The Monetary Reform: Part 2 – Looking At the Root Causes

Series: Iceland monetary reform

After a near death experience of its banking industry during the 2008 global financial meltdown, Iceland looks hard at the root causes of the crisis and contemplates the reset button to its monetary system, a system which shares the same characteristics and ills with the ones used by all major economies.

A recent report commissioned by the prime minister of Iceland lays bare in laymans’ terms the root causes of the 2008 collapse of the country’s banking system, the same set of core problems which permeate the rest of the monetary and banking systems of the world.

The possible outcomes to the monetary end game and the subsequent reset range from tolerably painful to devastating hardship and chaos. Part 3 of this series examines one which sits on the hit-me-gently end of possible monetary reset scenarios championed by a most unexpected tiny island nation of Iceland.

Hit by the global banking crisis in 2008, Iceland took a drastically different path from the rest of the Western economies captured by banking interests. Six years later the country stands to show the world what success looks like by doing the right thing.

(Note: Read Part 1 for an overview of the Icelandic banking system and chronology of its banking crisis.)

At the outset of the financial crisis, the tiny island nation of Iceland took a different path from the rest of the world including the greater economies of the US, Europe and Japan. Instead of accepting the mainstream “nobody saw this coming” narrative and dutifully lining up to be sheared like sheep, the people and a small set of courageous politicians had the spine to stand up to the banking cabal and refused to pick up the tab for the private bets by the bankers gone horribly wrong. They did the right thing instead – took over the banks, prosecuted the ones responsible for the banking collapse and refused outside pressure to stick the bill to the commons.

With this backdrop, the monetary reform proposal outlined in “Monetary Reform – A better monetary system for Iceland” examines the fundamental root problems of the country’s existing monetary and banking system over the past decades and tries to address them instead of coming with yet another set of half measures to patch up the existing system.

The report provides a good historical overview of its banking system, how it currently functions, a proposed new monetary scheme and how to transition from the current to the new scheme. Though lengthy, the 110 page report is free of the gobbledygook or ‘Fed speak’ typical of economic policy whitepapers. Instead, it is a pleasantly easy read and is recommended to be read in its entirety (link) for those who want to dig deeper than a cursory interest in the subject.

Fundamentally, the monetary and banking problems can be boiled down to one single element – money supply:

  • Who creates money?
  • How much money should be created?
  • Where the new money supply should be used?
  • What are the safeguards for depositors’ money?

Who Creates Money

Under the current banking system governing Iceland as well as practically the whole world over, the creation of money or credit of different forms is supposed to be done primarily by two entities – the central bank and the deposit taking commercial banks (ignoring the investment banks and the role of the shadow banking system for the time being).

The central bank issues notes and coins which are circulated in the economy. As banker to the banks, the central bank also creates central bank reserves which allow commercial banks to make payments to each other by transferring reserves between their respective accounts created for them by the central bank.

The commercial banks create money into existence by creating deposits when they lend or advance loans to individuals or businesses. Contrary to popular belief or what is written in economics textbooks and being taught in economics classes, a commercial bank does not require money from a saver before it can make a loan to a borrower. The money is simply created out of thin air, and the overall money supply increases by the same amount as the loan just created.

In the case of Iceland, 91% of the money supply is created by commercial banks while 9% is created by the central bank.

“Monetary Reform – A better monetary system for Iceland” does a great job debunking the conventional yet grossly incorrect conception on money creation taught in economics classes and explaining how this widely misunderstood mechanism works. A condense version can be found in “Primer on The Widely Misunderstood Money Creation Mechanism”.

How Much Money to Be Created

Another serious flaw with the existing banking system has to do with how much money creation is optimal for the economy and who gets to control the amount created. In theory, the central bank holds that decision and uses the following policy tools to affect the amount of money created:

  • Policy rates – by setting the policy rate paid by the banks, the central bank hopes to influence rates set by the commercial banks to borrowers, and, in the process, control the demand for loans. The problem with the policy rate as a tool is that during periods of asset inflation, expectations on assets going up in price exert a much stronger influence on borrowers than interest rates.
  • Capital requirement – the ratio of capital to assets (loans made by the bank) which the bank is required to maintain (typically about 8% as per Basel Capital Accords). The problem with this tool is multifold, not the least of which relates to the fact the assets are risk-weighted, meaning that the banks can simply overestimate the quality of their assets. Another serious problem with said tool is that through the process of ‘securitization’, banks’ assets are often packaged and shifted to other ‘special purpose vehicles’, off of their balance sheets and, therefore, reducing the banks’ on-balance sheet assets.
  • Reserve requirement – by fine tuning the reserve ratio and quantity of reserves provided to banks, the central bank limits the amount of loans allowed to be extended by the banks according to money multiplier model commonly taught in economic classes. In realty, however, strong evidence suggests that banks create loans first and look for reserves later, and there have been few to no cases where the central bank would refuse to create the reserves sought by the banks.

With profits coming from extending loans created out of thin air, commercials banks have all the incentives to expand their loan portfolios legally, or illegally as repeatedly proven, within this current monetary framework.

In the fourteen years from 1994 to 2008 broad money in Iceland grew tenfold while its nominal GDP managed to triple. And between 2003 – right after two of Iceland’s largest banks were privatized – to the fall of 2008, the money supply grew seven-fold or roughly 40% a year. Clearly the policy tools at the central bank’s disposal failed to contain the explosion of money supply.

Iceland broad money supply creationBroad money supply created by the central bank and depository banks in Iceland.

Where Should the Created Money Go?

Whereas the central bank has little control over how much money gets created by the commercial banks, it has absolutely no control over where the newly created money goes.

In the case of Iceland, as is the case elsewhere, the majority of the credit created was lent to borrowers that invested in existing assets while only a minor share was lent into the real economy (to fund new businesses or invest in new technology, for example). In other words, most of the extra money was created for financial speculation and to fuel asset bubbles.

What Are the Safeguards for Depositors’ Money

This bonus problem has to do with the safety of depositors’ money within the banking system.

In case you are still not aware of the fact that your money is no longer your money once it gets deposited into a bank account, you need to read the following paragraph carefully and keep doing so until this concept is firmly pounded into your head. Here it goes:

When you deposit money into a bank account, the money you put in becomes the asset of the bank.  The deposit becomes a credit to you and simultaneously a liability to the bank. You become an unsecured creditor of the bank in the process. Unless otherwise withdrawn, the bank gets to use that money for whatever purpose it sees fit. You get to earn interest for lending your money to the bank. Oh, by the way, that interest is about zero right now. Minor detail.

The problem with the above is multifold.

First, in a fractional banking system, many times the amount of depositors’ money is lent out by the banks. The assumption is that not too many depositors would demand withdrawal of their money at the same time at any given time. However, when they do, as so often happens in the event of the onset of a  banking crisis, the resulting bank run could quickly topple an otherwise functioning bank. In other words, the fractional banking system is built on faith in the system, the lack of which would cause the whole house of cards to collapse.

Second, the banks are free to deploy depositors’ money as they see fit as mentioned before. In a world where there is no separation between depository/commercial banking (business and personal loans, mortgages) and investment banking where the banks engage in speculative, unregulated and leveraged bets making extensive use of derivatives (see A primer on Derivatives) and other exotic instruments, inevitably some of these bets will go wrong and in a big way. When that bank blows up and if the deposit insurance is insufficient to cover the depositors, the depositors unwittingly become unsecured creditors in a long line of creditors trying to salvage whatever money they can from the carcass.

Which brings us to the third problem, and it has to do with deposit insurance. First and foremost, the amount in the insurance pool would be hopelessly inadequate in the event of a major bank failure. As the too-big-to-fail banks are getting even bigger and more concentrated since the financial crisis, any deposit insurance is guaranteed to get exhausted in no time, forcing the affected state to either bail out the banks, or, worse still, bail in the depositors. (check out the Bail-in At Your Local Bank series)

All in all, it all boils down to the following punch line:

The central bank has pretty much no control over how much money gets created by the commercial banks or where the newly created money goes, whereas the commercial banks have every incentive to create money. Like cancer growth, the money creation process runs with little control and the money supply continues to expand until it implodes under its own weight, at which point the governments and the public are pulled in to socialize the losses.

Part 3 of the series examines the Sovereign Money System proposal designed to address these fundamental root causes of Iceland’s banking crisis.

 

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Monetary reset

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