Bitcoin transaction to credit card. Currency exchange concept

Extraordinary Ordinary Things: Credit cards and beyond

The first part of this two-part blog, published last month, explored the fundamental ideas of money. Here are some key things to bear in mind as we continue our exploration of this endlessly fascinating subject.

  1. Money is a universal token (metal coins and paper bills) having a value that is expected, but not guaranteed, to be stable over time and is trusted by the people. This trust is usually established by a national government issuing and standing behind its currency (dollars, euros, francs, kroners, pounds, pesos, etc.).
  2. Money is a great facilitator of exchange transactions (buying and selling), the core of commerce.
  3. Money has no intrinsic value. Even when money is equated with silver or gold, the value of money can fluctuate with the prices of these metals.
  4. Money must move quickly and seamlessly from one place to another in today’s largely integrated worldwide society, which was not previously the case in local, largely isolated agricultural societies.

In short, to a large extent, the legitimacy and value of money is whatever a national government says it is.

This part of the blog will focus on a recent major change in how money is used, notably the introduction of credit cards, and subsequently the debit card (collectively known as “payment cards”). And finally, what may be just over the horizon.

Universal Currency

I am old enough to remember when credit cards didn’t exist, or at least they didn’t exist in the form and for the uses we think of today. I can also remember when I didn’t want one because the term “credit” meant debt, and I didn’t want to be in debt. For me and many of my generation, it probably would have been better from the beginning to have called them payment cards, a terminology much in favor today.

Although credit cards began coming into general use in the late 1950s, I refused to have one until 1978 when I discovered that I no longer had any choice.

In 1974, I relocated to Brussels (Belgium) from the U.S. Four years later, I had to make a business trip to the States, where it would be necessary to rent a car to get to my various destinations. Recognizing that not having a credit card was already becoming the exception rather than the rule, I called the Brussels branch of the car rental agency and explained my situation. They said there would be no problem, but I would have to put down a deposit before I left and pay for the car in the U.S. either with cash or traveler’s checks.

When I arrived, I went to the car rental desk in the airport to claim my vehicle. After I had filled out the paperwork, the attendant asked for my credit card. I explained the arrangement I had made with the office in Brussels to pay by traveler’s check. He then asked for my passport. He looked at it, then turned to me and apologetically said, “I am sorry, sir, but without a credit card I can’t give you the car.”

“What! But it was all arranged in Brussels.”

“I understand,” he replied, “but you are an American. When you talked to the office in Brussels, they thought you were a Belgian. If you were a Belgian, there would be no problem, but since you are an American, I must have a credit card.”

At first I thought I was in a Kafkaesque nightmare. A foreigner could rent a car without a credit card, but a U.S. citizen couldn’t. He explained: “As a foreigner, you would have to leave the country within three months, so we could be pretty certain of getting the car back. As an American, you can stay here forever, so the risk of not getting the car back is substantially higher. Our only protection is a credit card.”

I couldn’t fault his logic, but it put me in a difficult position. I had several important meetings in several different cities, so having use of a car was imperative. Then I got an idea. I said, “My wife is with me. She’s Belgian. Could we rent the car in her name and pay cash.” “If she is not an American citizen, yes,” he explained. Problem solved!

After this experience I seriously rethought my reticence about carrying credit cards, which I very soon thereafter acquired. Now more than 40 years later, I am quite comfortable about carrying credit cards. In fact, I have two of them just in case one fails (it happens). I have no intention of collecting a wallet full of cards because I see no need for more than two. However, the thought of not having a credit card at all is as remote to me today as the thought of having one was on that fateful day four decades ago.  

But let’s travel back a bit further. Before credit cards, traveler’s checks were already well established, allowing people to avoid the need to carry around loads of cash when away from home. However this was an inconvenience; traveler’s checks had to be purchased before leaving on a trip with no way of replenishing them if you ran out before returning home.

Many people wrongly believed traveler’s check issuers made their money by charging a 1% fee on the purchase. To buy $1,000 of traveler’s checks, you would pay $1,000 plus a $10 fee, so the total transaction would cost you $1,010. However, this fee barely covered the issuing company’s overheads. Their real profits came from how people used the checks. On average, people paid for something with traveler’s checks only about six months after they had bought them. This delay between people buying and using the checks meant the issuing traveler’s check company effectively benefited from a six-month interest-free loan. Hence, this is how a flourishing industry was built.

Imagine you had a six-month loan that cost you nothing, which you could in turn put into a bank account paying 4% interest. This would mean that for every $1,000 of checks you sold, you would see a profit of $20 every six months, i.e. $40 each year by using someone else’s money, and at essentially no risk. Not a bad deal.

However, the traveler’s check companies weren’t quite so passive. Besides putting the interest-free loan into a bank, they also used it to build their business. In the beginning, getting people to buy traveler’s checks and getting merchants to accept them was hard work. So the market was very small and profits very low. By using the interest-free loan to expand the market, they also expanded their profits, eventually making traveler’s checks a very lucrative business.

The Convenience of Credit Cards

In the early days, credit card companies faced a similar challenge. People had to be convinced that an increasing number of merchants would accept their cards before they would use them. And merchants had to be convinced that allowing purchasers to pay with credit cards would result in increased sales, i.e. profits.

The invention of the credit card is often credited (if you will pardon the pun) to John Biggins of the Flatbush National Bank, which was located in Brooklyn, New York. In 1946, Biggins conceived the idea of banks issuing a card assuring merchants that purchases made on credit were guaranteed to be paid. People, of course, were already buying on credit, but this usually meant convincing each individual merchant of your honesty and integrity, and in particular your financial solvency. Otherwise, you paid cash.

The first major credit card, meaning you could use it far away from the issuing guarantor, was issued by the Diner’s Club in 1950, a company specifically created for this purpose.

Today popularly referred to simply as “plastic,” credit cards were originally nicknamed “plastic money.” It would probably be very useful if people got back into the habit of using this older term to remind them that the card only represents money; it is not actually money itself. Many people seem to forget this and thus use their “plastic” recklessly, impulsively buying virtually anything they want at the moment they want it. However, at the end of the month when the bills arrive, they find themselves in a bind. If they can’t immediately expunge the debt they incurred by using a credit card, they are subject to serious interest charges, up to twice or three times higher than bank interest charges.

How credit cards, and eventually debit cards, accelerated the movement of money

“Debit cards” are a later development. When the first credit cards were introduced, transactions were done on paper. The purchaser would show the merchant his credit card. Once verified, the merchant would give the purchaser a paper receipt and send a copy of the paper receipt to the credit card issuer, who would then credit the merchant’s account with the money due. All this took several days.

Debit cards became possible thanks to the development of electronic communication networks and powerful computer data processing programs.

Debit cards are linked to the cardholder’s bank account. The link to the cardholder’s account can be either direct, i.e. big banks issue their own debit cards, or through an intermediary debit card service company, allowing smaller banks also to issue debit cards.

When a purchase is made, the merchant enters the data into his remote terminal, which is then electronically transmitted to the cardholder’s bank. The bank then quickly makes payment directly from the cardholder’s account into the merchant’s account. Since there is no credit involved, there is no interest charge. If the cardholder doesn’t have enough money in his or her account to cover the cost of the purchase, within limits the bank will pay it anyhow and charge a fee for the overdraft.

Charging for overdrafts is only one way debit card issuers make money, and certainly not the most important. A principal source of profits is the fee the card issuer charges the merchant on each transaction. In the early days when the market was small, many merchants found this charge discouragingly, if not prohibitively, high. Today, the market is huge and the charge is much lower, but still very lucrative for debit card issuers. 

Credit cards and debit cards (payment cards) are marvelous inventions; the modern world could hardly function without them. However, rather being thought of as “plastic” (i.e. something different from money), they should be viewed as a kind of “financial palliative.” They help you get over the momentary hick of not having enough money with you and make it unnecessary to walk around with loads of cash on your person. Contrariwise, thinking of payment cards (credit and debit cards) as not being money (or at least something very closely linked to money) can do serious damage to your financial health.

Computers, Credit Cards, and Cryptocurrencies

Before computerization, the use of credit cards was relatively easy for the purchaser, but less so for the merchant and the infrastructure behind the transaction.

For example, before computers the merchant didn’t have direct access to the credit card issuer. When a purchaser wanted to use a credit card, the merchant first had to verify the purchaser’s signature against the signature on the card. Next was a call to the bank, which in turn had to call the credit card company. A credit card company employee then had to manually look up and verify the card hadn’t been counterfeited or stolen, and the amount of the purchase would not exceed the purchaser’s credit limit.

Computerization entered the picture in 1973 when Dee Hock, the first COO of Visa, introduced a computer-based system that reduced purchase transaction time to about one minute. This encouraged more and more merchants to accept payment by credit card. However, until payment terminals and data transfer systems became significantly faster (today one minute is considered a long time) and more reliable, many smaller merchants still accepted credit card payment only for fairly low amounts and often only from stable, well-known customers.

What may be considered modern high-speed, computerized, credit-card transaction systems came into being only about 20 years ago at the turn of the 21st century.

From paper to plastic

Today, even very small merchants without a payment terminal are a very rare sight. Probably even rarer is someone like I used to be who refused to carry credit cards at all. I would feel naked without one.

As a pointer to the future, a small but growing number of merchants have stopped accepting cash for purchases. They accept only plastic. So while that wad of paper in your pocket may still be legal tender, more and more it is no longer accepted as money.

But, then, is all that paper still money? Indeed, it is. However, the payment card  isn’t and never was. As explained in Part 1 of this blog, money is essentially what a government says is money. No government has ever said payment cards are money.

Perhaps the best way to look at these very useful pieces of plastic is as keys to unlock the vault at your bank, where the real money is located. When you use a payment card, what you are actually doing is authorizing the merchant to unlock the bank vault and take out an agreed some of money. The idea that those plastic cards are actually money is false. However, they represent money and should be used with the same care as you would with real money in the form of paper and coins.

For the sake of completeness, it should be noted the statement that your real money is actually located at your bank is somewhat misleading. Chances are it isn’t, for the very good reason that requiring that your money be physically located at your bank would greatly impede commerce. And also because it would be impossible.

Generally, your bank must be able to supply you with your money (paper and coins) whenever you ask for it. However, the business of a bank is to lend money. This means what it has in its vault will always be less than what it has taken in as deposits. Laws regulate the amount of money a bank must hold in its reserves to meet day-to-day withdrawal demands. Money to meet day-to-day withdrawal demands is usually located in each of the bank’s branches. Money to meet exceptional withdrawal demands is usually located in the bank’s central vaults, but not necessarily. Wherever that money is physically located at any given moment is irrelevant. The important thing is the bank must have access to it virtually on a moment’s notice.

The fact that the business of a bank is to lend money leads to the point of major confusion about terminology (real money, virtual money, etc.) mentioned earlier.

It is often said that by lending money, banks actually create money. How? Suppose a bank has on deposit $100,000 (obviously a real bank would have much more). If the bank just keeps it in the vault, this money lies dormant. It has no effect. However, if the bank lends out $50,000 to borrowers who want to do something with it, the money wakes up. It’s like adding $50,000 to the economy that wasn’t there before. In a sense, the bank has “created” $50,000 of new money.

But is borrowed money real money or simply an I.O.U. (promissory note) masquerading as money? To most laymen, if you can spend it, it is real. However, economists can’t be so sanguine, because how they view borrowed money can strongly influence their economic forecasts and the advice they give governments on creating or maintaining a vigorous, growing economy. In turn, whether that advice is accepted, rejected, or distorted depends on whether politicians and the public believe banks somehow create money out of nothing. They don’t.

The fact that today we do so much of our buying and banking online (we never actually see the money) has led to the realization that most money is not physical cash but rather records in a bank’s electronic ledgers. In fact, economists estimate that only about 8% of the world’s money is “real money” in a physical form such as bills and coins; the other 92% is “virtual money” in the form of electronic inscriptions.

Currency for the digital age

A more recent term suggesting physical money may be losing it hegemony is “cryptocurrency.” The bitcoin is the most well-known example of a cryptocurrency.  However, there are many, many others (at last count more than 1,300) and probably more still on the drawing boards.

The point has been made that to a large extent, real money is whatever a national government says it is. But even this isn’t entirely true.

Have you ever attended a carnival, school fete, or other local event where you could not use the legal tender (real money) of your country to make purchases inside? Instead, you were required to convert your currency into local script (bills and coins) especially printed for the event. The principal reason for this is psychological. Because it doesn’t look like the legal tender you are used to, you are likely to spend more of it, which is the purpose of the carnival or fete in the first place.

However, the fact that it is not the legal tender of the country does not make this script virtual money. Why? Because within the confines of the carnival or fete, it is the only money you can use, so it has to be real money.

We can extend this idea a bit further. Some popular historical sites and even small villages occasionally employ the same tactic. You are required to convert your legal tender into the legal tender (real money) of the locality, which is the only thing you can spend there. When you leave, you convert whatever is left of the legal tender (real money) of the site back into the legal tender of the country.

So what about cryptocurrencies? Can they be considered to be real money? The answer isn’t all that clear[. Although some companies have declared the aim of making their particular brand of cryptocurrency real money alongside or even replacing national currencies, this was not the reason for their invention.

As noted elsewhere, for modern, worldwide, integrated economies to function at peak efficiency, money must be able to move from place to place as quickly and securely as possible. The purpose of bitcoin, the first successful cryptocurrency, and the other 1,300-plus cryptocurrencies that have followed in its wake is to do just that.

Transferring money quickly and securely via electronic impulses has been a reality for a few decades, ever since computers and the infrastructure to support such movements became available. However, for people who depend on quick and secure movement of money, some serious problems still remained, which bitcoin in 2008 seemed to resolve.

I will not go into them, because the problems are really quite technical. Rather, let’s look at the solution purportedly brought by cryptocurrencies.

But first keep in mind cryptocurrencies further muddy the waters of virtual money. Bitcoins, for example, are created by an expensive process called “mining” that can be done by anyone with a sufficiently powerful computer. However, mining is not sanctioned by any bank or government. People who own bitcoins acquired them through transactions or by purchasing them through a bitcoin exchange. The value of a bitcoin floats in the stock market; in December 2017 a bitcoin sold for $20,000, in March 2019 the same bitcoin would fetch only $4,000. In many ways bitcoins act like a currency, but are not. It is not really borrowed money, either.

Despite the term, cryptocurrencies are rather a subclass of virtual money. The fundamental purpose of cryptocurrencies is to quickly, securely, and anonymously make an electronic withdrawal (debit) from a financial account of one company or organization anywhere in the world and to electronically deposit (credit) it to the financial account of another company or organization anywhere else in the world. And that’s it. There is nothing more to it.

To be slightly more technical, cryptocurrencies are digital representations of money, with elaborate cryptographic protocols to maintain their integrity and prevent double spending.  Users can transfer cryptocurrencies under anonymized names (typically, their public keys) without having to reveal their true identities.[

The foundation of the developing cryptocurrency revolution is a data transmission and storage system known as “blockchain.” And the name aptly describes it. The system is built up in chains of individual data blocks with each block containing around 100 transactions. Blocks are chained together with links called “hashes” that depend on the content of the block. By design, blockchain hashes are very expensive to compute. A change in a block is expensive because you have to re-compute its hash. Then you have to re-compute the hash of the next block because its back-pointer to the current record is the hash, which changed and is part of the block’s content, affecting its hash.

While the plethora of cryptocurrencies have certain individual characteristics, virtually all of them claim to have a number of characteristics in common. However, such claims must be taken with a grain of salt. Although theoretically strong, cryptocurrencies are not immune to the genius of hackers. It’s just that hackers need to be more ingenious than ever before. And they are. Losses of millions of dollars have already been documented and there is reason to believe that many more are just waiting to be uncovered.

Demystifying Cryptocurrencies

Here are some of the claimed common characteristics of cryptocurrencies, and the reality of those claims:

  1. Irreversible. After confirmation, a transaction cannot be reversed, i.e. no one can meddle with a transaction once it has gone through.

    This is false. Anyone with sufficient computer power to modify a cryptocurrency’s underlying operating system can indeed meddle with a transaction. Extremely expensive, but doable, and has actually been done.
  2. Anonymous. Real people are never identified in cryptocurrency systems.

    This is true. Individuals are known only by so-called numerically encoded public keys. Their real world identities are not recorded anywhere in the system or any ledger.

  3. Rapid. Transactions are sent across the network almost instantaneously. Confirmation of the transaction requires only a couple of minutes. Rapid confirmation is vital. As long as a transaction is unconfirmed, it is can be forged. However, once confirmed, it is completely protected. It can be neither forged nor reversed. It is fixed for all time.

    This is false. By design bitcoin transactions take around 10 minutes to be recorded. That is a lot longer than the two seconds for approval you get in your supermarket and is longer than the original Visa.

  4. Location independent. Transactions happen over a global network of decentralized computers, so it makes no difference if a transaction is between persons just across the street or completely the other side of the planet.

    This is true.

  5. Secure. Because cryptocurrency funds are locked in numerically encoded public keys, only the key owner can send cryptocurrency. Combining the key with strong cryptography and other features makes it virtually impossible for an intruder to break into the system.

    This is false. As noted above, hacking the system is extremely difficult, but not impossible.

  6. Totally open. To use cryptocurrencies, you only have to download free software, then start using it. There is no application; there is no gatekeeper.

    This is true.

Cryptocurrency transactions are said to be “peer-to-peer” because they involve essentially only the sender and receiver of the currency transfer without going through any central computer or any other kind of centralized authority. However, through the miracle of computing, the two parties can be on opposite sides of the world rather than right next to each other.

Looking Ahead

Will cryptocurrencies ever become real money, i.e. accepted like national currencies are today? The rapid growth of cryptocurrencies among businesses (and to a lesser extend individuals) suggests just such a possibility. However, there are a number of significant impediments in their path.

The most obvious is the vast array of cryptocurrencies. This would be way too many for them ever to be accepted the way the hundred or so national currencies are accepted today. Most of these competing cryptocurrencies would first have to disappear, leaving the field open to only a handful of them.

However, there are two other factors that would seem to be considerably more important.

The first is the weight of history. For hundreds, even thousands of years people have equated money to something tangible. Notably gold and silver, and later trust and confidence in national governments for paper money detached from gold and silver. Cryptocurrencies are only secured electronic entries in secured electronic ledgers. There is nothing tangible about them, neither gold, nor silver, nor paper. Nothing. The modern world seems to be changing at a dizzyingly rapid pace. However, overturning ingrained ideas dating back virtually to the dawn of human society is likely to take generations rather than years or decades. If it ever happens at all.

Secondly, national governments are unlikely to give way to cryptocurrencies without a stubborn, protracted fight. Remember, what counts as real money is closely related to the idea of country and national sovereignty. Even countries that share a currency, such as the European Union euro, need to feel they still have some say over how that currency is used. Certain countries, notably but not exclusively the United Kingdom, declined to join the euro for fear of losing a significant component of their national sovereignty. Handing over the definition and regulation of real money to private companies would not only seem to be a radical idea, but a restructuring of all of human society.

Moreover, governments are legitimately concerned that cryptocurrencies are being used for money laundering and other criminal transactions (e.g., ransomware).

It is not unthinkable that sovereign countries could develop their own cryptocurrencies just as they have developed their own metal and paper currencies. But this seems highly unlikely. A battle to preserve the status quo (with perhaps some minor tweaks around the edges) thus seems to be very much on the cards. So buckle up and brace yourself for a long, bumpy ride.