Means of payment outside the banking system are likely to proliferate in the next century, undermining monetary policy

The late 1990s have been the era of central banks. In the US the Federal Reserve chairman Alan Greenspan has become a national institution. His every word is studied by hundreds of highly paid analysts. Information on the content of his next speech would have a high street value. A reliable interpretation of what he really means would be almost priceless.

Comparisons of financial magnitudes Per cent of GDP
	Bank reserves	Monetary base	Broad money	Outstanding government debt	Total domestic debt securities
Canada	0.6	4.0	43.4	71.8	84.5
Euro-11	1.8	8.8	80.6	n.a.	n.a.
France	0.6	4.0	66.0	47.6	81.9
Germany	2.5	6.8	67.5	38.2	85.4
Italy	4.5	10.0	47.7	101.4	132.8
Japan	1.8	12.2	73.7	79.8	113.6
Sweden	0.6	4.9	47.5	55.4	122.8
Switzerland	2.7	10.6	106.9	21.4	70.7
UK	1.1	4.0	91.7	35.8	59.8
US	0.5	6.3	70.5	43.8	163.8
Source: Benjamin Friedman

In the UK, the first act of the newly elected Labour government two years ago was to give the Bank of England operational independence over the conduct of monetary policy. The most powerful financial institution in 11 of the countries that belong to European economic and monetary union is the European Central Bank, which is freer from direct political control than almost any other central bank.

Nevertheless the vogue for any particular type of institution has limited life. The vogue for indicative planning reached its peak in the early 1960s. That for fiscal policy did so in the 1970s. And that for central banks is also almost certain to diminish.

This is not only a matter of fashion. It is also likely to result from deep-seated trends in financial evolution. The mainstream belief at present is that monetary policy exerts a big influence on output and employment in the short to medium run, and on prices in the medium to long run. Most central banks try to exert this influence by their power over short-term nominal interest rates, although there still exists a vocal group of economists who would prefer them to operate with targets for one or other definition of the money supply. They have such power because the greater part of the money supply consists of bank deposits; and banks are either obliged, or find it prudent, to keep reserves at the central bank.

The result resembles one of the older cosmological theories in which the world rested on top of an elephant which in turn balanced upon a mouse. For the supposed leverage is exercised by means of financial operations that are tiny in relation both to national and international monetary flows and also in relation to total output. For instance, bank reserves in the US account for only 0.5 per cent of gross domestic product.

This influence can only continue if the commercial banks continue to account for the bulk of the effective money supply and if they continue to hold reserves with central banks. Both these assumptions have been challenged by a paper given at a recent Oxford conference on "social science and the future" organised by the London-based Centre for Economic Policy. The paper in question, The Future of Monetary Policy, came from Benjamin Friedman of Harvard.

He suggested that the evolution of electronic means of payment would lead over a quarter of a century to the end of banks as we now understand them. The result would be that, even if the theory of central banks' influence is now correct, they would then lose all leverage.

Such developments were prematurely suggested when credit cards emerged some decades ago. But there is a crucial difference. In the case of most existing credit cards, at the end of the month you receive your dreaded statement, which is settled by a transfer from your bank to the credit card company. New forms of payment may not involve such transfers at all.

Mr Friedman provides three main reasons why central bank power may disappear. The first is the erosion of the demand for bank money. "Smart" cards - for example the single vendor advanced payment cards already used by many telephone services and the New York subway system - could develop into genuine private money. So long as issuers of these cards ask for settlement by transfers from bank balances conventional bank deposits are still required. But within 25 years from now firms and individuals might simply accept and swap balances on the books of a transport or telephone authority. In other words they would be means, not only of payment, but also of settlement.

Central banks could of course try to retaliate by imposing reserve requirements on more and more kinds of financial institutions. The issuers of private money would respond by changing their products to evade the new regulations. The central banks would almost certainly be one step behind the ingenuity of institutions in devising new products.

Some might object that the central bank would still have control over outstanding currency - notes and coins. But currency is now issued automatically in response to public demand. Monetary policy mainly operates through the banks.

A second development is the proliferation of non-bank credit. At present, when a bank extends credit, deposits are created on the other side of the balance sheet which have to be backed by reserves at the central bank. But bank credit has been steadily contracting as a proportion of total credit. Advances in data processing and the easier availability of information are likely to reduce the special advantages of banks in deciding on credit-worthiness. Moreover, even where banks still issue loans there is a trend to "securitisation". This means that the loans are sold to non-bank investors who are not subject to reserve requirements.

Third, reserves with central banks are often held as a necessary means of settling interbank transactions. This gives the central bank leverage to affect total deposits by means of small operations. Yet the evolution of private clearing mechanisms like the US net settlement system CHIPS threatens to erode the central bank role even here. The combined results of all these developments could well be to reduce, perhaps to the point of elimination, the need for bank reserves and even the need for banks and cash altogether.

Mr Friedman is disarmingly frank about some of the further consequences. For instance, he cannot say what will determine the price level, or rate of inflation, in this brave new world. Nor does he know whether national authorities will find an alternative way of limiting inflation and deflation or ironing out the worst of the business cycle. Some British economists may gleefully rub their hands and say that we will have to return to the postwar orthodoxy and use fiscal policy. Really? In a world where central banks cannot stop the creation or destruction of huge amounts of credit, it is difficult to see how moderate variations in the budget surplus or deficit can act as a substitute.

The Friedman prognosis is not completely novel. For instance two Bank of Ireland economists, F. Browne and J. Fell, put forward a similar thesis in 1994 under the title Inflation Dormant, Dying or Dead? (discussed in Economic Viewpoint of November 17 that year). They also predicted the end of monetary policy and money as we know it. They have since moved to the European Central Bank where no doubt they are preoccupied with the more immediate future where money exists.

The Irish economists took the optimistic view that in the longer run that the standard of value in which prices would be set and contracts denominated would be divorced from the means of payment. They suggested that values would ultimately be measured in terms of a unit of account defined in terms of a basket of goods.

The Irish authors were far from clear about how this would come about. But, whether the results are benign or dire, the problems of a transition to a society without money need as much thought as the problems of running the monetary system as it at present exists.