Understanding Intermediaries in Payment Systems — Introducing Liquidity to Law Students

So as I noted a few days ago, one of my annual rites of passage is returning to the University of Missouri each summer to teach Modern Payment Systems.  (Its always interesting to hear different people recall what the course was called when they were in law school — commercial paper, negotiable instruments, Commercial Payments, but I digress). This year, I decided to do something I have not ventured to do — teach the class through an article that I am writing on the role of payment intermediaries in consumer transactions.  (As an aside, I believe the material came across far more dynamic).

Each year, I introduce the course by starting with the central policies of liquidity and certainty as pillars of all payments systems.  Students that have had an economics background know certainty as the legal cornerstone to efficiency — but fewer students understand what liquidity is beyond the pale of converting something to cash; they don’t for example understand that liquidity can mean enabling something with cash-like qualities.  To explain liquidity (one of the central promises of negotiability) I turned the class into a mini-bazaar.  As a condition of staying in the class they must barter something to me in exchange for a cup full of M&M’s.  By exchanging goods, I tell them, we have established economic worth and created new wealth — I know my cup of M&M’s is worth a highlighter, bookmark, Lexis Flash Drive, or Starbucks card as the case may be. But, our economy has a problem — there is no certainty in the transaction.   A cup of M&M’s might be worth a highlighter to one, a flash drive or Starbucks Card to the next person.   The economy is far too personal to be effective as a predictive wealth creation tool.

So I suggest we create some established value — perhaps using M&M’s since everyone has some by now, there are several different types (colors) and people have differing amounts.  After we vote about which colors should have the most value (blue for some reason always wins and brown never wins — we still apparently value beauty over quantity since this year I made sure that every cup had more browns than blues — at least when evaluating has no real consequences), we decide that for convenience sake it would be better to have a central depository to hold our M&M’s and can issue statements of value.  After some prompting, we decide to forgo having to exchange the statements of value for M&M’s, and instead simply exchange the statements as having value in and of themselves — cut out the step of going to our M&M bank to collect our goods for later exchange.

So now, I ask the students in groups to consider the big question we have been building towards — if we are going to say that the paper is just as good as the things the paper represents, what kind of rules should be enforced to ensure that the paper (a) keeps its value; and (b) is accepted in the most places possible?  From this year’s class, here are some of their responses:

  • Establish some guidelines in which people can know the paper is legitimate
  • Have the government back the paper used in transactions
  • Enhance the value of the paper exchanged for goods over paper that is merely cashed in
  • Create co-ops of merchants that promise to the bank that they will  accept the paper regardless of who uses it for exchange
  • Insulate the market against forgeries by adopting standards of acceptance

These responses (amongst others offered) showed the intuitive reasoning that students can offer.   For example, students deduced that paper would only maintain is value if it were easily discerned as legitimate — either through formalizing the medium or through an outside body guaranteeing their performance.  Similarly, the students recognized that the paper could have value that varied according to the risk of the transaction — a principle idea behind discounting notes.  Finally, the students recognized the impact that networks have in payments — an idea that I will flush out more later.

In my next post I will talk about the constructs of liquidity and certainty — namely longevity, efficiency, and confidence.

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2 Responses

  1. Harry says:

    Very interesting idea. Thanks for sharing.

  2. A.J. Sutter says:

    Pedagogically that is a great idea. Philosophically, I’m not sure it explains anything about “wealth creation.” The certainty you have created is certainty about exchange value, but not certainty about the usefulness or marginal utility of the goods traded to each participant in the exchange.

    To arrive at a “predictive wealth creation tool,” you are simply quantifying the exchange values for each exchange, i.e. assigning a number to represent the “value” of a collection of M&Ms. However, this is better described (assuming money is wealth) as a wealth accounting tool. Indeed, in your classroom, the aggregate value was already known, before any exchanges occurred. Your economy doesn’t have any production, so nothing is being created.

    One could argue that wealth created through exchange is constituted by a surplus of marginal utility. You might feel that in exchanging a given sum for say, a flash drive you’ve gotten a bargain, whereas the seller might think the values are equal. The exchange value is less than the drive’s marginal utility to you; but by hypothesis the exchange value doesn’t capture this new-found “wealth”. If instead the marginal utility and exchange value are equal, no wealth is created. (Moreover, since the marginal utility of different individuals is not intercomparable, you’re really at sea in trying to quantify the aggregate “wealth” that has been “created” in your toy economy.)

    Modern formulations of neoclassical theory, such as revealed preferences theory, don’t help. They don’t eliminate the subjectivity, but simply assume that the increase in marginal utility is never less than zero. As Paul Krugman explains, “If the going price of widgets is $10 and I buy a widget, it must be because that widget is worth more than $10 to me” (NY Times, 2010/04/05, emphasis added). How much more is not knowable. But actually your classroom example muddies this. You condition acceptance into the class on the execution of an exchange. Therefore a student might be willing to accept a bad exchange — one in which the money received is worth less to her than the widget exchanged — in order to stay in the class. Your accounting tool captures neither the fact that the student’s marginal utility after the exchange (considered in isolation) might be lower than the exchange value of the thing she gives up, nor the amount by which her marginal utility increases from the knowledge that she will stay in the class. (In real society there are many such coerced exchanges, e.g. as a result of monopoly pricing, etc., without the offsetting externality.)

    Of course there’s another formulation of neoclassical theory, developed by Pareto, Slutsky, etc, which says that prices are orderings, and that absolute prices are meaningless. That too throws your predictiveness out the window. And there’s a pre-neoclassical theory of exchange going back to Aristotle’s Politics, which distinguishes between “natural” wealth acquisition (not creation) through exchange [χρηματιστικὴ κατὰ φύσιν] and “unnatural” wealth acquisition through exchange [χρηματιστικὴ παρὰ φύσιν]; the latter includes an exchange or series of exchanges whose ultimate purpose is to end up with a sum of money, gold, etc. Aristotle also holds that true wealth cannot be measured quantitatively in any case; and that what constitutes wealth (which we might call “use value,” although this is somewhat different from what Smith and Marx understood by that term) resides only in goods and services that have a benefit for society, not in whatever is capable of satisfying individual desires. (Bentham, Say and the neoclassicals threw out that constraint.)

    “Wealth creation” has become a modern catch-phrase to justify the benefits of markets. But it’s problematic to attribute it to exchange alone, and to measure it based on the value of exchanges (à la, BTW, GDP). Even if, contra Aristotle, measurable wealth has social meaning, and even if exchange alone, without production, could be sufficient to create such “wealth,” the quantity of “wealth” so created can’t be predicted, other than to assume it is zero (identity of exchange value and marginal utility).