Digital and cash-based economies both require trust. All participants want to be sure that the money in their wallets or accounts will retain its value. Many countries have managed to develop a national currency that is trusted in the population and is fairly stable with regard to other currencies. A central bank and a well-developed economy are essential for achieving this goal.
Trust in a digital economy can also be based on this trust in the currency. It is the same dollars, pounds, yen, or euro that are handled here. Participants also need trust in the technology, that the transactions are performed as they should be, and that the system is available when needed. However, since this is the same technology that we use for many other tasks, most citizens will already regard this as trustworthy, at least in the way that they are willing to use the technology for many different types of tasks.
I shall explore these issues in this chapter, which also includes a discussion of costs. As we shall see, the low direct cost of each transaction is an important factor in developing a cash-free society.
Trusting the Currency
A person in a country that has weak economic expectations may not trust the national currency. The answer may be to store funds in another currency, even making payments in it. US dollars and euros are often used in such cases. The person is then protected from inflation and fluctuations in the national currency with regard to cash holdings. Bank accounts will normally be in the national currency. However, some countries allow customers to have accounts based in a foreign currency; for example, a US dollar account. Value may also be stored by other means, such as gold.
Most well-developed countries have an active and independent central bank that has resources to support the national currency. The central bank will set interest rates. As we have seen, these are important in order to balance between excessive inflation or a depression. In times of crisis, the central banks have many other weapons that can be used, such as buying or selling bonds or setting reserve requirements to banks. In smaller countries that have their own currency, the central bank can try to control exchange rates by selling or buying dollars or euros. As we have seen, in many cases a weakened national currency can also be an advantage, especially to export industries. If the product you sell costs an amount of 1000 in the national currency, it will equate to $200 (based on an exchange rate of five to the dollar), but only $143 with an exchange rate of seven to one. More expensive international currencies will also raise the price of imported goods and holidays abroad. This will also boost national producers.
A negative effect of many states using the same currency, such as in the United States and in the Eurozone, is that one cannot use currency differences to boost the economy of a single state. For example, Mississippi, Romania, and other states that have a low GDP per capita cannot have their own exchange rate or their own interest rates.
However, there is no such thing as a free lunch. A weaker local currency will in practice imply lower wages; however, while it is psychologically impossible to lower wages directly, a price increase for foreign products will be taken in stride. There is also the danger that investors may have an interest in attacking a currency. They may sell the currency “short,” agreeing to sell it at a lower exchange rate than the current. These attacks will be especially harmful when a national currency is pegged to other currencies, often dollars or euros.
Probably the best-known currency attack was that on the Thai baht in 1997. Thailand had pegged its baht to the US dollar, aiming to stabilize the national currency and thus stimulate the export industries. However, at that time, Thailand’s government and also private citizens had huge debts in dollars. Around 1995, interest rates in the United States increased, strengthening the value of the dollar. At the same time, the economy of Thailand came under pressure. Investors sold baht to avoid losses. As a counter-attack to this flow of baht to dollars and other foreign currencies, the central bank can sell its reserves of these currencies to develop a flow in the other direction. However, the central bank of Thailand did not have these reserves.
Another option would have been to raise domestic interest rates to make it more profitable to keep funds in baht. This was done, but high interest rates weaken an economy and may cause further problems. In the end, the Thai government was forced to remove the peg and let the baht float. This started the Asian financial crisis.
Currency problems can also hit more developed countries. The British pound, the world’s oldest currency, was attacked in 1992. The famous investor George Soros shorted the pound—that is, he speculated that the value of the pound would drop compared to other currencies. At that time the pound was not allowed to fluctuate by more than 6 percent with regard to currencies of other EU countries. The Bank of England tried to strengthen the pound by buying the currency. They also wanted to increase interest rates, but did not receive authorization to do this. In the end, the attack forced the British government to withdraw the pound from the European Exchange Rate Mechanism on 16 September 1992 (“Black Wednesday”). Soros pocketed a billion dollars from his efforts.1 From then on the pound has fluctuated freely with regard to other currencies.
Switzerland had the opposite problem. Here, the danger was not a weaker national currency, but a stronger one. During the turmoil of financial markets around 2011, many investors viewed the Swiss franc as a safe haven and began to purchase Swiss francs in large amounts. This pushed up its value with regard to other currencies. A strong national currency will hurt the export industries. In order to reduce the value of the franc, the Swiss National Bank created more francs and used these to buy euros to create a flow in the opposite direction. This was successful and caused the value of the franc to fall relative to the euro, down to an exchange rate of 1.2 (one has to pay 1.2 francs for an euro). However, by 2015 many Swiss expected that the ongoing creation of francs and the large foreign-exchange reserves would cause hyperinflation. For political reasons, the central bank allowed the franc to float freely with regard to other currencies.2 At the time of writing this book the exchange rate is 1.1, which means the franc is somewhat stronger than what the Swiss National Bank wanted it to be.
Still, while citizens in Thailand experienced a situation where their savings in baht lost much of their value, citizens in the much more solid economy of Switzerland could trust their franc. The 1.1 exchange rate will make Swiss products more expensive abroad, but most Swiss export industries can live with that.
Trusting Banks
Banks may fail, but in order to establish an efficient economy, trust in banks or the other financial institutions that handle payments and funds is a requirement. If the banks get into problems and the authorities are not willing to step in, the money may be lost for the customers, which will hurt the economy. Some people who fear this may end up hiding their currencies at home or buying gold.
In many developed countries, the government will stand behind banks. There is sometimes also a guarantee. The EU will guarantee the first 100,000 euros in an account—that is, if the bank gets into problems the state will step in and there will be no loss for customers up to that amount. In other countries the guaranteed amount may be even higher. Norway, for example, guarantees amounts up to 2 million Norwegian kroner—more than 200,000 euros.3
Even when there is no guarantee, the government will usually step in to save the accounts of ordinary citizens. In most cases, a loss of trust in banks will be much more expensive than the cost of saving the customers’ money. A loss of trust will have serious drawbacks for the economy. In the panic that will follow such a situation, citizens may be more careful about using money and will store money at home, thereby reducing its effectiveness. That is, independent of explicit guarantees, governments will do everything possible to avoid ordinary citizens losing their savings.
A digital economy needs a similar level of trust in banks and the other financial companies. As discussed above, there is also a need to trust the technology. While this may be the case in normal situations, computer errors, network problems, and the loss of power may have serious consequences as it may not be possible to perform electronic payments or to access Internet banks. If such errors persist, the population may lose its trust in the technology. We shall return to this discussion in Chapter 10.
Transaction Fees
While customers and retailers would like zero transaction fees, any type of transaction incurs expenses and these expenses must be covered. The customer can pay an explicit amount for each transaction, or the merchant can pay, or the expenses can be shared between these parties. Alternatively, as is the rule with cash, the transaction expenses can be hidden among all other expenses.
Ideally, if there is a transaction fee it should be borne by the customer. Then the customer can take this into account when choosing how to pay. The problem is that we expect to have zero fees when paying in cash. There are traditional reasons for this. Even when a cash transaction is the most expensive option for the store, it will be very difficult to ask the customer to pay a fee. As discussed in Chapter 4, cash becomes expensive when it stops being agile. Then the cost of counting, storing and transporting the cash becomes prohibitive. This is especially the case when only a few customers use cash. The cost per transaction may then run into much higher percentages than the fees for a credit card transaction.
Debit cards, where the amount is retrieved directly from the customer’s bank account, may have transaction fees of only a few cents per transaction. Since there is no credit involved, no risks, no cash back, no insurance, or any other perks connected to these payments, they can be performed by a simple, low-cost, computer transaction. However, the bank may charge the customer an annual fee for the card.
Credit cards are more expensive to use. A store will usually have to pay a fee of between 1.5 and 3 percent of the total amount, higher for some cards. Since competition is tough between the various providers, the credit cards will often be offered free of charge to the customer. In many countries, credit cards have zero transaction fees for the customer; in others, restaurants or stores may warn the customer that the transaction fee will be added to the check. Usually this will be in the form of a small percentage.
There are also examples where the fee added to a credit card transaction is much higher than what the retailer has to pay, discouraging the use of digital payments. For example, a UK taxi company warns that it will add 10 percent to the bill if a credit card is used. One can speculate that the idea here is to keep income in cash, which has several advantages if the company wants to avoid paying VAT or other taxes.
Some banks charge their retailers a fixed minimum fee in addition to the percentage when a credit card is used. Merchants then feel obliged to introduce a minimum amount for using a card. This is not efficient. For the customers it will be convenient if the same payment option can be used everywhere, independent of the amount. In this case we see that the fee structure of the banks is maintaining the use of cash. In the long run it will be difficult to discourage digital payments for small amounts. When customers can pay small amounts conveniently by using their mobile phone or a tap-to-pay card, they will not accept high fees or resort to cash in these cases. Also, when the technology is in place, the cost of yet another transaction is very low.
Some countries do not demand any fees or minimum amounts, which makes it convenient to use digital payment for just about all transactions. As we shall see in the case study in Chapter 14, this may be a practical requirement for establishing a cash-free payment system.
Since it is difficult to put explicit fees on the usage of cash, digital payments should also enjoy zero fees on payments. This can be achieved either by asking the merchant to pay the 1.5-3 percent of the total for credit card payments, or by having a zero fee on debit cards. In the latter case, costs will be negligible.
Digital for All
The fundamentals for establishing a digital economy are that consumers trust the currency and the financial institutions. We discussed these issues above. In addition, there are several practical issues. Every consumer who wants to participate in the digital economy in the developed world needs a bank account or credit card account. In some countries banks will only offer accounts to customers who meet a set of requirements, such as a regular income and a place of residence. In others, regulations may stipulate that banks cannot refuse to set up an account. Usually the default account will be one that can be accessed with a debit banking card. Since it is not possible to withdraw money that is not in the account, the risk for the bank is minimal.
While an account with a bank or credit card company is the entrance requirement to the digital economy in a developed country, several underdeveloped countries offer banking services through mobile phones. Customers are then identified by their SIM cards.
If the complete population is not offered the possibility of participating in the digital economy, it will be necessary to maintain a cash economy in parallel with the digital. This can be expensive, especially once most transactions are performed digitally. But since the technology offers the possibility of checking the balance before a withdrawal, it becomes risk-free to offer a bank account to every citizen. We see that the digital economy solves the problems that it creates.
An alternative is to offer cash cards. In some countries, social security support may be offered in this way. A cash card can be used as cash, but the notes are here replaced by a plastic card with an amount on the card. This can be used in all terminals, similar to a banking or credit card. These cash cards may also be an option for small children. Parents can then fill up the card from their own accounts. However, in some countries, even children are offered standard debit cards. This seems to function very well. Experience shows that 10-year-olds are even better at protecting their cards than teenagers.
Most tourists have international credit cards, enabling them to participate in the digital economy in the visiting countries directly. Debit cards are often national and will only work in the country where they are issued. Tourists without a credit card rely on cash, either in the currency of the country that they visit or in a well-known currency, such as euros or US dollars. In a digital society these tourist would have to change the representation of their money from cash to a cash card. In the long run, we should expect most tourists to travel with an international credit card, which is also needed to rent a car or to check into many hotels.
A digital economy will require that the technology, from terminals to computer networks, is in place. It is also necessary to have a population that can master the technology, log in to online banking, perform basic monetary transactions, and more. This will be made easier as the technology moves forward. For example, smartphones offer good opportunities for simplifying payments. This will require the ability to download, install, and use apps. However, this is similar to installing apps for other purposes, which most people manage to do.
Since banks and credit card or cash card issuers are the backbone of a digital economy, these organizations need to go digital and be trusted by the population. If banks can fail and if there is no central government to protect customers, many people will feel more secure using cash, especially dollars or euros.
As we shall discuss later, several international companies such as Facebook, Apple, Amazon, Google, or Alibaba are in the process of establishing digital payment systems that can be used by everyone. However, for a citizen who receives his or her income in an unappreciated national currency, it may not be a viable option to use digital payment systems based on other currencies.
Conclusion
A digital economy must be based on a well-functioning currency, and banks and other financial institutions must play an active part. It will also be necessary to have the technological infrastructure in place, everything from terminals to data networks, central servers, and clearing systems. We shall discuss these aspects in detail in the next chapter.
Another requirement is a population that is comfortable with using digital systems. This will be the case in most developed countries, especially as the new payment services will be well integrated with other digital tasks, such as booking tickets or shopping online. Further, it is a requirement that all customers are in a situation where they may have a bank account. If not, expensive cash services would have to be retained for a small fraction of customers.
Zero fees will be important in leading customers from cash to digital forms of payment. If not, the tradition of zero fees for cash transactions, even where cash is more expensive to handle than the digital payments, may hinder the development of a cash-free society.
Notes
1 Mallaby, Sebastian (2011) More Money Than God: Hedge Funds and the Making of a New Elite, Penguin Press.
2 https://www.economist.com/blogs/economist-explains/2015/01/economist-explains-13
3 With an exchange rate of 9.6 kroner to the euro (one has to pay 9.6 kroner for one euro). This is the rate that we shall use in this book. The EU has criticized Norway for having a higher government guarantee, claiming that this makes Norwegian banks more competitive.