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