I have long railed against fractional reserve lending, duration
mismatches (e.g. banks issuing 2-year CDs and lending money for 15-year
mortgages), bank's ability to lend money into existence, and deposit
insurance.
Fractional reserve lending allows banks to lend out a near infinite amount of
credit with essentially no backing. Money inevitable creates asset bubbles,
but as long as the bubbles are expanding it appears the system is solvent.
Money that depositors believe is available on demand in their checking
accounts is not actually present at all. And banks are not required to hold
any reserves on savings accounts at all.
Deposit insurance is the epitome of moral hazard. It guarantees money will
flow to banks offering the highest yield. Of course, banks offering the
highest yields on deposits need to take the highest risks to be able to pay
that interest. Depositors do not care because the deposits are insured.
Iceland Ponders Radical Money Plan
I am somewhat surprised by this development, but Iceland is investigating a
banking system that will eliminate all of the above flaws.
The Telegraph reports Iceland Looks at Ending Boom and Bust with Radical Money Plan.
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".
"The findings will be an important contribution to the upcoming
discussion, here and elsewhere, on money creation and monetary policy,"
Prime Minister Sigmundur David Gunnlaugsson said.
The report, commissioned by the premier, is aimed at putting an end to a
monetary system in place through a slew of financial crises, including the
latest one in 2008.
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.
The Proposal
The proposal is a 110 page PDF called Monetary
Reform - A Better Monetary System for Iceland
The proposal describes in detail the problems of deposit insurance,
fractional reserve lending, and various moral hazards in a way that is easy
to understand. I encourage everyone to read the document as it debunks many
widely-held beliefs such as the money-multiplier theory of how money is
actually created.
The money-multiplier theory is widely taught and widely believed but totally
wrong as I have discussed many times.
Unfortunately, the proposal has a major flaw. It hands responsibility for the
creation of money to a panel. The document discusses that flaw in sections
9.5.3 and 9.5.4.
9.5.3 What if the money creation
committee makes mistakes?
It has been pointed out that the money creation committee may not possess all
the information necessary for creating the optimal amount of money for the economy.
The concern is that wrong decisions by the committee may lead to either
inflation or the economy failing to reach its potential.
It would be unrealistic to demand or expect perfect decisions on money
creation under a sovereign money system. But it would also hard to believe
that a committee tasked with creating the proper amount of money for the
economy would consistently create money to similar excess as the commercial
banks have done in the past.
9.5.4 Fear of government creating money to
fund its policies
Concerns exist that if governments are allowed to create money directly, they
will get carried away and create excessive amounts of money to pay for
vote-winning projects.
Under Sovereign Money, however, the government is not allowed to create money
directly. The decision to create money would be made by a money creation
committee, independent of government, on the basis of what is appropriate for
the economy as a whole. The committee will not have the power to decide who
benefits from its money creation or what new money will be used for. The
allocation of new money will be decided democratically by parliament.
What
is the Proper Supply of Money?
The obvious flaw is there is no all-knowing panel that has any idea what the
money supply should be.
Three Questions
- Would a panel be any better than the Fed?
- Would it be politicized?
- What increase in the amount of money is
necessary for growth?
I do not know the answer to the first two questions although it's likely that
the panel would be at least as good as the Fed, at least initially, if for no
other reason than the proposal corrects many of the flaws in the existing
monetary system.
I can answer question number three. The answer is zero. No growth in money
supply is needed to have a growing economy.
Please consider a snip from the eBook What has Government Done to Our Money? by Murray
Rothbard.
What “should” the supply of money be? All sorts of
criteria have been put forward: that money should move in accordance with
population, with the “volume of trade,” with the “amounts of goods produced,”
so as to keep the “price level” constant, etc. Few indeed have suggested
leaving the decision to the market. But money differs from other commodities
in one essential fact. And grasping this difference furnishes a key to
understanding monetary matters. When the supply of any other good increases,
this increase confers a social benefit; it is a matter for general rejoicing.
More consumer goods mean a higher standard of living for the public; more
capital goods mean sustained and increased living standards in the future.
The discovery of new, fertile land or natural resources also promises to add
to living standards, present and future. But what about money? Does an
addition to the money supply also benefit the public at large?
We may ask ourselves what would happen if, overnight, some good fairy slipped
into pockets, purses, and bank vaults, and doubled our supply of money. In
our example, she magically doubled our supply of gold. Would we be twice as
rich? Obviously not. What makes us rich is an abundance of goods, and what
limits that abundance is a scarcity of resources: namely land, labor, and
capital. Multiplying coin will not whisk these resources into being.
We may feel twice as rich for the moment, but clearly all we are doing is
diluting the money supply. As the public rushes out to spend its new-found
wealth, prices will, very roughly, double — or at least rise until the demand
is satisfied, and money no longer bids against itself for the existing goods.
An increase in the money supply, then, only dilutes the effectiveness of each
gold ounce; on the other hand, a fall in the supply of money raises the power
of each gold ounce to do its work. We come to the startling truth that it
doesn’t matter what the supply of money is. Any supply will do as well as any
other supply. The free market will simply adjust by changing the purchasing
power, or effectiveness of the gold-unit. There is no need to tamper with the
market in order to alter the money supply that it determines.
Aside from the errors regarding the amount of money
and who is in control of creating money, the proposal is an excellent
starting point for addressing many of the flaws inherent in the existing
fatally-flawed fiat currency scheme.
Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
