E-Currencies and Money Part 3 – Money, Investment, Payment System, Or All of the Above?

Wikipedia defines money by its use as “a medium of exchange, a unit of account, and a store of value.”

Currency is but one form of money, and fits in the first category of this definition. Currency is also the smallest component of what economists define as the “money supply.” The money supply includes different components such as credit, deposit accounts, and the like.

Since virtually all e-currencies are used as units of value in exchange for goods and services, virtually all of them qualify as money and as currency. I further am of the opinion that Visa(tm) and MasterCard(tm) dollar units are also currencies, though the companies don’t like you to think of it this way (this view may be controversial to some). In fact, credit card accounts are the most widely used e-currencies in circulation today. I will go further and state that the distinction between currency and e-currency is, in fact, virtually zero in today’s electronic world.

The more interesting distinction is between government-issued (call them “public”) currencies and those that are issued by private companies (call them “private”).

With the introduction and widespread adoption of PayPal, private (e-)currencies suddenly became a hot topic. PayPal was one of the first private currencies tied neither to a government nor to a credit card issuer. But, private currencies are certainly nothing new. The original currencies in existence in the United States were in fact privately issued “Bank Notes” issued by banks in the US. They served a very important purpose in the early days of this country, since they had value independent of whether the US continued to exist as an independent country. (Go visit a coin shop and you can see some of these interesting documents.)

The original US bank notes were generally backed by a precious metal – in fact, they were often gold or silver certificates that could be exchanged for the precious metal at the bank if you wished. A bank account was a stash of gold for which you were given certificates. The US government later issued their own currency, and these were also gold or silver certificates. Those days didn’t end until 1972, when the US “went off the gold standard” which pegged the value of a US dollar to a certain amount of gold. Up until that time, the US government was required to back up the value of its money with gold held in depository facilities around the country. Fort Knox is the most well-known of these facilities, but by no means is it the largest.

It is in this context that we must look at the private e-currencies in circulation today.

All currencies are backed by something which establishes its value. The easiest to understand are gold-backed currencies. The units of value of such a currency is tied to some amount of gold held in reserve someplace “safe.” You can in fact still purchase gold certificates, just not from very many governments. Usually they are issued by gold-mining related companies who will issue a certificate to represent ownership of gold held in their vaults (“paper gold”). Make it a bearer certificate, and it’s pretty much gold-backed paper money.

The next easiest to understand is a currency-backed currency (such as PayPal is). For example, some smaller countries issue their own currencies at a fixed rate in relation to the US Dollars it holds in its own reserve. These are dollar-backed public currencies. There is no shortage of dollar-backed private currencies – one of the first was the traveler’s check. Merchants accept these pieces of paper because there is a well-financed, trust-worthy company who will accept that paper in exchange for US Dollars. Visa, MasterCard, and others also back their currency with US Dollars (and other currencies). Their units have value because merchants believe that they will (usually) receive a public currency in exchange for the units stored electronically in their accounts. Yet in reality, merchants value credit card units significantly less than the currencies that are held in their accounts. The reasons behind this are chargebacks and fees (as well as hassle factor). However, merchants are not permitted to charge consumers more due to their agreements with these credit card companies. As a result, even cash customers pay more for goods and services from these merchants (and why you should always demand a 2-3% discount when paying cash).

One mystery is why public currencies that are not backed by anything of value have value. These currencies are often called “fiat” currencies because people take them at face value based on confidence in the issuing government. But this is only part of the story. In reality, these currencies have value based on several factors. First, they are the only way to settle debts to the government (in most countries). Therefore if you owe taxes, you had better have some of these around. The second often overlooked component of value is the earning power of its population of people and corporations (more or less the current and future gross domestic product, or GDP, of that country). In fact, I would claim this is the most important factor when considered in combination with the monetary and other policies of the government in question.

To understand why, look at the global bond and bill market. The us government borrows billions and billions of dollars from investors and foreign governments every year. It must do this in order to finance its budgetary deficits, which of course include debt interest and principal payments. The US government enjoys a very low interest rate on its debt. The reason for this is a high level of confidence in the world that the US will repay that debt very reliably and predictably. Why does the world have such confidence in the US government? Because of its ability to collect taxes from its citizenry!

If the US government suddenly repealed all of its taxes, the value of the dollar would plummet as investors lost confidence in dollar debts owed by the US government. If the US government suddenly raised taxes by say, 10,000%, the dollar would plummet as well, as the world of investors would realize that there was no longer any motivation for people to work to make money, and therefore the ability of the government to raise money through taxation would go down the toilet. If unemployment were to skyrocket, or corporate profits collapse, or both, the US dollar would similarly lose value.

On the other hand, if the US government drastically cut back on waste and unproductive spending, the value of the dollar would rise, because investors worldwide would see that the US government was even more able to pay its debts. (Rising dollar value means lower interest rates paid on bonds issued by the government, which leads to a lesser need to raise taxes, which leads to a rising dollar.) In short it is your earning potential and that of your children that sets the value of the dollar. The value of the US dollar is for all intents and purposes, tax-based.

You won’t hear this analysis directly, only indirectly in the media. It’s a scary reality that the US government has complete control over the value of your savings, and the right to effectively steal from you (take value away without your permission). It’s also a pretty negative way of describing things, true as it is. Instead you will hear about factors that underlie or correlate with the ability of the government to raise taxes to pay its debts. As an example, “consumer confidence” is a predictor of how much junk we will buy this year, incurring sales taxes and leading to corporate profits, leading to more tax revenue. It may seem strange that this is more important than a rise in wages for the common worker. Why? Several reasons. Higher salaries may reduce corporate profits, and lower the government’s tax base. And, higher wages may not result in higher spending, it depends on how secure consumers feel, or whether they feel the need to save for retirement or a rainy day. It’s all about the taxes in reality.

Contrast this complex situation with the simplicity of an asset-backed currency, and you might wonder why anyone bothers with tax-based (a.k.a. fiat) currencies for commerce. The simple answer is that public fiat currencies allow the government a monstrous degree of control over its economy and ultimately its citizenry. If the government were to suddenly announce that everyone’s salary was to be cut by 50%, or that everyone had to give up half their savings to pay down the national debt, there would be a revolt (one would hope). Its far easier to simply “print more money” by raising taxes (but not too much), borrow more from the public markets against the earning power of future generations, etc. These are all things that ultimately reduce the value per unit of the money we all receive, but so far, no riots. But I digress….

Before putting you to sleep any further, let’s jump to the concept of private, asset-backed currencies. It should be clear at this point that a private currency backed by the US dollar is not much different than a US dollar. It might be more or less valuable than a US dollar in its purchasing power however. Consumers (should) love to use credit cards and value their credit lines more than money, because of the protection they get from fraud, and the flexibility to choose to be stupid and delay payment at exorbitant rates. Merchants should value a credit card less because of the chance of not getting paid by a fraudulent consumer, but more because of the increase in sales by accepting a consumer-preferred means of purchase. Because many traveler check companies will still honor counterfeit or fraudulently passed checks (in certain circumstances), it was common for many years to find that you could buy more foreign currency using these than by using cash! E-currencies based on the US dollar have similar considerations in determining their value – what are the costs, benefits, and risks involved in using these versus the alternatives? For the consumer and for the merchant?

For legitimate merchants, the primary differentiating concern is this: “When I get paid, what are the chances of a chargeback? What are the assurances that this currency is not counterfeit?”

For typically unsophisticated consumers, primary differentiating concerns are these: “How broadly is this currency accepted in case I need to use it for a different purpose? What are the extra features of this currency? Do I have some degree of protection from merchant fraud? Does it have reward points?”

Concerns common to both include: “What fees do I have to pay to complete a transfer? How much does it cost to exchange this currency for another that I need? What is the exchange rate for this currency going to be over time in the future?” And, since the currency is privately issued, “What is the chance that my currency will suddenly lose some or all of its value because of fraud on the part of the issuer?”

However, there is one much more significant and overriding concern that has emerged, thanks to whom else, the US government. It is: “what is the likelihood that this currency will suddenly become worthless because the US Government goes after the issuer?” This is not a new concern, of course. Even a gold-backed public currency could quickly become worthless if that country suddenly came under attack, or the government of that country was exposed as corrupt. This is the nightmare scenario for any currency, especially if the attacker is the US government.

So we know that e-currencies, even those backed by dollars are a currency with different characteristics than the dollar. Is the act of exchanging public currency for e-currency an investment? The answer is….not inherently, no. It depends on the intention of the one purchasing the e-currency. In many cases, purchase of an e-currency is performed for the sole purpose of enabling an exchange with a counter-party. In this case, the e-currency, regardless of its backing value, is an investment (ignoring whatever rewards result from the exchange). An e-currency by itself is generally NOT an investment if it is backed by the same currency that the holder would hold anyway. Moving your US dollars from a bank to an e-currency for no particular reason does not constitute an investment. However, if a holder of an e-currency doesn’t normally hold the dollar for other purposes, it can be a wise investment whose return is tied to the change in exchange rates. The same is true for currencies backed by gold (unless you already held the gold). E-currencies do not yield interest or dividends in and of themselves for many good reasons. It is possible however, to invest using e-currencies. I will cover that topic in a later installment.

I will draw this installment in the series to a close with the following summary. E-currencies are money, and as a medium of exchange of value, are always tied to a payment system of some kind. As privately issued currencies, they have different risks than public currencies, as well as different value-adds. Exchanging public currency for private currency is not inherently an investment, though the purpose of making the exchange may enable an investment. While many features of a private currency may add to or reduce the value of a currency, no other factor has more impact on the value of a private currency than the risk of it becoming suddenly valueless. The two primary potential causes for an e-currency losing its value are fraud by its issuer, or the issuer coming under attack, threatening the ability of holders of the currency to conduct commerce, perform exchanges, or access their funds. For this author, it is a sad statement that the two most likely attackers of a currency are the US government and cyber-terrorists who have an interest in reducing the value of an e-currency (e.g. competitor currencies, disgruntled individuals).

In the next article, I will cover why the current hostile US government posture with respect to e-currencies is both a) a very real concern, and b) perhaps the second biggest strategic blunder ever made by the US government. (Ok, well at least its in the top 10. ) I will then go on to conclude that this won’t change the future importance of e-currencies.

Stay Tuned!