Iceland may have cure to bad banking

April 8, 2015

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Radical bank reform is mostly endorsed by academics, commentators and crackpots. So it is certainly worth taking note when a senior person in a real government calls for a top-to-bottom makeover of banks and the monetary system.

Admittedly, the suggestion doesn’t come from the U.S. Federal Reserve or President Obama. It comes from tiny Iceland, population 330,000. Still, Frosti Sigurjonsson is chairman of the Economic Affairs and Trade Committee of the nation’s parliament and the prime minister commissioned his report, “Monetary Reform, A better monetary system for Iceland.”

Besides, Iceland is a poster child for the current system’s weaknesses. Before the financial crisis, its banks turned the nation into a giant and seemingly successful global hedge fund. GDP, expressed in dollars, rose 150 percent between 2001 and 2007. Then it all went wrong. The banks all collapsed, bringing the currency and GDP down with them. In dollars, GDP is still about 20 percent below the peak.

“Monetary Reform” offers a better way. It is clear, relatively short (93 pages, not counting the summary in Icelandic) and persuasive. Sigurjonsson proposes a version of the Sovereign Money model of banking. Basically, this is the way a clever 12-year old would design a banking system.

Right now, adult intelligence is needed to understand what experts call fractional reserve banking. Although the government issues coins and notes, most new money is actually created through bank loans. The proceeds of each new loan are deposited in a bank, but no old deposits are destroyed, so the total funds which customers can spend increases.

The intelligent child trying to understand all this will feel something is wrong. Surely, she will say, all money should simply be created directly by the government. A sovereign money system satisfies the child’s reasonable requirement.

It works like this. Banks manage transaction accounts, which are effectively electronic forms of bank notes. Like a $20 bill, a transaction account balance is a claim on the economy which is registered with the national monetary authority. The bank is only a custodian, keeping track of the balances and executing transactions. Losses are impossible.

There is also some grown-up banking, known as investment accounts. The name explains the purpose – the bank invests the money in these accounts in economically helpful ways. Withdrawals from investment accounts are limited and final value is not strictly guaranteed. Although Sigurjonsson does not mention the possibility, investments would not have to take the form of bank loans. The accounts could also be designed to buy bonds and shares.

What is crucial is that the two types of account are kept strictly separate. Money is either kept for transactions or reserved for investments.

This sovereign money arrangement is a big improvement over the current banking system. It totally eliminates one of its big risks: losses and runs on current accounts. The money in transaction accounts is as sound as the central bank itself.

Sovereign money’s investment accounts also sharply reduce the current arrangement’s other great danger – of financial panics. These usually start when new money is no longer available to prop up prices. The pain is amplified as highly leveraged investors become insolvent. With sovereign money, the supply of funds is strictly limited in the first place, so investors cannot easily build up leverage. Bubbles will be smaller and less common.

Money creation is not always harmful. On the contrary, the supply of money should generally increase at roughly the same pace as output. Since banks do not create money in a sovereign money system, someone else must. Sigurjonsson proposes dividing the responsibility between a technical decision on quantity and a political decision on allocation.

The central bank does the legwork. Much as now, it would base its decision on the optimal money supply on employment, output, inflation and the state of the financial system. Unlike now, it would not use policy interest rates to prod banks or quantitative easing to push money into them.

Instead, the legislature would decide what form of distribution is most just and advantageous. Its choices include additional government spending, a citizens’ bonus and loans to banks and other intermediaries with strict instructions to fund businesses.

The clever child may not notice some important issues Sigurjonsson glosses over, for example foreign currency inflows and shadow banking. But children do know about greed, so even a 12-year can identify the largest flaw: sovereign money will be at risk as long as too many people want to make too much easy money from investments.

Still, the Sigurjonsson plan is a plausible blueprint for better banking and Iceland is a good place to start. The population may be embittered enough to try something new and the established global powers of banking would probably tolerate an experiment in this miniature economy. But they might regret it. The bankers’ lucrative money-creating power could be threatened by a monetary revolution which started in Reykjavík.

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