Sunday, March 16, 2014

Credit cards as media of account

What is this gas station using as a medium of account? Visa/Mastercard dollars or Federal Reserve dollars?

In this post I'll argue that in many cases, a nation's medium-of-account doesn't consist of base money issued by its central bank, but credit card money created by Visa and Mastercard. This may have some interesting implications for monetary policy. Whoever issues, creates, or manages a nation's medium-of- account determines the general level of prices, and this makes it a monetary superpower.

But before I get to that, let's revisit the meaning of the word medium-of-account.

I've written a number of posts on the idea of medium-of-account because it has always seemed to me like an important concept, although admittedly it's taken me a while to zero-in on a satisfactory understanding of the term. What I like about medium-of-account is that along with the ideas of unit-of-account and moneyness, it allows us to pretty much remove "money" from the list of terminology we use when talking about monetary phenomena. No single word is so widely-used yet so imprecise as money. And because of this, no word has bred as many bitter econblog battles. By splitting apart the various ideas associated with "money" and passing these meanings on to alternative words like medium-of-account, some of this morass can hopefully be unclogged.

Without further ado, here are the definitions. By the way, these aren't mine. I've picked them up from folks like Jurg Niehans, who coined the term medium-of-account; Scott Sumner; and Bill Woolsey—hopefully nothing has been lost in translation.

The unit-of-account is a word or symbol like $, ¥, £. Inherent in the idea of UOA is the subdivision of the unit, so that $1 is comprised of 100 cents. (1)

The thing (or things) that defines that unit is (are) the medium-of-account. When a merchant chooses to sell a painting for $100, for instance, he is selecting the unit in which he prices, say the $, as well as the specific medium that defines the $ unit. This last choice is important because dollars might appear in any number of different mediums, or forms, including Federal Reserve paper money, Federal Reserve deposits, branded private bank deposits, cheques, credit cards, and more.

Isn't it the case that a merchant chooses "all of the above media of account" when choosing to price in dollars? After all, one dollar is just as good as another.

Not necessarily. For instance, we know that in the early to mid-19th century a plethora of dollar-denominated exchange media circulated, much like now. There were dollar coins, which the U.S. Mint coined out of a certain number of grains of silver and/or gold. There were also privately-issued dollar banknotes, these being the most prevalent exchange media since coins rarely circulated. However, when merchants set sticker prices, the medium they had in mind when defining the $ unit was the less-common coin, not the more-prevalent notes. Notes were only accepted by merchants at varying discounts to their face value, despite the fact that most banknotes were branded as "dollars".

For example, if our merchant listed a painting for $100, then it could be purchased with one-hundred one dollar coins, or, alternatively, $102 in banknotes from a certain bank, or $103 from another.

If the value of all banknotes simultaneously inflated, what would happen to prices? Given that the value of the coin had remained constant, the merchant's price as well as the general price level would not have changed during this inflation. All that would adjust would be the varying discounts applied to the whole range of private banknotes. The painting would still be listed at $100, and it could still be purchased with the same quantity of coins, but it might take $110 or $115 worth of notes to purchase it.

However, if the U.S. Mint had chosen to reduce the quantity of gold or silver in a coin, then the merchant would increase his sticker price for the painting to $110 or so. The general price level would inflate.

So a unique feature of the medium of account is that the general price level pivots around the MOA's value. If the owner or issuer of the medium of account, in our example the U.S. Mint, has the wherewithal, it can control these economy-wide price changes by modifying the nature of the media it emits, say by reducing the metal content of coins. Few institutions have this sort of monetary superpower because only a few institutions create media that also happen to be media-of-account. Because 19th century private banks didn't issue media of account, they were not monetary superpowers.

Let's bring this back to the present. What is the modern medium of account? Who controls it and thereby earns the mantle of the U.S.'s reigning monetary superpower? Scott Sumner argues that central bank base money serves as the medium of account. I don't doubt that he's right. But in a large subset of transactions, I'd argue that Visa and Mastercard dollars are the medium of account. And this means that Visa and Mastercard rival (in theory at least) the Fed as monetary superpowers.

To understand why Visa and Mastercard dollars serve as media of account, you need to know a bit about how credit cards work. Merchants who accept credit cards as payment must pay a small percentage of each transaction's value to the credit card networks (comprised of the Visa and Mastercard associations, plus the banks that issue cards and process payments). So if someone buys $1.00 worth of stuff, the merchant might get $0.995, the remaining half cent going to the card network.

The fee that the merchant must pay varies by the quality of card. Basic cards might result in the merchant giving up 0.5% to 1% to the card network while premium cards, those offering better rewards, might bring a fee of 2-4%. Merchant fees have been rising over time, especially as card rewards become more exotic.

Merchants hate seeing credit cards, especially premium cards. They hate them because they are required to pay the card fees but cannot pass these costs off to the customer. Why? Well the best way to pass these costs off would be for the merchant to put a surcharge on each credit card transaction equal to the fee the card network charges the merchant. A surcharge policy would mean that it would cost any customer wishing to buy a $100 painting with Visa or Mastercard $102 or $103.

However, as a condition of using the card networks, merchants are prohibited from discriminating against card users. Surcharges are 'illegal'. Visa and Mastercard can extract these sorts of promises from merchants because they are oligopolies. If you are exiled from their networks for breaking their rules, you're as good dead.

So the upshot is that if a customer buys a $100 painting with cash (or debit), the merchant gets $100; if they buy it with a basic Visa card, the merchant might get $98; but if the customer buys it with a premium card, the merchant will only get $96. I'd hate premium cards too if I only got 96 cents on the dollar.

To get around these rules, merchants who accept cards have come up with an ingenious strategy: change the medium of account. Basically, the unit of account that merchants use, the $, stays the same, but whereas the merchant's original medium of account was Federal Reserve dollars, they now switch over to defining the $ in terms of Visa/Mastercard dollars. In the eyes of a merchant, a credit card dollar is only worth around 97 or 98 cents. Having adopted Visa/Mastercard as his MOA, our merchant will proceed increase his sticker prices by a percent or two across the board. The painting which retailed for $100 is now priced at ~$102. When someone buys the painting with a credit card, two dollars of this amount goes to the card network, leaving the merchant with $100. He earns the same real income as before.

This switch in MOAs allows our merchant to inflate their prices and thereby pass off card fees to their customers without illegally imposing surcharges. Fed cash has ceased to be the MOA, but will still be a popular exchange medium. But now customers who prefer paying in cash must request a cash discount at the merchant's till. Given the $102 sticker price on the painting, they should be able to buy the painting for around ~$100 Fed dollars.

Since Visa and Mastercard now manage the medium of account for a large proportion of American merchants, they have become monetary superpowers and can exercise their own brand of monetary policy. If Visa and Mastercard increase the rewards on their cards, merchants will be docked larger fees. Merchants will react by increasing sticker prices across the board. Thus we get inflation. If rewards are lowered so that the merchant is penalized less, then merchants will lower their sticker prices. This is deflation. These price changes are independent of any action taken by the Federal Reserve.

That's not to say that the Fed would have lost its monetary superpowers. It can still cause inflation or deflation by engaging in open market operations are adjusting the interest rate on reserves. However, in an extreme scenario, we could imagine the Fed's effort to increase prices being offset by Visa and Mastercard's efforts to decrease prices. A monetary battle of sorts could erupt.

I think that a good analogy to help understand this is to return to the 19th century example of dollar coins issued by the U.S. Mint. If gold prices rose, the price level would fall. But if the U.S. Mint were to simultaneously reduce the gold content of dollar coins, the MOA, it could entirely offset this fall and create stable prices. Just like the U.S. Mint can offset any change in the value of gold by increasing or decreasing gold content of coins, Mastercard and Visa as issuers of MOA can (in theory at least) offset any change to the value of Fed dollars by increasing or decreasing the reward content of Visa/Mastercard dollars.

An interesting bit of news worth pointing out is that in 2013, Visa and Mastercard finally allowed U.S. merchants to introduce surcharges on credit card transactions. I'd expect that merchants will slowly start to transition back to using Federal Reserve dollars as their medium of account. We should see the various types of credit cards dollars being priced at varying discounts to Federal Reserve dollars, similar to how banknotes in the 19th century were priced, with each note earning a discount relative to the dollar coin. Premium cards will face large surcharges, and regular cards small surcharges.

This means that in the U.S., Visa and Mastercard have effectively lost their monetary superpowers. They can no longer effect the general price level. In other places like Canada, however, courts have allowed the no-surcharge policy to continue, which means that Visa and Mastercard dollars will continue to be MOA. The card networks will remain as Canadian monetary superpowers.

There's a lot more material that I'd like to add to this already-dense post, but I'll hold off for now. In sum, in this post I'm "kicking the tires" of the basic definitions that folks like Scott Sumner and Bill Woolsey provide us. In applying them to the world around us, it sure seems to me like credit card media-of-account currently coexist with the standard Fed dollar medium-of-account. But I'm curious to see if others agree with my interpretation.

P.S. Here are two interesting tangents I plan on writing about next month:

1) A bimetallic monetary system has two media of account; gold and silver. When the market rate between gold and silver shifts, the system suffers from Gresham's Law. If we have a monetary system that uses Federal Reserve dollars and Visa/Mastercard dollars as the two media of account, what does a modern version of Gresham's Law look like?

2) The Fed gathers price data so it can better target a 2% decline rate in the CPI value of the "dollar". But if some merchants are pricing goods in terms of a different dollar medium of account, isn't the Fed gathering inappropriate data? If credit card networks are pushing up prices via fee increases, the Fed might misinterpret these changes as being Fed-inspired and adopt the wrong monetary policy. How might the Fed adjust its methodology to account for the use of credit card MOA?

(1) As Tom Brown points out, some economists describe the unit-of-account not just as a sign, but also as a fixed quantity of the medium-of-account. So if the unit of account is the $, and the medium-of-account is gold, than the number of grains of gold that defines the dollar is rolled into the concept of unit-of-account. Alternatively, we can leave the unit-of-account as a mere sign, and refer to the medium-of-account not just gold but a given quantity of gold grains. Thirdly, we could give the quantity of the medium of account that defines the $ an entirely different term, say the "Tom Brown multiple". As long as we remember that there's a sign, the thing that represents that sign, and the quantity of that thing then we can avoid unnecessary semantic debates


  1. JP Koning, nice post! ... I'm honored to have made your footnote! :D

    A lot of material there... I read it pretty fast (honestly I was looking for a resolution to my question I left for you before... and then saw you footnote. Lol).

    Very interesting... I'm going to go back and read it again.

    And regarding that footnote, you say "some economists" roll the definition (the "Tom Brown Multiple") into the UOA, but do you think that includes Jurg Niehans?


    1. I never did get a response from Woolsey BTW.

    2. I don't have a primary source on Niehans, only secondary sources, and they are contradictory. You can find out exactly what he wrote here:

      Niehans, Jiirg. The Theory of Money. Baltimore: Johns Hopkins University Press, 1978.

  2. “But in a large subset of transactions, I'd argue that Visa and Mastercard dollars are the medium of account. And this means that Visa and Mastercard rival (in theory at least) the Fed as monetary superpowers.”

    I agree and I would take it further. Most transactions are performed through non fed issued dollars actually. The price or accounting is always identical between commercial bank deposits and currency so they are both MOA. All dollars are interchangeable.

    1. Danny, we're not really agreeing. My point is that two types of dollars mentioned in my post are NOT interchangeable. Visa/Mastercard dollars trade at a deficit to Fed dollars. Secondly, the category of merchants I'm describing are NOT using both dollars as MOA, rather, they are using only Visa/Mastercard dollars as their MOA.

    2. I thought we were agreeing. Anyway...

      Mastercard and Visa dont extend credit. There is no such thing as Visa dollars. Look it up. They just facilitate EFT's. The difference in price if using credit cards is because of the payment system incurring extra costs. Always accounting in terms of dollars. Visa is just the means by which you move those dollars around.

    3. "Mastercard and Visa dont extend credit."

      Well, you're right that Mastercard and Visa don't, but the card issuing banks are extending 30-day credit to card holders. But I'm not really sure what this has to do with the point of my post.

      "The difference in price if using credit cards is because of the payment system incurring extra costs."

      Exactly, and those costs are precisely what gives rise to the Visa MOA.

      "Visa is just the means by which you move those dollars around."

      19th century banknotes were just ways to "move gold around". That each note incurred different redemption costs gave rise to a varying note discounts relative to the dollar coin. If banknote issuers had all conspired to make it illegal for 19th C merchants to put a discount on notes, then merchants would simply adopt banknotes as the MOA, mark their prices up, and accept coins at a premium (ie. offer customers a coin discount).

      Same thing.

    4. How could there be a VISA MOA if VISA is not money? A MOA needs to be money. No one is accounting for the transaction in terms of VISA dollars. The transaction is accounted for in terms of US dollars for US transactions. Do an online transaction and find me a quote in VISA dollars.

    5. "A MOA needs to be money."

      As I mentioned in the early part of my post, which I'm not entirely sure you read, the whole point of having terms like MOA and UOA is to avoid the use of the term "money".

      You probably mean is that the MOA needs to be highly liquid. Not necessarily. Read my post on Angolan macutes, 2nd last paragraph. You can have illiquid media-of-account.

      "Do an online transaction and find me a quote in VISA dollars."

      The photo above shows gas priced in Visa dollars.

    6. “As I mentioned in the early part of my post, which I'm not entirely sure you read, the whole point of having terms like MOA and UOA is to avoid the use of the term "money".”

      “And this means that Visa and Mastercard rival (in theory at least) the Fed as monetary superpowers.”

      “Few institutions have this sort of monetary superpower because only a few institutions create media that also happen to be media-of-account. Because 19th century private banks didn't issue media of account, they were not monetary superpowers.”

      So your trying to avoid the use of money while calling Visa and Mastercard monetary superpowers? Can you clarify this? In what sense are they monetary superpowers if they don’t issue money? I was under the impression that a medium of account needs to be a form of money.

      What media do VISA create if they don’t create money?

      “The photo above shows gas priced in Visa dollars. “

      It doesn’t say VISA dollars anywhere. It’s just quoting a price. Can you refer me to any specific place where some entity has quoted in terms of Visa dollars where it is clear that is the case? I use my Mastercard frequently and I never experience a price differential at all.

    7. "It’s just quoting a price."

      It's offering a cash rebate off the listed price, so the listed price is defined in terms of Visa dollars. Anytime a merchant gives you a cash rebate off of the sticker price, cash can't be the merchant's medium of account.

      "What media do VISA create if they don’t create money?"

      I'd say that the card networks create a short-term non-negotiable dollar-denominated credit instrument that yields rewards when spent, and when accepted requires a large redemption fee.

    8. “I'd say that the card networks create a short-term non-negotiable dollar-denominated credit instrument that yields rewards when spent, and when accepted requires a large redemption fee.”

      From Wikipedia: “Visa provides financial institutions with Visa-branded payment products that they then use to offer credit, debit, prepaid and cash-access programs to their customers.”

      The financial institutions offer the credit not Visa. It seems quite clear.

      So the clearing house for equity trades or any clearinghouse also issues a short-term non-negotiable dollar-denominated credit instrument because it charges fees to use the clearinghouse?

    9. Last comment from me on this thread...

      "The financial institutions offer the credit not Visa. It seems quite clear."

      Read my previous comment CAREFULLY. I said that the credit card networks create credit, and these networks are comprised of the banks, not just the Visa and Mastercard associations. Of course the associations don't issue credit! (See my definition of "credit card network" in the original post, or this comment.)

    10. Nobody is probably reading this anymore but just in case.

      “I'd say that the card networks create a short-term non-negotiable dollar-denominated credit instrument that yields rewards when spent, and when accepted requires a large redemption fee.”

      Im sorry it just doesnt make sense to me. So the networks issue two types of credit, one non negotiable as described above and the other which is the balances in your card are negotiable?

  3. If posted (credit) prices increase by 1% but the increase is rebated back (and the cash price doesn't change), then I'd say the true price level hasn't changed, even if a simple price index could be "fooled".

  4. I agree, but would point out those other $s also have their costs which are not necessarily transparent. It used to be checks cost 3% through fraud and other processing charges and even cash has costs in terms of counting and miscounting, shrinkage and theft, counterfeit, and even processing costs in terms of bank merchant account fees.

    1. I agree. The Fed forces par-clearing of checks upon its members, but that wasn't the case, checks would trade at at a discount to par. in the old days this discount would have varied by cheque-issuer since geographical distance would have created different costs for different banks, but now that checks are all digital I'd imagine the discount to par would be more uniform across banks.

  5. great stuff, I've always wondered why payment systems don't get more fundamental attention in macroeconomic analysis.

    I'll take a stab at 1... the relative prices between both MOAs could change if the surcharge/rewards are increased (I'm going to assume they have to move together)... It would decrease the convenience yield of holding cash both in your pocket and in your checking account (instead of needing money for constant purchases you basically need it only once a month to pay off your credit card balance)... So perhaps the price of assets with a lower convenience yield will rise as rewards/surcharges are increased?

    2) I actually don't think this one is too important. The purpose of price targeting is the stickiness of the sticker price. So... lets assume that the "dollar" price moves in exact proportion to the monetary base to make it easier to think about. If the sticker price is needing to move faster because surcharges are also increasing, the Fed should slow the production of base money so that anticipated price changes actualize.

    I'm not too sure, though, perhaps this one depends more on the wedge between the surcharge and the rewards (the provider of the payments system take) as that gets to the difference between the sticker price, the sellers take, and the customers expense.

    Three different prices for one good, this could get very complicated.

    1. Thanks, John.

      I'm still mulling over 1 and especially 2. On 1, in the old days when gold was artificially overvalued relative to silver, and a fixed ratio between the two metals was enforced by the mint, all the silver would flee the country. Silver can buy more in a nation where it is fully valued. If Visa dollars are artificially overvalued relative to Fed dollars, and a fixed ratio between the two is enforced, how do Fed dollars flee the country? Well, they don't have to literally cross over the border. They only need to flee to another store within the US that properly values them.

    2. The dollars wouldn't have to flee to change the relative prices between assets with a different convenience yield though, right? the supply can be fixed and just the demand/utility functions change.

  6. Merchants are no longer prohibited by network rules from passing on interchange fees to consumers. The major cc companies agreed to change their policies as part of an antitrust class action settlement last year.

    Some state laws may still prohibit the practice in a minority of states.

    1. I noted that point near the end of my post. In theory they should switch back to pricing in Fed dollars, but I'm wondering how long the switching process will take.

    2. I'll read more carefully next time! Anyway, I can think of better reasons to discount V$ to US$ -- what about the significant risk of charge-backs? Interchange fees are predictable, and the merchant will either eat them or attempt to pass through, depending on demand elasticity. Demand can fluctuate as locally as one corner to another, in the case of gas stations. Thinking of a particularly convenient station near my house that charges $.20/gal more than its neighbors across the highway on cc purchases; is this passing through a cost, or attempt to capture surplus cc convenience value at the merchant? Charge-back risk, on the other hand, is less predictable, and if merchants could legally and technically price it in, I imagine the spread could fluctuate. Would require some pretty gnarly POS tech to automatically calculate MOA value at the time of purchase...

    3. Great point. There's no potential for charge back fraud in Fed cash transactions. And whichever card company provides the more merchant-friendly rules would earn a smaller discount.

  7. Interesting. Imagine a single bank. Imagine a VISA transaction between 2 customers of that bank. Imagine those 2 customers have negative balances only (so they cannot withdraw cash and arbitrage VISA $ for Fed $). VISA provides daily credit. Sounds a lot like a central bank! Now, imagine two type of MOA, red MOA and green MOA ....... ahhh, just kidding.

  8. Your picture reveals that the station is using three systems of payment: cash, shell credit card and an assumed other credit or debit card. The unit-of-account appears to be dollars in all cases but what you are calling "medium-of-account" would be better called "system-of-exchange".

    The gas merchant has decided that three systems of exchange are acceptable for payment. He could post the price three times to clearly display the price demanded for each system but chose to display only the highest price, in this case, the price in the other-than-Shell-credit-debit system.

    I would judge that all three systems could be considered as "medium-of-account", but, if we were planning to use this transaction as part of GDP calculation, we had better learn the cash price because cash is the basis for all government payments and GDP should be based on cash prices.

    This thought raises an interesting question: would this gas sale be reported in GDP as the posted price or the discounted cash price? In other words, which payment system is being reported in gas sales (and auto sales or home sales), the "credit card" system or cash? Of course, this would relate to the inflation question and calculation.

    Based on my comments so far, I don't think I would consider that Visa and Mastercard are ISSUING medium-of-account, They (and the examples on different bank currencies) are all different payment systems, using the same unit-of-account. The next question is to agree on what constitutes the unit-of-account.

    I would suggest that economist use the same unit-of-account that is used to pay for government services. Usually government pays in cash but if government uses a credit card, then use the credit card figure as unit-of-account.

    1. Interesting point about GDP. It's similar to my point about CPI.

      "He could post the price three times to clearly display the price demanded for each system but chose to display only the highest price, in this case, the price in the other-than-Shell-credit-debit system."

      That's right. FWIW, here's a picture of a gas station that has actually chosen to display the price multiple times ie. it is using multiple MOA. That's fine when you sell one thing, but if you sell tens of thousands of things, having one MOA is far easier:

      And here's a station that has chosen cash as the MOA:

      "I would suggest that economist use the same unit-of-account..."

      I'm not sure what you mean here. In the US, everyone uses the same unit of account; $s. It's the MOA that differs.

  9. JP, O/T: Trying to figure out why Nick & Scott differ on a very simple hypothetical.

    1. I added an explanatory paragraph at the top to identify why I care... and a short wrap up at the bottom discussing my hypothetical vs reality. It's still a short post.

    2. And much thanks for taking a look!

  10. JP,

    massively OT - but became interested in your comment here, with my take on it:

  11. Almost a decade after your splendid post, Visa and Mastercard no longer prohibit surcharges in Canada either. However, hardly any merchants are using their new gained freedom.

    In fact, it seems to me that more and more are going fully cashless. (Which is bad for several reasons I won't get into here.) But for most merchants it makes sense: The cost of handling the cash, and the risk associated with cash, outweigh the fees charged by the banks who issue Visa and Mastercard cards; yes, even the premium cards.

    Some larger merchants try to find middle ground. Only one checkout of many may take cash. If a customer wants to get out quickly, they better pay with credit or debit card. But they still have an option to pay cash.

    There are other significant advantages of credit (and to a lesser degree debit) cards to merchants: The spending power of the customer is not limited by the arbitrary amount of cash the customer happens to carry.

    Furthermore, certain merchants can significantly reduce their risks by accepting credit cards (only), because they can charge an amount to be determined in the future. Think of after-the-fact charges with car rentals, hotel incidentals, telephone bills, gas station fleet cards, veterinarians, etc. Our local vet uses clients' credit cards like open tabs. Never once have I seen someone pay cash at that vet, and often people don't even show a credit card. It's already on file.

    Can't do with cash.

    To wit: most merchants hate credit card fees. But they dread cash, because it is even more expensive.

    In the European Union, they have reduced credit card fees to a minimum, by law. The result is that credit cards have become even stronger (while consumers lose their rewards) and will eventually become the MOA there, too. Cash use is declining more rapidly, and new entrants into the payment market can't gain a foothold, as due to their initially low revenue share they can't compete with the cheap credit cards. Sure, we get Google Pay and Samsung Pay and whatnot, but those are, again, based on credit cards in the background in most cases.

    Given all the aboce, credit cards are even more the media of account than a decade ago.