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Moving Money
The Future of Consumer Payment
Brookings Institution Press
Copyright © 2009 Brookings Institution Press
All right reserved.
ISBN: 978-0-8157-0277-1
Chapter One
ROBERT E. LITAN
and MARTIN NEIL BAILY
Introduction
Money is one of those words with multiple meanings. Economists tell us that it serves as a medium of exchange, or the way in which actors in an economy pay for goods and services. It also is a unit of account, or the device by which prices of those goods and services (think dollars and cents) are determined. It is a store of value, a way in which actors can hold their wealth, though in modern financial systems there are typically more productive ways to hold wealth, such as financial instruments or hard assets such as real estate (in which case the value of those assets is expressed in the chosen monetary units).
This book is about money and its use, primarily by consumers in the first sense of the term, as a medium of exchange. More precisely, the chapters in this volume attempt to answer the following questions: Over time what forms has money taken? How are these means of payment likely to change in the years ahead? What, if anything, should policymakers do to facilitate those changes or, at a minimum, to avoid holding them back?
Why do answers to these questions matter? For one thing, the payments industry-governments and the firms that enable payments-is large and important in our economy. As noted in chapter 2, in the United States alone, private sector payments providers generate approximately $280 billion a year in revenue. This number does not include the substantial governmental resources that go into making money (coins and printing money) or moving it (checks and various electronic transfers).
Second, it turns out that how we pay for things influences what and how much we buy, and when. As we note below, and as a later chapter discusses in much greater detail, there is a significant psychological aspect to how we pay for things. Other things being equal, people tend to buy more goods or services, and to be willing to pay more for them, under certain circumstances, for instance, if they can pay by credit (credit cards) than with cash or its equivalents (debit cards). How the means of payment evolve, therefore, can influence how economies themselves evolve.
Third, the technology of money and means of payment is fascinating in its own right. Continuing advances in technology-communications and the digital revolution in particular-have shaped and will continue to influence what means of payment are devised. At the same time, however, consumers ultimately will determine which of these technologies they will actually use.
Fourth, the payments landscape is likely to be very much affected by public policies toward payments. Any form of payment requires trust on the part of both the seller and the buyer. No one wants to be the victim of fraud or theft. Government is required to enforce laws against such outcomes. Historically, governments also have had monopolies on the manufacture of money and on the means of its transfer (other than in face-to-face transactions). More contentious is whether, and to what extent, government is also needed to protect the market in private sector payments systems.
The chapters that follow address these and other issues associated with consumer payments. The authors are recognized experts, from both the academic and the private sectors, on payments issues. Initial drafts of these chapters were presented at a conference at the Brookings Institution on September 16, 2008.
We set the stage in this introduction by providing a brief history of money and consumer payments and discussing some of the economic characteristics of payments systems. We then outline some of the broad themes that run through the chapters. In doing so, we concentrate, as most of the chapters do, on payments technologies in use in the United States. Where relevant, however, we draw on experiences from other countries.
Money: A Brief History until the Age of Plastic
For thousands of years, people have used different things as money, replacing perhaps an even longer history of a system of barter, the exchange of different goods or services between buyer and seller. Barter is highly inefficient. What I want, you or someone else must have. There must be a coincidence of wants for barter to work. These happenstances become more costly to arrange as the number of people in an economy grows.
What has counted as money has changed over time. Livestock and foodstuffs probably were the first forms. Early in American history, tobacco was also used in some places in the South, and in fact was recognized as legal tender in Virginia in the seventeenth century. But these perishables had a basic problem: they couldn't be stored without much effort and expense, and they eventually spoiled. People turned to more durable inanimate things like shells and stones to overcome this difficulty, but even these forms eventually eroded in value, either through natural causes or because they were easily debased-with enough effort people could find more of them and thus reduce the value of what was already in place.
Nonetheless, certain forms of money have endured, though each is becoming less relevant for consumer payments in our increasingly digital world. For example, metal coins, in one form or another, have been in use since 700 BCE. Paper monies-more precisely, notes giving their holders rights to receive some form of metal in return-are a more recent innovation, first used by the Chinese in 140 BCE and later by the Romans. Paper monies became popular, however, only many centuries later during the Renaissance in Europe, and then in the American colonies, especially during the Revolutionary War.
But paper monies also have shortcomings. Without regulation or some explicit tie to the amount of a recognized commodity (such as gold), the production of notes can easily proliferate, destroying their value. That is why, in modern societies, governments (through their central banks) now exercise control over the production and distribution of so-called fiat money, money that can be used as a means of payment, a unit of account, and a store of value, but which is not necessarily backed by or redeemable for a given quantity of metal.
There is another drawback to both paper and metal money: it must be guarded against theft and must be transported to be used in exchange. The establishment of banks by Venetian traders as early as the twelfth century solved the storage problem by enabling depositors to place their money for safekeeping elsewhere. The banks would move money by simply changing entries in their account books or issuing bills of exchange, the predecessor to the modern check.
But bank money can lead to other problems. Banks can effectively print money by issuing bank notes, promising the holders the ability to redeem such notes in specie, typically gold or another hard metal. This system of fractional reserve banking arose as banks expanded the volume of their note issues relative to the amount of reserves, or specie, they had on hand. The banks counted on the fact that their depositors would not all want their specie back at the same time.
But what if they did, and banks did not have enough reserves to repay them? Such was the weakness of fractional reserve banking, which in fact was subject to periodic depositor runs or panics. In the late nineteenth century and early twentieth, one giant figure of finance-J. P. Morgan-personally used his bank to fight off such panics. Yet one man alone could not be expected to support an entire banking system, and so, in 1913, Congress created a government-controlled central bank to meet the liquidity needs of individuals and firms throughout the economy. The Federal Reserve System (Fed), governed by a central board in Washington, was given authority to establish reserve requirements for banks, to buy and sell government bonds and thereby exercise control over the money supply (although banks' willingness to lend also influenced how much money was in the system at one time), and, if necessary, to serve as a lender of last resort to the banking system.
It is now widely recognized that the Fed failed in discharging two of these responsibilities during the Great Depression, by allowing the money supply to shrink rather than continue to expand, and by not providing enough liquidity to prevent depositor runs that ultimately brought down roughly 9,000 of the nation's banks. Central banks here and elsewhere throughout the world have learned much since then. Although debate continues as to the Fed's role in contributing to the housing bubble that led to the 2007-08 financial crisis and ensuing recession, few have argued with the Fed's massive show of financial force in responding to the events: expanding the money supply at a rapid clip and lending not only to banks with liquidity problems, but to nonbanks and to the commercial paper market as well.
The Fed was given authority not only for managing the nation's money supply but also for clearing checks between banks, which previously had been the domain of private clearinghouses. These clearinghouses had levied the equivalent of small taxes on the checks they cleared to cover the risk that a paying bank would not be able to honor its commitments to payee banks. In 1918, the Fed assumed the risk of nonpayment, meaning that all banks could exchange their checks at par without any discount. In addition, the Fed absorbed the substantial cost of running this clearing operation, which has until recently required the physical counting and movement of an ever-growing volume of checks. Not surprisingly, the check became the dominant payment method in the U.S. economy from the end of the nineteenth century through the twentieth.
That was not the case in Europe, where giro payment systems instead have long dominated. Unlike checks, which put the onus on a payee's bank to collect from the payer's, giro payments put it on the payer, who instructs the bank, which only then transfers the funds to the payee's bank. Direct payroll deposit is an example of how the giro system works: your employer automatically puts funds in your account without writing you a check. Some customers in the United States use similar direct transfers to pay their utility bills and their mortgage or rent, but still often use (again until recently) checks to pay other parties. In Europe, individuals rely overwhelmingly on such direct transfers, and only rarely write checks.
Payments Methods: Plastic and Beyond
We avoid getting enmeshed here in the academic debate over why the United States went one way in payments (check) and Europe another (giro), largely because both systems are under assault from continuing technological change-the leitmotif of this book-which renders the history of how each side of the Atlantic got where it is today increasingly anachronistic. Payments technologies and the industry that has grown up around them have changed dramatically since the end of World War II. The change that launched it all was when money began to go "plastic"-that is, when consumers could pull out a card from their wallets and use it rather than cash or a check to pay for goods and services. This volume takes the plastic era as a given, and explores how the world of payments has moved and will continue moving beyond it.
Actually, the first payment cards were not plastic at all, but paper or cardboard, and limited to certain retailers, such as Sears. What we know today as the general purpose payment card-one that could be used at multiple vendors-began in 1950, when Diners Club launched its card for use at New York area restaurants (later expanded to many other locations). Shortly thereafter, Hilton Hotels introduced the Carte Blanche payment card, for use at hotels. Both of these cards, however, had limited usability, but were notable in how they adopted a two-sided business model: consumers paid an annual membership fee, and merchants paid the payment network a fixed percentage of the amounts consumers paid for the product or service.
American Express and Bank of America changed the payment card industry forever in 1958, when each issued a card that consumers could use at many types of vendors. With a much broader range than either Diners Club or Carte Blanche, both issuers were in a much better position to take advantage of network externalities-the chicken and egg notion that as more users are attracted to the cards more merchants will join, and vice versa. That is precisely what happened. Both American Express and Bank of America's Visa grew rapidly thereafter in popularity.
But the two new players used very different business models. American Express expanded organically, first within the United States, and later throughout the world, adding merchants and customers to its roster, and directly clearing all charges by cardholders and payments to merchants. Bank of America initially tried to expand by franchising, inducing smaller banks to join its network. Eventually, a rival group of banks formed MasterCard, a membership association of banks. Bank of America did likewise, abandoning its ownership of the network in favor of a federation of banks, which became the Visa network. Later, Sears launched its own card network, Discover, eventually spinning it off into a separate business line. Like American Express, however, Discover operated its card network directly, in contrast to the cooperative or membership business model followed by MasterCard and Visa. These contrasting business models coexisted for nearly five decades. In response to litigation over the way in which their members set network fees, both MasterCard (in 2006) and Visa (in 2008) adopted the direct ownership model and became public companies.
American Express's business was also unique in another respect. Whereas the other card networks offered their cardholders credit, for many years the American Express card was only a charge card, which required customers to pay the entire monthly balance when billed. Eventually, however, American Express began to offer credit cards as well so that it could more effectively compete with the other card networks.
Today, credit cards are ubiquitous. In 2007, American consumers charged more than $1.7 trillion in purchases on them ($1.9 trillion in constant 2006 dollars). Outstanding credit card debt topped more than $2.5 trillion, or a median value of $2,200 per household that owes money. Having a credit card has become essential to consumers and businesses, even for those who pay their bills promptly (so-called convenience users) and do not use the cards for credit. In many locations, or with many vendors, credit cards serve as personal identification.
In 1975, banks introduced another type of payment card, the debit card. As its name implies, the debit card immediately deducts charges from users' bank accounts. Banks typically have coupled debit card features on their ATM cards, and many now permit credit charges as well. Debit cards historically have been far more popular outside than inside the United States, especially in Europe. But they have been rapidly gaining popularity here despite the fact that users cannot take advantage of the float that credit cards offer (the period between when charges are made and payment of any credit card balance is due). Apparently, many consumers prefer the discipline of spending within their means that debit cards help enforce.
The Internet revolution is now pushing payments increasingly into cyberspace. With Internet banking, customers no longer need to write checks to pay for many routine household expenses, or even to pay off their credit cards. With a few keystrokes on their banks' home page, bank customers can use their computers, tethered to the Internet, to pay bills. European countries with giro systems, meanwhile, have adapted them to the online environment. The Internet also has made possible entirely new payments networks, such as PayPal, that enable individuals to transfer funds either to other individuals or to vendors.
Wireless or mobile payments technologies are the next frontier in payments. In some countries consumers can already use mobile devices such as cell phones to charge payments to their credit card accounts or to debit their bank accounts. In Japan cell phone users are charged directly for the amount of content they download from the Internet. The major payment networks in the United States, along with several new ventures, are working on ways to introduce such services in the American market.
(Continues...)
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