Academic journal article Economic Commentary (Cleveland)

A Beginner's Guide to the U.S. Payments System

Academic journal article Economic Commentary (Cleveland)

A Beginner's Guide to the U.S. Payments System

Article excerpt

High living standards depend critically on many types of infrastructure--both technological and institutional--that few fully comprehend. The payments system, the means by which funds are transferred between economic agents, is one such critical support.

The importance of technology in the payments system is undeniable, but technology is not enough to ensure that a payment instrument will be widely accepted. For example, the basic technology for financial electronic data interchange--high-speed electronic communications and computers--has been around for at least 20 years, but the institutional arrangements between those with access to this technology and their banks are still lacking.

Today's advanced economies could not function without an efficient payments system that, from the viewpoint of the user, can handle transactions throughout the world almost as easily as across the street. Modern business organizations could not flourish with anything less. The production of everything from automobiles to the new financial derivative instruments requires coordinating people and capital across regions to ensure that all parties will be paid for their services in a timely manner.

This Economic Commentary outlines the evolution of the U.S. payments system, with particular emphasis on the role played by the Federal Reserve. After examining exactly what the payments system is and how it functions, I present some of the technological and institutional challenges confronting the current system.

* PAYMENTS SYSTEM EVOLUTION

Describing how the payments system has developed over time illustrates how it depends crucially on both technology and economic institutions. Although no written record exists, the first exchanges must have been barter transactions. Barter requires locating someone who not only has the goods or services you want, but is also willing to take your items or services in exchange. These high search costs, plus the time spent haggling over the exchange rate for your goods relative to his, makes barter an expensive proposition.

A poorly functioning payments system can impose two types of losses on an economy. First, resources employed in completing transactions (time in a barter economy) are unavailable for other uses, resulting in reduced output of additional goods and services. Second, to the extent that transactions are costly, there may be less specialization of labor and capital than is desirable.

One of the first innovations in the payments system was settling on a common medium of exchange, such as precious metals or, in colonial Virginia, tobacco. A common exchange medium lowers search and haggling costs because now, all that matters is the price of an item or service in terms of the medium chosen. The seller can use the proceeds to purchase whatever he desires.

Precious metals were first used as a medium of exchange around 2500 B.C. in Mesopotamia. Their enduring popularity is based on the fact that they are nonperishable, easily recognizable, and small amounts generally command a large quantity of other goods.

Coins stamped from precious metals, which date back to 700 B.C., represented a significant advance over nonuniform pieces of metal because of their convenient form and their standardized sizes and metal content. Generally, the face value of a coin exceeds the worth of the metal it contains. Over time, this difference--known as seigniorage--has been a reliable source of revenue for mints, which tend to be government monopolies. People are generally more than willing to pay a small seigniorage fee for the convenience of carrying coins. An even larger amount of seigniorage can be extracted when the law requires that coins be accepted as payment for debts regardless of their actual precious metal content.

Paper money, which is backed by either precious metals or the compulsory power of the state, developed in eleventh century China. Paper represented another vast improvement in payments system efficiency because it requires relatively few resources to produce and is less costly than bullion or coins to transport. …

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