The Monetary Reform: Part 3 – Sovereign Money Proposal

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.

Monetary resetSince the near total collapse of the global financial system in 2008, our modern monetary system has been turned into an insane asylum where the world over is engaged in a game of extend-and-pretend trying to kick the proverbial can of the need for monetary reform further down the road.

With the ECB getting on board the last train of money printing or otherwise euphemistically labeled Quantitative Easing, as we argued in Draghi and the Chocolate Factory, there are growing signs that the end of that road is getting near and that the final end game is beginning to take shape.

There are many possibilities and outcomes for the coming end game or monetary reset ranging from a relatively painless and orderly transition to downright economic collapse and social unrest. One beacon of hope and an early glimpse of one such potential positive outcome come, surprisingly, from a most unexpected place and one of the tiniest of nations – Iceland.

Faced with the full frontal impact of the collapse of its banking system, the tiny island state did the unthinkable: they stood up to other major and bigger nations captured by the banking interest and refused to socialize the losses incurred by its largest banks from wrong bets they made in the financial casino and put the banking executives responsible in jail. And now they are talking about a new monetary system to fix the problems once and for all.

In the department of the Land of the Brave and Home of the Free, the courageous Icelandic people and some of their politicians put the current claimant to this title truly to shame.

Part 1 of this series on monetary reform briefly chronicles the turbulent history of Iceland’s monetary system, culminating in the collapse of its banking system amid the global financial crisis in 2008.

Part 2 of the series examines the root causes of our modern day banking system through the lens of the monetary reform proposal commissioned by the Iceland government, with a sidebar primer on how money is created in the real world (spoiler alert: very different from what you learned in economics classes).

In Part 3 of this series, we examine the key tenets of the Sovereign Money Proposal commissioned by the prime minister of Iceland with a view of coming up with a better alternative to the monetary system.

As argued in Part 2, the problems inherent with the Icelandic monetary system are identical to those plaguing the global monetary system and can be summed up in the following paragraph:

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 out of thin air to make money. Like cancer growth, the money creation process runs with little control and continues to expand until it implodes under its own weight, at which point the government and the public are pulled in to socialize the losses.

The Sovereign Money proposal lays down the following fundamental principles.

  • Who should create and control the money supply – this power should reside exclusively with the central bank. Private banks no longer create money.
  • Separation of creation and allocation of money – whereas the power to create money resides at the central bank, the power to allocate how the money is used rests with parliament.
  • Separation of monies – depositors’ funds earmarked for payment and transaction services are segregated from funds available to make loans, thus protecting the payments system from being sucked down the drain when banks fail.

With the above principles in mind, let’s look at the nuts and bolts of the proposal.

Creation and Management of Money Supply

In order to halt the uncontrolled expansion of money supply by commercial banks to the potential perils of and at the expense of the overall society, the power to create money is repatriated to the central bank which will control the creation of coins, notes and electronic money. Whereas electronic money currently exists in two forms, i.e. central bank reserves (used between banks and central bank) and demand deposits (used by banks and their customers), there is only one form of electronic money under the Sovereign Money System.

An independent Money Creation Committee (MCC) decides in a transparent process if and how much new money gets created or existing money gets destroyed. It is questionable such a body, independent as it may be, would have more collective wisdom than, say, the current Fed, to decide how much money to create. Nonetheless, such a system cannot possibly do worse than whatever system is in place currently.

This scheme substantially eliminates the risk of the power to create money being misused or abused by commercial banks for private gains. Instead of relying on indirect and questionably ineffective policy tools such as interest rates, the central bank now has direct control over the money supply.

Allocation of Money

Whereas the power to create new money rests with the central bank, the power to decide how the money is used is controlled by parliament. New money created by the MCC is granted to the government which decides how the money enters the economy (e.g. via increased government spending, tax reduction, public debt reduction or strategic lending to small businesses) according to its allocation plans approved by parliament.

The separation of power to create and allocate money substantially eliminates the conflict of interest inherent in any structure which posses both, as in the case with the current commercial banks.

Segregation of Transaction from Investment Monies

Commercial banks serve two major functions. They facilitate and administer payment and transactions among individuals, businesses and government. They also serve as intermediaries between lenders and borrowers. Although loan intermediation is an important function in and of itself, the facilitation of the payments system is absolutely vital to and underpins the real economy.

In the current fractional reserve system, roughly 90% of the money consists of bank deposits created out of the 10% of money received from the depositors. These deposits are liabilities of the commercial bank and their functionality of money depends on the banks remaining solvent. By association, the real economy, which depends on the functioning of such payments system, is also at the mercy of the solvency of commercial banks. That is the reason a government cannot avoid being drawn in to bail out a failing bank.

Under the Sovereign Money System, banks will offer two distinct types of accounts to customers: transaction accounts and investment accounts.

Transaction accounts are used for storing funds that are available on demand to make payments and transactions. They differ from existing accounts holding demand deposits by the following important distinctions:

  • Though managed by commercial banks, these accounts are held by the central bank. More to the point, they remain the legal properties of the account holders and do not become assets of the bank as in the case of the current scheme.
  • They do not earn any interest but instead incur account service expenses. In exchange, these accounts are risk free.
  • No deposit insurance is required for these accounts as a result.

Investment accounts store funds customers are willing to lend to banks and earn interests in return. These accounts are similar to present-day savings accounts but different in several ways:

  • They pay varying rates of interest in proportion to the account’s risk and duration.
  • They are liabilities of the banks. Money deposited in these accounts becomes the property of the banks. The banks promise to repay the account holders the invested amounts plus interest at a future date.
  • Deposits in investment accounts will not be available on demand. Customers will agree to either a maturity date or a notice period that will apply to the account.
  • Upon maturity of the investment account, the bank transfers the principle plus interest from its own account to the transaction account of the account holder.
  • Investment accounts are risk-bearing with the risk being shared between holders of the investment accounts and commercial banks according to the terms and conditions of the specific account. The amount of interest earned should be proportional to the level of risk associated with the specific account. In this regard, money investment accounts are very similar to investing in different types of bonds, mutual funds or other investment vehicles.

It is noteworthy to point out that when a loan is being made by a commercial bank, money is pooled from the bank clients’ investment accounts and transferred to the transaction account of the borrower. In contrast to the existing fractional reserve system, there is no increase in the quantity of money in circulation in the process.

Under the proposed Sovereign Money System, commercial banks continue to provide the function of maturity transformation whereby longer term loans are made available via a series of shorter term loans.  Note that the inherent problems of duration mismatches as a result of maturity transformation are not eliminated with the proposed system.

From the view of system stability, the account separation principle provides substantial and clear benefits compared to the current system:

  • The critical payments system is placed under the control of the central bank and is no longer vulnerable to bank solvency crises.
  • Short term funding, i.e. money set aside by businesses and individuals for payment and transactions, will not be become part of the commercial banks’ balance sheets.
  • It substantially reduces the risk of the state having to intervene at the expense of taxpayers when commercial banks fail.

Conclusion

It remains to be seen whether Iceland will follow through and adopt the proposed Sovereign Money System either in whole or in part. Whereas the proposed reform might work in a relatively small economy, whether it would scale in much larger economies involving currencies heavily used in world trades also remains a subject for further studies.

Instead of the prevalent mainstream debates centering on how to pile additional regulations on top of a financial sector already inundated with complex regulations, however, this conceptually simple yet radical proposal elevates the much needed discussion on a radical monetary reform/reset from academia and the fringes of blogosphere to the political mainstream.

 

References and further readings:

 

 

Monetary reset

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