Iceland considers a radical monetary proposal

I found this news intensely interesting.  If implemented, it would overturn a pattern of banking that’s taken hold over the past century.

Iceland’s government is considering a revolutionary monetary proposal – removing the power of commercial banks to create money and handing it to the central bank.

The proposal, which would be a turnaround in the history of modern finance, was part of a report written by a lawmaker from the ruling centrist Progress Party, Frosti Sigurjonsson, entitled “A better monetary system for Iceland”.

. . .

According to a study by four central bankers, the country has had “over 20 instances of financial crises of different types” since 1875, with “six serious multiple financial crisis episodes occurring every 15 years on average”.

Mr Sigurjonsson said the problem each time arose from ballooning credit during a strong economic cycle.

He argued the central bank was unable to contain the credit boom, allowing inflation to rise and sparking exaggerated risk-taking and speculation, the threat of bank collapse and costly state interventions.

In Iceland, as in other modern market economies, the central bank controls the creation of banknotes and coins but not the creation of all money, which occurs as soon as a commercial bank offers a line of credit.

The central bank can only try to influence the money supply with its monetary policy tools.

Under the so-called Sovereign Money proposal, the country’s central bank would become the only creator of money.

“Crucially, the power to create money is kept separate from the power to decide how that new money is used,” Mr Sigurjonsson wrote in the proposal.

There’s more at the link.

The creation of credit by banks is de facto the creation of money, because they’ve long since been allowed to lend money they don’t actually possess or borrow from anyone.  When you go to your bank to ask for (say) an auto loan, it agrees to lend you (say) $20,000 – but it doesn’t actually have $20,000 in its vaults.  It simply issues a check for that amount to the car dealer as if it had it.  It then bills you for regular payments over the agreed period of the loan, applying the principal payments to its ‘debt’ on its books and the interest payments to its profit.  In so many words, the credit has been ‘created’ by the bank as if it were cash.  The auto dealer is satisfied, because he got paid;  and the bank will be satisfied when you eventually repay the money.

Iceland’s proposal would profoundly change that.  Instead of being allowed to create credit at will, every bank would be subject to the authority of a central authority, which would dictate how much and what types of credit could be offered, and could also set capital requirements – for example, that a bank must possess (say) ten cents of capital for every dollar it lends.  That would automatically bring a screeching halt to the creation of unsupported credit. It would also ensure that banks scrutinize borrowers’ credit-worthiness much more closely, as they would now have ‘skin in the game’ and would no longer be able to absorb a default so easily.  (That’s not as difficult when you’ve created money out of thin air as it is when your actual deposits are at risk.)  So-called ‘sub-prime’ loans would almost inevitably disappear, except at ruinous rates of interest.

This is a very interesting proposal.  I don’t know whether Iceland will adopt it, but I’m more than half hoping it will.  It could have profound implications for finance in the rest of the world if it proves successful – although it would also put a radical crimp in economic growth that’s debt-dependent.  That might not be a bad thing, of course . . .

Peter