Digital Cash and the Development of the Apolitical Currency

John Michael Makoto Dykes

Paper for MIT 6.805/STS085: Ethics and Law on the Electronic Frontier, Fall 1995

There will come a further and final evolutionary stage towards a single overarching monetary system in which convertibility into legal tender ceases to be a condition for electronic money; and electronic money will thereby become indistinguishable from. . . .other, more traditional sorts of money. Money will be money whether it is constituted as a string of digits or a piece of paper or an entry in a ledger. Some electronic money might be backed by governments, some by private issuers; if so, private issuers that were properly regulated, or enjoyed the absolute confidence of the market, might prove to have a better "name" than many governments.

Ideally, the ultimate e-cash will be a currency without a country (or a currency of all countries), infinitely exchangeable without the expense and inconvenience of conversion between local denominations. It may constitute itself as a wholly new currency with its own denomination-- the "cyber-dollar", perhaps. Or, it may continue to fix itself by reference to a traditional currency, in which case the American dollar would seem to be the likeliest possibility. Either way, it is hard to imagine that the existence of an international, easy-to-use, cheap-to-process, hard-to-tax electronic money will not then force freer convertibility on traditional currencies. It may even, by example, or by the competition it provides, provoke currency unions--a sort of marriage a la modem. A wild vision, perhaps; but most people would have said the same in 1970 if somebody had guessed that within 25 years millions of people would regard themselves as part-time citizens of something they called cyberspace. It is surely not surprising that they should now want to take some spending-money when they go there. The Economist

For decades now, money has been flowing electronically as a stream of bits between banks, governments, and other institutions; indeed, private citizens have also become accustomed to using various forms of digital money, like stored-value cards, debit cards, credit cards, and ATM cards. However, the advent of networked society has opened up a whole new venue--digital cash. Digital or electronic cash is the logical but revolutionary next step in the history of money. Money's history is all about moving from the tangible to the intangible. We start with John Locke's acorns, that is, physical goods whose main purpose is to further our survival and whose primary role as currency is in the bartering system.[1] Acorns have the unfortunate trait, however, of spoiling and becoming worthless, so people began assigning value to certain precious metals or minerals, and society as a whole agrees to that value, allowing acorns to be traded for, say, gold and vice versa.

For a little while, gold's value continued to be tied to physical goods, but with time, gold was recognized as having "value" in its own right. This represented a major shift in society's perception of worth. After all, gold is not edible, yet it somehow stores value. The argument could be made that it is scarce; hence, its worth increases, but the heart of the matter is the shift from a concrete, tangible object's worth to something slightly less so. Metal coinage would dominate the monetary scene for centuries. However, gold and other metals are heavy and difficult to transport and store, leading to the introduction of paper money. Paper notes were basically a promise on the part of the issuer that upon presentation, the holder of the note was entitled to some quantity of gold, silver, or other precious metal, that is, the value of paper money was tied to gold.

All of that changed in 1971 when President Richard Nixon moved the U.S. dollar off of the gold standard. This was the same shift that happened to gold so long ago: the U.S. dollar was effectively recognized as being invested with "value." This is an even clearer example of the shift towards the intangible--paper is not a scarce resource, so the scarcity argument no longer holds. Most major currencies around the world followed the U.S. lead in moving off of the gold standard.

By extrapolation, it is easy to see that digital cash is the next logical step in this evolution. Electronic transactions are denominated in dollars, and if the bank computer says that you have $1,000.00 in your account, you are entitled to $1,000.00 paper dollars upon demand. Considering the historical trend, how long will it be before money is freed of its physical form completely, and its digital inception itself carries "value"? As The Economist put it:

The particular excitement of electronic money is that it poses the questions afresh in a pure, almost conceptual form: electronic money promises no intrinsic value, and barely even the trace of a physical existence. The Internet is about to push to the limit the question of what makes money worth what it is deemed to be worth.[2]

I stated above that digital cash is not only the logical next step, but also the revolutionary next step. Following historical trends does not seem to be revolutionary, but digital cash will be revolutionary for the same reason that public-key encryption is revolutionary, indeed for the same reason that a networked society is revolutionary: it leads to the decentralization of power.

Public-key encryption gives us the power to keep some things private despite the best efforts of any number of government supercomputers. Networked society makes the restriction of information more and more difficult. Power streams away from institutions and government entities into the hands of millions of individuals. Digital cash similarly decentralizes power away from the central bank regime. The development of digital cash effectively causes the state to lose control over the money supply and exchange rates--losing the tool called monetary policy, which can control the economy. Digital cash will lead to the renaissance of denationalized or apolitical money.

Before discussing apolitical money, it is useful to first examine digital cash in general. The minimum requirements of digital cash are that it must emulate real money. Camp, Sirbu, et al describe these minimal requirements as atomicity, consistency, isolation, and durability.[3] These are defined as follows:

Either a transaction occurs completely or it does not occur at all. For example, consider what happens when I transfer funds from a savings account to a checking account. Either my checking account is credited and my savings account is debited or neither account balance changes.
All relevant parties must agree on critical facts of the exchange. For example, if I buy a good for three dollars, the merchant and I should both agree on the amount of the purchase. After the purchase is completed, we must agree on that fact as well.
Transactions should not interfere with each other, and the result of a set of overlapping transactions must be equivalent to some sequence of those transactions executed in non-concurrent serial order.
Even if my computer or the merchant's computer crashes, we should be able to recover to the last consistent state. For example, money that was available to a computer before it crashed should not disappear when the machine reboots.[4]
These minimal requirements are necessary for digital cash to fulfill the main use of money as a medium of exchange and a store of value. Few would argue over these requirements. Disagreement and squabbles are centered about the extent and form of additional features, like anonymity or privacy, the capability to conduct low-value transactions, and security in the form of data integrity.

Security concerns are certainly valid. Transactions must be carried out in such a way to prevent tampering in transit, on receipt, or in storage. In other words, hackers should not be able to break in to a storage site and damage or change the data. Nor should they be allowed to forge or falsify transactions. Finally, counterfeiting must be prevented at all costs--in the electronic medium, being able to make an infinite number of copies is easy; hence, even a single case of counterfeiting could bring down the entire digital cash system. Security concerns are probably at the forefront of the public mindset. Before digital cash can gain wide acceptance, it must gain and keep the public trust.

The other concerns are less concrete, but no less important. Digital cash proponents often demand that anonymity be an essential component of the system. Electronic media makes the widescale observation of the habits of consumers easy enough already. The anonymous component of digital cash is seen as protecting, or even restoring, the privacy of consumers and private individuals--lost to massive electronic databases.

So-called "societal" concerns do not end with privacy however. Quotes from an unnamed source appearing in a text file located at George Mason University noted two other serious concerns, namely division of society along technological lines and crime:

E-cash could foster a have and have-not society: Those with PCs would have ready access to the stuff, while those without, many of them low-income consumers, would not. [Meanwhile,] money laundering and tax evasion could proliferate in stateless E-money systems as criminals use untraceable cyberdollars to hide assets offshore.[5]
Dealing with the societal consequences of digital cash are just as important as aspects like security.

If societal shifts are big with plain electronic cash, the changes under a system of apolitical currency would surely be massive. First, let us a present a short history of apolitical currency and the reasons behind its downfall. This will allow us to determine its viability on the Net.

There have been times in history when apolitical currency, or "free banking," was the rule and not the exception. Prominent examples are Scotland from 1728 to 1845, Canada for much of the nineteenth century, and the United States from 1836 to 1863 (perhaps even until 1913).[6] The perceived success of those systems depends upon the bias of the observer; however, Dowd, a supporter of apolitical currency notes:

A note-clearing system was developed during the free banking period in Scotland and was widely credited with checking potential over-issues of notes. . . . Scotland appeared to enjoy a relatively stable system of note issue. In England, by contrast, there was a series of acute crises in the early 19th century, and many observers blamed these on over-issues of notes by the Bank of England.[7]
Supporters of free money believe strongly in the forces of the open market. Problems will resolve themselves because of the strength of Adam Smith's "invisible hand." Central banks holding a monopoly on the issuance of currency works against the concept of the invisible hand.

Despite these claims, however, there is no denying the problems that existed with free banking. In 1836, the charter of the Second Bank of the United States expired. Until that time, it had served as the central bank of the United States, but it was perceived "as a threat to [citizens, politicians, and businessmen] and as a menace to American democracy."[8] In fact, Andrew Jackson ran his presidential campaign on a platform opposed to the Bank, citing the dangers of "such a concentration of power in the hands of a few men irresponsible to the people."[9] Under Jackson, the Bank's charter was not renewed, and free banking became the law of the land.

Jackson was completely unaware of the havoc this would unleash. Without a central bank to issue notes, private banks all over the United States began issueing their own notes. Hence, Pawtuckaway Bank in New Hampshire would issue dollar notes to their own local customers, while Shawmut Bank in Boston would issue a different set. Problems with this system emerged quickly, and grew worse over geographic distance. Because of the multitude of notes, interconvertibility between notes was difficult. In other words, a Pawtuckaway Bank customer, journeying to Boston, would either have to hope that Pawtuckaway notes would be accepted in Boston or hope that Shawmut would exchange them for Shawmut notes. Because of the geographic proximity of the two banks, this was probably possible without too much trouble. However, Shawmut would be much less likely to accept notes from Lu's Bank in Dakoto Territory. With no way to test the credibility of Lu's notes by contacting Lu, accepting such notes would be fraught with risk, since the notes could be forged, i.e., Lu's Bank does not exist. In short, geographic distance made interconvertibility difficult if not impossible, thereby severely restricting the liquidity of the money supply.

Any introductory macroeconomics course teaches that restricting the liquidity of the money supply for a long period of time slows the economy's growth. Liquidity was further hampered by the lack of adequate check clearing facilities. Some areas developed clearinghouses, notably the Suffolk system in New England leading to "lasting benefits" for the local economy.[10] Other areas like the South and the West did not develop clearinghouses, resulting directly in underdevelopment of the local industrial complex and slowed urbanization.

In order to combat the regular economic slowdowns that occurred because of illiquidity, local banks would issue more notes. Violent fluctuations in the amount of issued notes (or in economics jargon, the size of the money supply) resulted in even more damage to the economy as a whole. Meanwhile, with interregional communication difficult or impossible, the issuers could not correlate their actions to correct the trend, despite the claims of free monetarists that the the open market should correct itself. The free banking system was in a shambles.

Calls for reform of the system grew loud by the 1860s, and in 1863, Congress passed the National Banking Act. It was intended to be a halfway point behind a central banking scheme and free banking. Under the new legislation, only "nationally-chartered" banks could issue bank notes. The legislation also created a "pyramid" structure of national banks: country banks, reserve city banks, and central reserve city banks.[11] The pyramid structure allowed greater control over the issuance of notes, while still allowing for a great number of issuing banks. The scheme was substantively free banking without the danger of overissuance.

Unfortunately, many problems remained unsolved. Interconvertibility was still difficult between regions. Also, overissuance may have been solved, but the result was "inelastic" currency, or underissuance. During the crop selling season, the demand for currency from the country banks skyrocketed. Because of reserve requirements under the National Banking Act, country banks were forced to draw down reserve accounts with reserve city banks before issuing currency. This forced the reserve city banks to draw down reserve accounts with the central reserve banks.[12] This series of events was complex and slow; hence, the necessary short term growth in the money supply was restricted.

Geography played yet another role in the demise of this scheme. Because of the reserve requirements, reserves were scattered in 50 cities around the U.S., effectively weakening the power of the collected reserves. It was also hard to move money to parts of the country, which needed them. This phenomenon came to be called "immobile reserves." "As the American economy became larger, more urban, and more complex,the inelastic currency and the immobile reserves contributed to [a] cyclical pattern of booms and busts."[13]

Free banking in the United States was widely seen as a complete and utter failure. It was out of this environment that the idea behind the Federal Reserve was born. On December 23, 1913, President Woodrow Wilson signed the Federal Reserve Bill into law. The Federal Reserve became the single legal issuer of dollar notes. Its powers were increased during the 1930s due to the perceived failure of the laissez-faire marketplace. Meanwhile, the globalization and interdependence of world economies increased its powers even more. Today, the Fed controls interest rates, the size of the money supply, and plays a large role in determining exchange rates.

Considering the failure of apolitical money in the United States, why would anyone consider the development of apolitical money just because of the Internet? First, the Internet is international. Carrying out financial transactions in any one state currency is really an anachronism of the world of fixed borders. As The Economist put it, "Ideally, the ultimate e-cash will be a currency without a country (or a currency of all countries)."[14] Indeed, trying to use the currency of any one state would probably be denounced as economic or monetary imperialism by poorer countries, while other wealthy nations may feel that their own currency is a stronger choice.

Second, reading through the problems of free banking in U.S. history, the biggest problem seems to have been the difficult of communication over geographic distance. On the Net, clearing and mobility of reserves is easily done within microseconds, whether the transaction occurs between neighboring states or around the world. Confirmation of a digital note's legitimacy is similarly unhampered by distance. In short, distance and time are no longer factors in the argument because in Cyberspace, both are of "constant" (Order-one) magnitude.

Third, we should note some of the failures of the central banking system as well. Dowd notes that a central bank treats the symptoms not the cause of economic weakness. A fundamental policy of a central bank is to protect banks to sustain the economy and protect deposits. With the removal or lessening of the threat of bank failure,

insolvent banks will continue in operation possibly long after they should, and managements will be encouraged to take risks they would otherwise have avoided. . . . this will aggravate banking instability rather than reduce it.[15]
This observation is borne out by the aftermath of scandals like the Savings and Loan debacle and BCCI. In both cases, taxpayers ended up carrying the costs of mismanagement.

Although a controlled money supply is in general better for the economy, over- and underissuance continue to be a problem leading to an erratic and unpredictable inflation rate. This results because the Fed bases its targets for the money supply upon the current economic state. In essence, the Fed is reactionary, as opposed to a completely open and free market, which would dictate change, rather than react to it. Claims by free monetarists that denationalized money would lead to a zero inflation world are probably overoptimistic. In fact, a prominent free monetarist, Antoine Clarke, scoffs in "The Micropolitics of Free Market Money: A Proposal":

The claims of an end to monetary inflation . . . are widely propounded; they lack serious appeal when the causes of price movement are not well understood and when the plethora of distortions in the marketplace are such that prices bear no relation to production costs, supply schedules, demand schedules nor purchasing power.[16]
However, there is evidence that inflation would be significantly lower.

This is not to say that all of the problems associated with free money are solved by the Net. One of the biggest problems of the free banking period in the United States was the impossibility of interconvertibility. There are already a number of different digital cash systems on the Net, and there are many more proposals. The systems are often not interoperable, which raises serious questions about their viability. Similarly, the problem of overissuance looms large on the horizon. Free monetarists say that improved connections between issuers will result in controls, but there is certainly no guarantee of that. Any mistake or mishap could have serious consequences for the economy.

More importantly, there are a number of obstacles to the establishment of truly apolitical digital cash. First, there are the problems associated with digital cash in general, which I listed above. In addition, issuers will have to face simple societal inertia. People are often loath to give up the tried and true. Griffith writes in "Cashless Society or Digital Cash?":

An even greater obstacle to the elimination of physical cash is consumer resistance. In spite of the availability of a variety of non-cash payment means already, there has been only a slight decline in the relative usage of cash over the past decade. Even among those consumers who are not concerned by the privacy implications, simple inertia requires a greater incentive for change than has so far been evident.[17]
Apolitical digital cash means that issuers will have to overcome not only distrust of the security of the digital medium and simple inertia, but also strong nationalistic trust in political currency. This has been a big problem for the European Union's attempts at currency union. Simply put, the Germans love their Mark, Britons love their Pound, and the French love their Franc. Clarke quips, "The psychological, one might even say emotional, attachment to state money is that of a heroin addict to his fix. . . ."[18]

Societal inertia is nothing in comparison to the whole host of enemies and opponents that such a currency would face, as Clarke humorously explains in the following extended passage (in the context of the United Kingdom):

The basic list of opponents to change is more powerful than for any privatisation to date. . . .The opponents come in four categories: interest groups in favour of less choice in currency exchanges than exists at present (i.e. Socialists, certain sections of bureaucracy); interest groups in favour of the status quo (i.e. the Bank of England, H.M. Treasury); some financial institutions that would benefit in a marketplace, issuing currency, but with more to lose (in terms of market share to new operators and in faster clearing of credit) than seems prudent to stake on change (i.e. some banks and building societies, particularly the larger ones); those potential users of private currencies who would prefer to keep `safe' state currency because it's the known quantity and because it is `guaranteed' (i.e. the entire population of the United Kingdom).[19]

The establishment of apolitical money is thus a hard problem. Clarke recommends a six step process, which could easily be implemented on the Net.

  1. The demonstration that state money is a catastrophe.
  2. The exposure of interest groups which favour the status quo as monopolists - if they are irreformable.
  3. The provision of equivalent benefits to those interest groups which are either neutral or look favourably at change.
  4. The mobilisation of a crucial interest group in favour of change.
  5. A clear and concise set of instructions for reform.
  6. Widespread communication of the progressive nature of these changes and their empathy with new technology.[20]
The first two points are easily done through the ease of information transferal on the Net. The fourth point could be taken care of by getting large segments of the Net community behind the cause. It should be relatively easy to play upon the mostly anti-government, libertarian attitude of the citizens of cyberspace, especially, if one could convince them of the merits of a new system. The last point applies so clearly to Net, I need not explain it.

Other requirements of digital cash would be to guarantee instant convertibility. There are a number of ways to implement this. Most conservative would be to tie the value of the currency to the dollar or some other national currency for the short term. Another is to tie it to some other tangible good like gold or a "basket" of goods. This first step is necessary to build trust among the consumers. In the long term, the ties will drop away:

there will come a further and final evolutionary stage towards a single overarching monetary system in which convertibility into legal tender ceases to be a condition for electronic money; and electronic money will thereby become indistinguishable from other, more traditional sorts of money. Money will be money whether it is constituted as a string of digits or a piece of paper or an entry in a ledger.[21]

Chances are, such a scheme could emerge on one of the many private network providers, like America Online, Compuserve, Prodigy, and E-world. Already, these private companies provide not only access to the Internet, but also enables buying tickets and many other goods online. Currently, these transactions are denominated in dollars, but since each of the networks are private, closed systems, there is really nothing to prevent them from developing a private, apolitical currency exclusively for use in their own virtual arena. Advantages for the company would be the lower overhead involved in processing purchases. Advantages for the consumer include an inflation-resistent form of money, which happens to have as much functionality (in the network of which the consumer is a member) as regular money. It could also serve as a tax shelter for a while because legislation will have to catch up with the movement. It would not be long before the various currencies spill over into the Internet proper.

The consequences of the successful launch and development of apolitical currencies are vast. Assuming that the currencies become popular enough, the Federal Reserve would effectively lose control over the size of the money supply. This would result in market-determined floating interest rates. Opinions about the effect of free-floating interest rates differ. Indeed, no one is sure whether it would lead to good or ill. Considering the way the Internet ignores national boundaries as well, the Fed's control over foreign exchange rates will also weaken considerably. As with interest rates, this would lead to true free floating exchange rates, instead of the "dirty" floating exchange rates of the present. In the light of these changes, the very existence of the Fed would become superfluous. Indeed, the continued existence of every central bank in the technologically developed countries would have to be questioned.

The federal government would also face a multitude of problems. For instance, current domestic legislation technically only covers dollar transactions. All of the controls that the legislation enforces could become worthless before a completely new apolitical currency. Tax laws would similarly become even more of a twisted snarl. After all, how would you tax a citizen who was paid into an account halfway around the world in an apolitical currency? Also, one unintended consequence of free money would be proliferation of money laundering enterprises all over the world.

Finally, banking institutions would also have to change dramatically. Business Week states, "E-cash will be offered by both banks and nonbanks. . . . Sure enough, DigiCash or CyberCash could join forces with AT&T or Microsoft just as easily as with Citibank."[22] Consumers will realize that banking is necessary, but not the bank. Hence, banks will have to become adept at the new technologies, and offer compatible or competing services.

In conclusion, digital cash is the natural and logical next step in the evolution of money. The investiture of digital cash with its own value is sure to follow because of historical trends. The development of digital cash, and in particular, apolitical digital currency will further fragment the power of central governments and central banking regimes in a variety of financial arenas--taxation, interest and exchange rates, foreign exchange, inflation, and the money supply. The problems faced by free banking during earlier periods in U.S. history are directly attributable to factors, which no longer constrain the system, namely geographic distance and the difficulty of interregional communication. The development of apolitical currency is not merely the possible--it is another revolutionary step towards distributed power.

Author's Note: "The Great Simoleon Caper" is a fictional work dealing with some aspects of what I have discussed here.

Works Cited

Business Week. [Cover Story]. June 12, 1995.

Camp, Sirbu, et al. "Token and Notational Money in Electronic Commerce"

Clarke, Antoine. "The Micropolitics of Free Market Money: A Proposal."

Dowd, Kevin. Private Money: The Path to Monetary Stability. London: Institute of Economic Affairs, 1988.

The Economist. 26 November 1994 v333 n7891 p21(3)

Griffith, Reynolds. "Cashless Society of Digital Cash?"

Johnson, Roger T. Historical Beginnings. . . The Federal Reserve. Boston: Banking and Public Services, 1982.

Locke, John. "Concerning Civil Government, Second Essay."

"The New World of E-Cash."