would likely choose to take that alternative as well.

Many business firms and some individuals are already partially turning their assets into money only at the moment they need to make an expenditure. They do this by obtaining a line of credit from the bank, using their assets as collateral. When they need to purchase something, they write a check or make an electronic transfer against the line of credit. In this case, the bank credit performs many of the functions of money. It makes economic sense for the business to operate in this way when the rate of return it receives on its assets is greater than the cost of the line of credit from the bank.

Debit cards often are issued against interest-bearing accounts. Smart cards, which combine the capabilities of a prepaid and debit card, can also be interest bearing. (This is only true with some smart systems; it is not necessarily applicable to those systems that allow anonymous card-to-card transfers.) Almost all electronic money will be interest bearing. Therefore, the money that countries' Central Banks issue almost certainly will decline in importance because of its lack of competitiveness.

The most likely development is that the future issue of electronic money will be primarily through mutual funds. Mutual funds, by having diverse and liquid assets, can offer less risk than traditional banks. With a mutual fund, holders can cash in all or part of their ownership of the fund at any time, but not at a fixed price. Thus the mutual fund account is as liquid as a demand account deposit at a bank. In some countries, mutual fund shareholders already can write checks and request electronic transfers to third parties against their share balance.

Mutual funds also have the advantage of not being subject to bank runs resulting from a loss of confidence. A bank can find itself in a position where its obligations to depositors are greater than its assets. Given that bank deposits have a par value, the first people in the withdrawal queue after the bank's funds run out get nothing without deposit insurance, and with it, wait long periods to get their funds.

With the mutual fund, increases and decreases in share values in the underlying securities portfolio of the fund are distributed (actually, "marked, to market") on an equal pro-rata basis to all of the holders of the fund. The value of the fund may decline, meaning each fund holder shares the same percentage decline, as contrasted with the bank deposit all-or-nothing par value system. This means that a holder of a mutual fund share has more risk than a holder of an insured bank account, but this risk is offset by the greater returns the mutual fund holder normally receives. So-called money market mutual funds (which hold highly rated government and corporate debt obligations) are available for those seeking little risk but still higher returns than normal demand accounts.

Reduced inflation risk

As more "money" becomes interest-bearing electronic money, there is less inflation risk because there is no incentive for private banks or other financial institutions to overissue interest-bearing currency, since it increases their own liabilities. The unit of account (e.g., the US dollar) will probably continue to be set by the Central Bank, even though the use of government money as a transaction medium will decline. But the government will only be able to retain its function of establishing a unit of account if it operates in a deflationary manner. Governments are being disciplined by the market because — in the age of instant global communications and financial institutions — inflation increases immediately cause a capital and currency flight.

Governments increasingly must compete with other governments and private providers of monetary numeraires (e.g., the US dollar, Japanese yen, British pound, Swiss franc). Eventually, some governments probably will define their currency's value explicitly in the form of a tradable basket of goods and services. Having a universal price, commodities traded on organized commodity futures exchanges are prime candidates. For example, the dollar might be defined as x amount of gold, plus y amount of crude oil, plus z amount of corn. This would amount to a modern version of the old gold standard, but the basket of goods and services will more clearly reflect what the world both produces and consumes and those goods and services more easily measured — metals, agricultural products, energy products, and even insurance rates.

If governments fail to develop explicit definitions of the value of their currencies, the private sector will. Commodity and security indexes traded presently augur the establishment of definitions that could serve the unit of account function of money.

In the economy of the future, most wealth will become divisible and liquid, instantaneously transferable, and, consequently, usable as transactions media. Without the need to withdraw wealth-producing assets to provide purchasing power, as in a monetary economy, and assuming the unit of account is defined by a specific additive quantity of goods and services, there will be no pressures to produce inflation or deflation. All the requirements to facilitate trade will still be met, and improved upon.

Many of those seeking to regulate digital money, smart cards, the Internet etc., claim that without regulation, tax avoidance and evasion will occur. But this objection misses the point. Such claims are correct that tax evasion and avoidance will increase — unless the tax laws are changed to reflect the digital reality. It is wrong, however, to assert that more regulation will succeed in coaxing much more tax revenue from unwilling payers. The digital revolution will make some tax evasion very easy, causing increasing numbers of people to take advantage of it. If a few keystrokes on a computer will avoid tax payments the temptation to do so will be great.

Smaller government

Reductions in the tax base and tax rates required in the digital age will necessarily reduce the size of government. The relative shrinking of government however, is necessary for societies to reach their full economic, social an personal potential. Studies of the relationship between economic growth and government spending have found negative correlations for most countries for most time periods — that is, big government impedes strong economic growth.

In conclusion, it is clear that privately issued digital money will increase until nearly all money is privately issued. The increase in digital money will make it more difficult for governments to collect taxes, particularly on financial capital (unless most governments introduce stringent controls). A smaller tax base will force governments to downsize which is beneficial for economic growth as well as financial privacy. The pressure to downsize government will be felt directly by declining government-owned enterprises, increasing the incentive to privatize such enterprises.

Dr. Richard W. Rahn is Chairman of Novecon Financial and a senior fellow at the Discovery Institute. He is the author of The End of Money and the Struggle for Financial Privacy from which this article is adapted.

Sri Lanka has no story to sell

Sri Lanka's present economic policy of operating a level playing field instead of promoting an export led strategy, has led to the country losing its export dynamism, a leading economist said last week.

Manufacturing exports were excessively promoted from 1991 to 1994. But from 1994 onwards these exports did not get any privileges as the government promoted economic development on a level playing field.

"To my knowledge no developing country has ever developed without an aggressive export led strategy. The maximum that agriculture will grow is by 2%-3%. Manufacturing grows by 10%-15%, and the services sector can never match the manufacturing sector numbers. Once you lose that export dynamism you can then see the economy growing at best between 3% to 4%. Because it's only exports that can give you high growth of 9% to 10%," Economist Dr. Howard Nicholas said.

"With that sort of growth rate you see a rapid rise in stock markets. You can have all the high tech stocks you want, but if you don't have the dynamism in the economy investor's won't come," he told The Sunday Times Business.

People are very pessimistic about the stock market, because they don't have a story. "The story is always we have the fantastic export led economy, its earning hundreds of dollars and you never need worry about exchange rate depreciation. That's the story that Sri Lanka has to sell."

Nicholas cited the example of China, who despite having a billion plus population, rigorously followed an export, led economic strategy since 1980.

However, the government's present economic strategy is also dictated to by the on going civil war.

"As long as the war lasts, the only economic strategy is to balance the budget and keep the exchange rate at a level where they [the government] can pay for the arms.

"In such a situation you can't progressively go forward. That is basically what the government is doing - balancing the budget, privatising a few things and perhaps providing a few infrastructure facilities and hoping the economy will get going."

I go back to what I say about Sri Lanka. It's a small economy with a lower production base. One of the characteristics of a small economy with the lower base is that profit growth can be high in many areas. It is not unusual in small economy which is quite dynamic to have profit growth up by at least 50% a year.

In the global market, a small economy's share price can easily grow 10 fold without much of a problem if the economy is dynamic.

If you are asking foreigners to come in, you have to convince them about the country. With the US economy going in for a recession, Sri Lanka has to be careful, especially in textiles and garments, he warned.

On the other hand there are other opportunities. Investors are getting out of the US market and are looking at Asia which is the flavour of the month, he said.

Celltel opens second cyber portal

Celltel Lanka Limited opened its second cyber portal at the Rock Cafe for avid surfer to enjoy a hot cup of java while surfing the net.

A company release said that the campaign aimed to promote Internet for education and entertainment.

Company officials were unavailable for comment to obtain more details about the cafe. However we understand that this was the begining of many more cyber cafes to be opened by Celltel. We were unable to find out if the other cafe's too would be opened in places like the Rock Cafe.

The release said that the cafe allows users to surf the net, receive and send e-mail, Chat on-line, play computer games, use popular software, listen to music and view sporting events.

The Celltelnet Cyber offers services to single uses as well as on monthly membership and the billing is dine on-line according to the usage time, the release said. The Cyber Cafe will be open from 10am to 10pm every day of the week except for national holidays.

This is the first cyber cafe to serve eats and drinks, incorporating the real cyber cafe concept.

Celltel's Chief Executive Officer Mr. Michel Schluter said, the clientele of Rock Cafe is mainly young adults, most of whom use cyber space for entertainment and education." Our main aim is to allow our future generation to experience the cyber space at affordable and reasonable rates as well as to promote our Internet and e-mail facilities," he said in the release.

Tritel launches Voice-mail

An e-mail account that was introduced to Sri Lanka in the early 90s, you have to pay for.

A V-mail account introduced last year, you get it free.

Tritel Private Limited voice mail service was re-launched as V-mail recently. The voice mail service acts as an answering machine accessible from any part of the island.

Company officials portray V-mail as an individuals own private telephone number. They said that it was launched to facilitate the many Sri Lankans without a phone.

The service is provided free to any individual who registers of the service.

Individuals once registered are given a V-mail number along with a changeable password.

The registered individual will be thereafter identified by that registration number and will be required to dial in the id number to access their respective accounts.

Users are offered an unlimited storage space within the companies 36 GB server, which officials said would be increased in future as required.

However officials said that each messages would be limited to 10 minutes to limit misuse.

In addition officials said that the number of lines available to access the service would be doubled at the end of the month from the 16 lines at present.

Officials said that the programme to operate the service was developed in house.

They said that the service was tested for over a year as paid service and added that it was a huge success. Tritel officials said that thay already had 18,000 registered users.

Officials believe the new service would compliment their widespread payphone network. At present they operate 1600 payphones islandwide and hope to increase that to 3000 by the end of August.

FCBU: the issue of profit vs overheads

The commercial banking industry has attributed a sizeable chunk of its profits to Foreign Currency Banking Units (FCBUs) in recent times. This is a far cry from the inception of FCBU units in 1979, to enable local banks to compete with foreign banks for off shore deposits. Foreign banks which have parent companies abroad were traditionally better placed to exploit this segment of the market.

However in 1999 Seylan Bank's profits from FCBU units as a percentage of profit before tax was 64 per cent while Hatton National Bank attributed 39 per cent of its profits to FCBU units and Commercial Bank 24.6 per cent.. In comparison FCBU income as a percentage of gross income was 2.99 per cent at Seylan Bank, 10 per cent at Hatton National Bank and 9.05 per cent at Commercial Bank.

Meanwhile FCBU units are taxed at a concessional rate. On shore deposits are taxed at 10 per cent while off shore deposits are tax free. In comparison the activities of the domestic banking unit are taxed at 30 per cent.

This has left many banking sector analysts pondering whether overheads are under allocated to FCBU units in order that a higher profit could be depicted in this sector which is taxed at a lower rate.

The banking sector is quick to contradict this. Overheads of the FCBU units are minimal as there are a few people employed in this unit which occupies a small area of the head office, said Managing Director, Commercial Bank, Amitha Gooneratne. "And there is a realistic allocation of overheads to this unit," he added. Business is done in dollars and when you convert it in to Rupees it becomes a fairly large proportion of profits, says General Manager, Seylan Bank, Rohini Nanayakkara.

"These are high value not high volume transactions, which are highly profitable," she stressed. Costs allocated to the FCBU unit are actual and a Profit and Loss Account and Balance Sheet is prepared according to a Central Bank format each month and this is monitored, Deputy General Manager Treasury, Hatton National Bank, Gamini Karunaratne said. And Inland Revenue chief O M Weerasooriya corroborates this, saying tax files of banks are monitored on an individual basis to prevent an under allocation of overheads.

But analysts point out that certain overheads incurred by the banks which should be transferred to the FCBU units go unnoticed. Non-Resident Foreign Currency (NRFC) accounts are an example of this.

NRFC deposits are canvassed by all bank employees including those attached to bank branches. NRFC deposits are consolidated by the banks' treasury section and lent to FCBU units.

However the marketing and overhead cost of employees who canvas NRFC account holders is not levied to FCBU units.

Differential tax rates may have resulted in the system being exploited to the hilt but the macro economic benefits of FCBU units cannot be overlooked. "The banks are mobilising funds for the country and this has affected the balance of payments," Mrs. Nanayakkara said. "Foreign banks have recourse to lines of credit from their head offices but local banks rely on NRFC deposits," she said.

Seylan Bank recently conducted a promotional campaign in the Middle East including Saudi Arabia and Oman. FCBU units service foreign investors and Board of Investment Companies who, under section 16 and 17 of the Board of Investment Act, are permitted to borrow in foreign currency, Mr. Karunaratne said.

Mr Gooneratne pointed out that FCBU profits were retained in the country while the differential tax rate enabled local banks to compete with their foreign counterparts.

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