CURRENCY EXCHANGE | CURRENCY CONVERTER |
EXCHANGING MONEY
THE CENTRAL BANK OF
THE REPUBLIC OF TURKEY
Yuksel Gormez – Christopher Houghton Budd
Abstract
This paper discusses electronic money, its relation to free banking and some
implications for central banking. It begins by introducing its conceptual
framework for modern central banking, in terms of which it then rehearses the
free banking argument. It then reviews the development of e-money in terms of
both electronic payment methods and electronic issue, with special attention
paid
to the latter. The discussion includes both mainstream developments, such as
Mondex, and ‘alternative’ schemes such as LETS. From here the paper proceeds
by way of a consideration of the synergy between electronic issue of money and
free banking precepts, to a consideration of some implications for the future of
central banking generally. It offers an ‘contestable’ model of central banking,
which endeavours to show the effects that e-money may be expected to have (and,
indeed, may already be having) as regards monetary policy, financial supervision
and seignorage. It concludes that even in its current stage of development, the
emergence of e-money not only reflects and supports key free banking concepts,
but may be nudging modern central banking towards free banking practice.
Keywords: electronic money, free banking, central banking
1 Introduction
Our aim in this paper is to discuss the possible impact of electronic money (emoney)
on central banking. The frame of reference is the free banking debate,
which revolves around the issue whether or not central banks are in fact
necessary
and useful. The free banking controversy has highlighted several conditions,
which are critical for monetary systems to function well in the absence of a
traditional central bank. The way in which these conditions come into play is
being transformed by information technology, however, and we want to consider
the ensuing possibilities and challenges for the monetary system.
We begin by introducing a conceptual framework summarising the role of central
banking in a modern monetary economy. This framework is based on
distinguishing the different functions and tasks of central banking as regards
the
management of the monetary system, in order to find out how the development of
e-money might affect the “public-good” nature of these functions.
The second section of the paper overviews the case for free banking as an
alternative to the current monetary policy framework and pinpoints the parts of
the argument relevant to the emergence of e-money.
Section three reviews the development of e-money in terms of both electronic
payment methods (representative e-money) and electronic issuance of currency
(independent e-money). We focus on the latter because were it to be shown that
emoney
qua unit of account was not an alternative to conventional money
circulation, then its ultimate effect is unlikely to go beyond the displacement
of
currency in circulation by advanced payment systems including credit and debit
cards or advanced clearing systems – something that has been going on for some
time now. After defining e-money, the paper investigates its implications with
regard to finance, banking and the functions of money.
Section four considers the relationship between e-money and free banking
precepts. The discussion details how e-money helps to address three main aspects
of the free banking debate – the lender of last resort function, currency
backing,
and multiplicity of currencies. The focus of this section is on possible
implications
for the future of central banking generally, rather than predicting radical
change to
the current monetary policy framework. If the incumbent central banks could be
led to behave in a way, which would make their currencies as attractive as those
produced, by the private sector, the benefits of the free banking system may be
attained even without displacing current institutions or currencies. In the
fifth
section, we offer an ‘contestable’ model of central banking, which endeavours to
take into account effects that e-money may be expected to have on monetary
policy and seignorage. We stress the importance of the market mechanism on
central banking and note that this may enable (or force) central banks to offer
some of the benefits associated with “free banking” even under the present
institutional arrangements, while defending the integrity of money for the whole
society.
2 Background
We begin by clarifying the view of central banking that provides the background
to this paper, and the conceptual framework in terms of which our discussion is
formulated. Our focus is on the central monetary authority in its most basic
functions, shorn of its role as banker to or agent of government and no longer
handling debt management or other services that can as easily be provided by
private firms
In this context, the central monetary agency is assigned three main functions –
facilitating price stability, promoting financial stability, and ensuring the
integrity
of money, with the third of these arguably subsisting in the other two (Figure
A).
Money is a public good which has certain systemic network externalities at its
core. In a word, the integrity of money refers to money’s ability to remain a
reliable and stable cover for purchasing power over time (short, medium and
longterm).
It refers to the soundness of money, implying the absence of ‘bad’ (overissued)
money, while the concept of a stable measure connects it to the unit of
account function of money and related topics, such as network externalities and
the enforcement of legal tender provisions. Integrity of money, in other words,
entails anything that increases or sustains the reliability of the unit of
account by
convincing economic entities to trust to the future quality of money. It covers
the
avoidance of inflationary effects but goes beyond that to include anything that
may have an influence on the reliability of the unit of account.
It is in this sense that we say the integrity of money subsists in price
stability and
financial stability, since its ability to act as a stable measure will be
maintained if
price stability is maintained and if price stability in turn is not undermined
by
financial instability. Price stability can be understood as a short-hand
reference to
the wider concept of central bank independence (whether instrument or goal,
partial or complete) with its concern to provide a constitutional context
appropriate to price stability and its need to meet the challenge posed by
competition in the quality of money -the possibility of enabling good money to
reaching the end user. With its focus directly on the avoidance of inflation,
price
stability is clearly related to the means of exchange function of money, also
Figure A : Three Main Functions of Central Banking
INTEGRITY OF MONEY
PRICE STABILITY FINANCIAL STABILITY
7
referring to currency competition with a mechanism of direct danger of
substitution in case of an unreliable monetary policy. Financial stability, on
the
other hand, addresses such issues as free entry to financial service provision
and
the perfection of information by promoting financial awareness of individual
economic entities. It also deals with problems of regulation and supervision of
the
financial sector and is thus related to the store of value function of money,
although we recognise that there is continuing debate over whether financial
supervision should or can be divorced from the conduct of monetary policy.
Although we only intend it for exploratory purposes, a further image (Figure B)
can be derived from Figure A., an image that is not an arbitrary invention on
our
part. It has its genesis in Keynes’s (1923) discussion on monetary reform and
seems to be born out in current experience by the case of the Reserve Bank of
New Zealand (RBNZ), for example, which describes its strategy as one that,
wherever possible, leaves it to the markets to do the central bank’s work. As
regards monetary policy, this means the pursuit of price stability by way of
single
objective monetary policy. In terms of supervision, the RBNZ calls on banks
(99% of which in New Zealand are foreign-owned) to account directly to the
public in terms of meaningful reporting and transparency. The third function,
the
integrity of money, the Bank reserves to itself in its capacity as sole issuer
of the
NZ dollar - a fact, the Bank believes, that gives it a force over against
otherwise
autonomous global markets. While one may wonder at the certainty of this last
claim, the interesting point in terms of our framework is that the RBNZ may not
be just a one-off or special case. It may indicate a generic along the lines of
the
Goodhartian (1988; 1) definition of a central bank as an “outside agency to
regulate and control the banking system … in the otherwise free working of a
free
market.”
This image also reflects Issing’s (1999) criticism of Hayek’s (1990) claim that
it
is free competitive issue of money that guarantees a stable and efficient
monetary
system. For Issing, money is accepted as a public good and because money acts as
a basic convention in society, like language and standards of physical measure.
Issing points to the network externalities involved in the use of money in
transactions and criticises Hayek’s assumption that complete, symmetric and free
Figure B : A Possible Generic Form of Central Banking
INTEGRITY OF MONEY
PRICE STABILITY FINANCIAL STABILITY
Societal
Market
8
information would obtain in a monetary system based on competitive currency.
He also questions the transition period and argues that the change to
competitive
issue would be inflationary itself and generate uncertainty for future prices.
For
these reasons, Issing envisages money as a public convention standing above the
fray.
Finally, such a generic image may serve to indicate, in responding to modern
developments, central banking is undergoing a transformation away from unitary
forms towards an articulated expression. Our interest is, therefore, in
developing a
relevant, appropriate, and viable tool of analysis for understanding the
possible
effects of e-money’s seeming affinity with free banking on central banking
generally, giving evidence where available of such effects
3 Free Banking
The location of monetary policy in central banks is a recent development in the
history of finance. Central banks became monetary policy makers only as the gold
standard was replaced by fiat money, which was controlled by governments.
There are alternatives to central banking as practised today, like currency
boards,
full convertibility (under a commodity standard) and free banking, which we
discuss here in some detail.
3.1 Definitions and Characterisations
The assumption of this paper is that central banks are facing fundamental
changes,
which may in the end lead to their demise or, as argued here, a transformation
of
their behaviour in a way that approximates the free banking concept at least in
some key respects. This possibility is not of our invention, of course; the
existence
of central banks is already under discussion. For example, King (1999) argued
that “central banks may be at the peak of their power. There may well be fewer
central banks in the future, and their extinction cannot be ruled out. Societies
have
managed without central banks in the past. They may well do so again in the
future.” This was also the focus of a recent World Bank Conference on the future
of monetary policy. Although these discussions do not directly consider the idea
of free banking as an alternative to the current monetary policy framework, it
may
be that, once the continued existence of central banking is brought into
question,
free banking may yet emerge as an alternative, or provide an important
benchmark in whatever transformation comes about.
White (1995) defines free banking as “a monetary system without a central bank,
under which the issuing of currency and deposit money is left to legally
unrestricted private banks, ” a definition representative of a general consensus
in
the free banking literature - see, for example, Dowd (1993). White points out
that,
as a monetary regime, free banking consists of two main elements - unregulated
issue of transferable bank liabilities and unmanipulated supply of base money or
basic cash. There is no government role in regard to the quantity of money
produced inside or outside the banking industry, and outside money free of
central
9
bank control is desirable. Money issue is not seen as a device of governments to
achieve their goals, but operates as the means for individuals to pursue their
own
purposes. That said, White (1995) does not reject the idea of a clearing house
(considered later in this section) at the centre of the financial system when
without
a central bank; his view is that this should be a market mechanism designed to
eliminate imperfections within the financial system.
As envisaged by Dowd and others, free banking is regarded as the multiple issue
of currencies by competing banks, whose notes, however, are interchangeable and
redeemable against a “community-recognised commodity”, while option clauses
protect against “sudden excessive demands for liquidity”. This last is an
arrangement that obviates the need for a lender of last resort, since free
banking is
a system in which monetary and financial stability are guaranteed by market
determination of the preferred currencies and interest rates. Dowd (1996) has
underlined the basic requirements for successful free banking based on private
money. One of them was the emergence of a clearing system. Another was the use
of option-clauses - auto-control mechanisms used in cases of ‘fire-sales’ to
defend
against bank-runs. The final one was the development of a private lender of last
resort within the financial sector to help individual institutions that were
solvent
but facing a liquidity crisis. In an earlier study, Dowd defined the distinctive
features of a free banking system as:
1. Multiple note issuers who would guarantee to redeem their notes in a
commodity recognised as valuable.
2. A regular note exchange between note issuers, and
3. The insertion of option clauses into the convertibility contracts to protect
the note issuers against sudden excessive demands for liquidity (Dowd,
1993).
An important contribution to the literature came from Hayek (1990). While not
restricting free banking to a commodity standard only, when arguing for the
denationalisation of money, Hayek said that “the past instability of the market
is
the consequence of the exclusion of the most important regulator of the market
mechanism, money, from itself being regulated by the market process.” He
thereby invoked the idea of the invisible hand as the basic requirement for a
successful monetary policy regime. The invisible hand is thus seen to lead to
the
most reliable money, while competition is deemed to play its part in the issue
of
money also. Hayek also argued that central banks should be abolished, since the
free issue of competitive currencies would solve the lender of last resort and
elasticity of circulation problems in a financial system. He argued that the
demand
for a lender of last resort arises from liquidity crises created by nationalised
currencies, whereas under competitive issue there is no risk of excess liquidity
as
the competing currencies are fully backed by purchasing power. It is in this
sense
that central banking can be seen to be not the only choice for a monetary policy
framework, especially if it is not able to guarantee the integrity of money as a
reliable medium of exchange and store of value.
10
Free banking as an alternative to central banking was discussed by Capie,
Goodhart, Fischer, and Schnadt (1994). Although they described today’s free
banking proposals as a “somewhat fringe academic exercise without much support
from financial practitioners, ” they emphasised that free banking ought not to be
discounted as an alternative to central banks and currency boards for the
operation
of monetary systems. They pointed out that the preference of governments for
central banking stems from national pride and seigniorage interests, while the
financial community in general and commercial banks in particular support the
central banking option for two reasons of their own. First, commercial banks
economise systemic non-interest bearing reserves by offering a safety-net. As a
result they are able to reduce individual bank capital requirements when
providing
leadership in joint exercises like establishing payments and settlement systems.
Second, commercial banks enjoy an influence on central bank decisions through
the dynamics of the relationships between controllers and controlled,
supervisors
and supervised. (This influence may not, however, extend to the full theory of
capture, which argues that commercial banks capture central banks and thus
approve their operations.)
Capie and his colleagues identified four problems associated with free banking
theory:
1. It may lead to extra transaction costs.
2. Some additional bank reserves of real assets may be needed.
3. There may be possible minor inefficiencies connected with multiple note
issue.
4. 4. It seems indeterminate how the system as a whole behaves since free
banking theory relies on the law of flux1.
They also noted that an insufficiently capitalised bank would adopt a riskier
portfolio due to the incentive to allow any resulting loss to fall on the
depositors
or an insurance fund.
They then summarised four responses of free banking advocates to the argument
that free banking may lead to bank runs and contagious panics. The first is the
denial of the likelihood of such events in a free, competitive system. The
second is
the argument that an implicit central bank safety net or a deposit insurance
scheme invites moral hazard (absent in free banking), while intrusive regulation
to
minimise moral hazard leads to further distortion and misallocation of
resources.
The third is that free banking decreases susceptibility to instability through
its
adoption of self-regulatory mechanisms like option clauses, clearing houses, and
narrow banking. The fourth is the denial of any sizeable externalities and
social
losses in excess of internalised private losses in the case of banking failures.
Such
possible externalities were not found to be potentially greater in banking than
in
other industries.
1 The theory of reflux is explained as a situation where a note issuing bank
will lose/gain reserves at the
clearing if it expands faster/slower than other competing note issuing banks.
11
3.2 Clearing House and ‘Central’
Central to the free banking concept is the clearing house. Under the clearing
house
system not only do currencies clear, but over issue is pre-empted. If a
participant
issues more than it can clear, the clearing house immediately will realise it
and put
sanctions on the member so that the problem will never get out of hand. It is
important to note, that, although against central banking, free banking
recognises,
both theoretically and in practical instances, the need for a centralised
clearing
function – not on political grounds, to be sure, but out of the practicalities
of
enabling the interchangeability of currencies yet providing for the return of
oversupplied
or ‘bad’ money. It is also said that this clearing function is in the
selfinterest
of the issuers of currency. Moreover, Horowitz (1992) regards clearing as
neutral to the players so that it can be said to be without (or contextual to)
rather
than within the market.
In the light of the free banking debate, if one considers central banking in its
economic, as distinct from its political meaning, the adjective ‘central’ can be
read
as referring not to governments’ use of central banks as instruments of
centralised
financial control, but to the fact that the financial system ineluctably has
nodal
points or centres, places at which the system as a whole comes to a focus. Since
this also underlies the free banking concept of a clearinghouse, it is not,
therefore,
a question of whether or not such a central agency can be avoided, but of the
form
it takes, whether it is forced by a ‘central bank’, which is given a monopoly by
fiat
or whether it is shaped by market forces: national or international financial
markets for example.
Insofar as free banking is based on competitive issue of money, end-user
preference is a function of the soundness or backing of money, not just its
name.
It is important to note in this regard that, although sound money usually means
‘real’ backing, real can have various meanings, ranging from ‘solid gold’ to
noninflationary
behaviour. In this sense, if a national currency (even if state-issued)
fulfils the requirements of price stability in a way specified by the users of
money,
it should be able to compete with other currencies . In this sense, the recent
advent
of central bank independence and stability-oriented central banking arrangements
may act as a transition arrangement or conversion device. Monetary arrangements
working much like the free banking system may not, therefore, be as distant a
prospect as one might think, hence the importance of avoiding too fixed usage of
terms, giving rise to a false contrast between the free banking doctrine and the
underlying nature of modern financial developments.
In sum, free banking envisages an environment without central banks and is put
forward as an alternative to central banking, meaning central banks when subject
to political manipulation and thus made into distorting agencies. Whatever the
final outcome of the debate, these arguments and counter-arguments reflect the
fact that central banking is not the only monetary policy framework available to
us. It is Hayek’s contention that other approaches should be explored, and
competitive money issue in particular. His point is that in a free environment
with
concurrent currencies, it will be people with better ideas who determine
12
development through their imitation of what works best, as opposed to a national
currency system where only those with power can shape evolution.
4 Electronic Money
Electronic money has different shapes. Up till very recently, electronisation of
the
payment systems has been based on improvements in account-based systems,
their reach (domain) and their speed. Account-based systems record all the
transactions and authorise them centrally, whereas non-account-based systems
circulate e-tokens through telecommunication networks or on smart cards and
may allow transactions without central authorisation. Account-based e-money
systems are really very little different from the debit card of credit card
networks
of EFT systems currently in use. Token-based e-money, “e-cash”, on the other
hand, is radically different in the sense that it introduces an electronic form
of
currency.
Ultimately, the impact of the perfection of account-based systems of electronic
transfer and the expansion of token-based e-money is the same because both
compete with (or create an alternative to) the use of conventional currencies in
payments. Paper currency has hitherto been able to compete against accountbased
payment systems because of its anonymity and the absence of verification
costs, which have been prohibitively high for very small payments
(“micropayments”). Now, the challenge to paper money comes from both sides –
the reduction in verification costs on the one hand and the development of
electronic tokens, which avoid verification altogether. The major difference
between these two systems is actually just the cost of authorisation as e-cash
targets micro-payments. The other is security. If the authorisation cost can be
lowered to a certain level so that even micro-payments are executed by
accountable systems, it may be expected that even the non-account-based systems
may prefer to authorise all the transactions due to security concerns. In that
case,
the distinction between token-based systems and account-based systems would
become rather blurred.
Regardless of the form of e-money, the main technological developments behind
e-money are firstly the decreasing cost of communication, and secondly the
increasing computing power in ever smaller units. The first one favours all kind
of
networking models including the conventional and mobile Internet and also local,
national and international networks based on digital personal assistants,
digital
TV, ATMs and any other networking model that will be designed and developed
in the future. Cheapening communication not only allows to lower the operating
cost of existing networks but also provides an opportunity to create alternative
or
competing local, national or international networks as well.
The increasing power of computing allows the operation of networks with
improved data and risk management techniques, including artificial intelligence
and cryptography. It may be argued that e-money will be the most sensitive data
on the networks and unless managed perfectly with almost risk-free technology
(or at least less risky than currency), the e-money will never succeed. This
development is thus very critical. Increasing computing power will also reduce
the
13
cost of secure hardware including smart cards, as more advanced processors are
being developed.
The formal definition of e-money offered by the European Central Bank is as
follows: “an electronic store of monetary value on a technical device that may
be
widely used for making payments to undertakings other than the issuer without
necessarily involving bank accounts in the transaction, but acting as a prepaid
bearer instrument.” (ECB 1998, p.7.) This definition highlights some important
aspects of e-money:
- The fact that it stores monetary value on a technical device with a capacity
to
be used widely for making payments.
- Its role as a prepaid bearer instrument, excluding account-based electronic
payment instruments such as credit and debit cards and EFT payments.
- Its use to cover payments to undertakings other than the issuer, essential to
differentiating e-money products from single purpose prepaid cards like
telephone
cards.
- Its ability to by-pass bank accounts or any other financial service providers’
authorisation.
Because it does not specify the type of technical device used, such a definition
serves as a useful starting point and is well suited to a development that is in
an
emerging state, the full technical potential of which remains unclear. In
particular,
the above definition includes card-based schemes, which can be used in
conventional retail commerce, as well as various types of “cyber money” which
are designed to circulate in the Internet. The definition is unsatisfactory,
however,
in two respects: Firstly, it may overemphasise the technical distinction between
account-based and token-based systems, which have ultimately similar effects.
Secondly, it does not distinguish clearly enough two quite distinct kinds of
emoney
issuance strategies: the conventional strategy of a new electronic payments
medium and the more radical one of electronic issue of alternative, competing
currencies (not based on conventional, government-organised monies).
We might call the two different kinds of e-money "representative" and
"independent" e-money, respectively. As long as it is representative of legal
tender under a given monetary policy framework, 'e-cash' is a form and extension
of cash generally, an addition to coinage, notes, cheques and debit and credit
cards, etc. In this respect, e-money is clearly nominal in its effects - such as
increasing velocity - and may be regarded as neutral in terms of systemic
change.
It has important implications for the current monetary framework, in that it
makes
for easier payments, revolutionises monetary base management, and enriches
currency choice through making it easier to use several currencies and/or to
switch between them. It would reduce the demand for conventional central bank
money. But, e-money as a mere representation of a given currency may have no
different effect on monetary policy frameworks than what has already been
caused by advanced payment systems, which have decreased the proportion of
currency in circulation to total money stock especially in the last couple of
decades.
FOREIGN CURRENCY | EXCHANGE RATE | POUNDS TO EUROS
|
