Economic view: Internet's tangled money Web worries central banks

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When the Bank of England set up its home page on the World Wide Web three months ago, the first e-mail it received came from an Internet surfer in California. The inquirer had, appropriately, a question about the concept of legal tender.

Appropriate because the aspect of the Net that could turn out to be most vexing for the Bank, and other central banks, is the development of electronic money. A working party set up by Europe's monetary authorities is looking into the implications of cyber-transactions .

One City of London economist thinks these implications could turn out to be grave. Stephen Lewis, at the London Bond Broking Company, says: "If a large proportion of transactions in the economy were to migrate from traditional banking channels to the information superhighway, there would be a clear threat to law enforcement and to the financial foundations of government. Ordered society might be imperilled."

This is strong stuff, so it is well worth exploring electronic money in some detail. There are two main categories to think about. One, the better established, is the electronic purse. Mondex is probably the best- known example. It is a smart card with extra bells and whistles that allow money from a bank account to be transferred to the card and subsequently drawn on for small transactions. In effect it is like a telephone card except that it can be used for making a wide variety of payments.

The electronic purse is therefore much like a debit card, and is designed to save using cash in low-value transactions. Just like debit cards, they have no particular consequences for monetary policy beyond the fact that they might change the proportion of cash people use in their spending - in other words, the velocity of circulation of narrow money. Technical changes such as cash machines and cash-back have changed this velocity dramatically, anyway. It is not something that causes central bankers to lose sleep.

The chief worry about electronic purses is their security. The European working party has concluded only authorised credit institutions should be allowed to issue electronic purses, and that central banks should scrutinise the security features of the cards. They should also make sure statistics on their use are collected.

It is the other category of electronic money that worries people like Mr Lewis more. That is straight banking on the Internet - not so much going on-line to access your normal bank account as the development of new banking activities.

A cursory search of the World Wide Web reveals at least a dozen cyber- banks, sporting names such as DigiCash, NetChex and the First Virtual Holding Company. The European Union has its own electronic money trial, the Cafe project. Some of these are conducting transactions in an existing currency, mainly dollars. Others, linked to local exchange trading schemes, use their own, new monies.

One reason the cyber-banks ought to worry the central banks is the difficulty of monitoring what is happening on the Internet. It would be easy for this banking activity to go almost completely unmonitored.

As things stand, there is no possibility of collecting statistics, never mind regulation or supervision, on the Internet. There is no reason to expect Internet banks to voluntarily set themselves the same prudential standards as conventional banks. The German Bundesbank is concerned they would not hold adequate reserves, for example, unlike the normal banks which are required to meet a minimum reserve ratio.

So the electronically-generated money supply could grow at a supersonic pace with no central bank being any the wiser. Internet banks could make unwise loans, resulting in a credit crunch that the authorities would only discover when it was too late, and perhaps even a systemic collapse.

More likely, perhaps, would be the exploitation of Internet banking for tax evasion, money laundering and fraud. Mr Lewis says: "You might imagine that all the risky business would graduate onto the Internet quite naturally." There is no technical reason why this should not already be taking place. The main barrier, to fraud at least, is most people's healthy distrust of on-line security. After all, there are people who still distrust cash machines and credit cards. And it is only in the latter half of this century that banks managed to persuade a majority that their money was safer on deposit than in a sock under the mattress.

A longer-term difficulty for the authorities will stem from the further development of barter systems using newly created currencies on the Internet. These are linked to rapidly expanding local exchange trading schemes (Lets), the local barter schemes where people in a community trade goods and services they produce themselves. For example, one LET has a unit of account called the nella which has the characteristics of money - it is a unit of account, a medium of exchange and a store of value.

If there were enough such schemes, the conventional money economy could be progressively undermined. This would mean, not only that it would be near-impossible to run monetary policy, but it would be much harder to raise taxes too. Tax is already a thorny issue with Lets. In principle, the activity they generate is subject to income tax. But how do you value the made-up units of measurement, the modern-day equivalent of cowrie shells, for tax purposes? And how much harder would it be to keep track of this sort of activity on the Internet?

The irrepressibly pessimistic Mr Lewis says: "How would the tax authorities ever be able to raise the revenues to fund national defence in this kind of economy?"

It has to be said that the central banks - even the Bundesbank, which is most alarmed about electronic money - are not nearly so gloomy about the potential implications. The American authorities are quite keen on it, partly because it is administration policy to embrace the information superhighway, partly because American retail banking is not as technologically advanced as in Europe.

The Bank of England is content to keep an eye on developments, partly because it thinks the spread of both electronic purses and cyber-banking will be very slow. Even if it expanded rapidly, it would still account for only a tiny proportion of the money supply for a long time because it is starting from near zero.

Perhaps this is right. After all, the initial Mondex trial in Swindon, which ended recently, was not marked by a huge take-up of the electronic purses.

Yet the Bank could be in for a surprise over the speed with which Internet transactions take off. It is a phenomenon unto itself, with an estimated million new users a month, and something whose utility those users swiftly discover. After all, from that first inquiry on day one, the number of daily hits on the Bank's own Web page has grown to 75-100, and climbing.

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