Revolutionising MoneyTaking the power away from the banks
Since the financial crisis in 2008, industrialised countries have enacted numerous reforms to get the global economy up and running again. These have not not had the desired effect though, and economic growth is already on the decline again. This comes as no surprise to Icelandic politician and entrepreneur Frosti Sigurjónsson, who claims we haven’t yet addressed the root of the problem: our monetary system. Read More
Since the financial crisis in 2008, industrialised countries have enacted numerous reforms to get the global economy up and running again. These have not not had the desired effect though, and economic growth is already on the decline again. This comes as no surprise to Icelandic politician and entrepreneur Frosti Sigurjónsson, who claims we haven’t yet addressed the root of the problem: our monetary system. To better understand his ideas, let’s have a look at what happened in his home country, one affected very severely by the breakdown.
Once upon a time there was a small Nordic island with three banks. The banks were strong and rich. One day they decided to expand their business dealings to become even richer: They started handing out loans, lines of credit, and mortgages, and trading with other banks and business people from abroad. And as they did, they forgot about something very important: the money involved. With every loan, line of credit, and mortgage the banks gave out, they were handing out money. Suddenly so much money flooded the small Nordic island that prices rose by 18% in only six months! For as we know, too much money in circulation causes inflation.
There was another bank on the small Nordic island, the central bank owned by the government and thus – in theory – by the people. Initially, the central bank supported the three banks by extending them credit whenever they needed it. But when the central bank saw that there was too much money circulating on the island, forcing everyone to pay so much more for typical food and drinks like skyr, Þorramatur, and Brennivín, they tried to stop the three big banks.
But it was too late. In the meantime, the three banks had gotten themselves into trouble: Their foreign business partners did not want to trade any more, and were demanding their money back. The three banks asked the central bank to help them out like it had in the past. But by this time, the three banks had grown so much that the money they owed their trading partners was more than the central bank, the government or the people of the small Nordic island had. Like a fat man who has eaten too much Þorramatur and drunk too much Brennivín, the banks collapsed. The people’s money disappeared when the banks failed, and any remaining cash they were left holding was practically worthless.
The island had suffered what we call a financial crisis.
Iceland, a small island where the North Atlantic meets the Arctic Ocean, was hit tremendously hard by the 2008 financial crash and became a symbol of devastating effects of the global crisis. At the same time, it has recovered better than many other countries. As new crises loom – the IMF just released its annual report with new warnings for the global financial system – Frosti Sigurjónsson, Member of the Icelandic parliament and Chairman of the Parliament Committee for Economic Affairs and Trade, wants to put an end to the looming risk of financial breakdowns. Our financial system could be easily fixed, he explains, if we changed the way money is created.
Frosti, we have been taught that the central banks control the money supply. What went wrong in Iceland and in the world in the recent past? Did the central banks fail?
The problem is not limited to the banks or the central bank. It is also the current monetary mechanism, the fractional-reserve system, which does not work well.
Fractional-reserve banking means that a bank can accept deposits, give loans or make investments while holding reserves that are only a fraction of its actual deposit liabilities, where the central bank usually acts as lender of last resort.
This system has limited the central banks’ ability to control the money supply. At the same time, commercial banks have been given the power to create money.
But doesn’t the central bank control the money supply through the interest rate? When there is too much money in circulation, it usually raises the interest rate to make creating money more expensive for the commercial banks.
Between 2003 and 2006 the Central Bank of Iceland raised the interest rate to stop the huge money expansion and warned that the economy was overheating, but this did not stop the banks from expanding their money supply. The Central Bank of Iceland is not in control of the money supply you see.
Facing with a run on the banks in 2008, the Icelandic government nationalized the banks and restructured them using public funds. All over the world banking regulations are being tightened. If the monetary system is the problem as you claim, how helpful are these measures?
It is tempting to add more rules and regulations as was done with Basel I and Basel II, but in the end we need to reform the monetary system. As long as the bulk of our money is tied into the liabilities of commercial banks, the state will have no option but to guarantee these deposits to avert crisis. When a bank is forced to sell its assets quickly to payout depositors, this causes market prices to drop and gets other banks into trouble. The implied state guarantee of banks’ liabilities encourages risky lending. Plus, it gives an unfair competitive advantage to commercial banks. They can access cheap funding in the form of state-guaranteed deposits, while investment banks have to borrow funds at markets rates.
In the report you wrote for the Prime Minister of Iceland, “A better monetary system for Iceland”, you claim that the sovereign money system is a promising alternative to the existing fractional-reserve system. What would this alternative monetary system look like?
In a sovereign money system, private banks do not create money. All money, whether it is physical or electronic, is solely created by the central bank. Instead of relying on the interest rate to influence money creation, the central bank can directly control the money supply: New money is transferred to the government and released into circulation in the economy via government expenses or the reduction of public debt.
How did this happen?
When commercial banks extend credit, give out loans and mortgages, they create money. The Central Bank of Iceland must provide the banks with reserves so as not to lose control of interest rates. For decades, commercial banks have been expanding the money supply much faster than what was needed for economic growth. Between 1994 and 2008, the commercial banks in Iceland expanded the money supply nineteen fold, and the central bank was forced to provide new reserves to accommodate the banks. This system was a contributing factor to the various monetary problems in Iceland, including the banking crisis of 2008.
And who would decide whether and when to create money?
A committee that is independent of the government and works transparently would make such decisions, while the government would decide how to spend the newly created money, whether on public spending, the reduction of taxes, or repaying public debt. In this system, we have a separation of power between those who decide how much money will be created and how much will be spent.
What have reactions in Iceland been like following your report?
There has been some general interest, but less debate on the contents than I expected. The report generated a lot of interest in other countries though too. It was positively reviewed by major media and this attention from abroad has generated more interest locally.
If Iceland implemented a sovereign money system, what would happen to the commercial banks?
The commercial banks would continue to administer payments services for customers and act as intermediaries between savers and borrowers, but they would not be able to create money. The transformation could happen gradually over a number of years, so the banks would have time to adapt their operations.
But surely the finance lobby will never agree to have the privilege of creating money taken away from the banks. How do you plan to win them over?
After the crisis, most of the privately owned commercial banks in Iceland became state owned. The finance lobby will definitely object, but in the end it will be a decision made by our democratic parliament and not by lobbyists.
Iceland has a small economic system. If the sovereign money system were actually implemented, wouldn’t this put the country’s performance in the global economy at a disadvantage?
There are no obvious disadvantages. In regard to international transaction systems, it makes little difference whether the Central Bank of Iceland or commercial banks create the local currency. If you communicate the idea properly, show that this system creates greater stability for a country’s currency and therefore for its economy, it should not make the country any less attractive for foreign investors, nor affect exchange rates.
One of the advantages of commercial banks, one driven by interest in profit, was how fast they could react when it came to financing new business opportunities. We all know how long it takes governmental institutions to take a decision. Doesn’t this system make the money supply extremely inflexible?
Banks are quick to finance the purchase of existing assets, which creates financial bubbles, but not much real value. Banks have been less quick in financing new ventures and business opportunities in the real economy. The important question here is whether there will be enough credit available for people to buy houses and meet funding needs. This should be the case as long as the money supply grows in step with the economy.
Hand on heart, how high are the odds that a sovereign money system will actually be implemented in Iceland?
Elections are coming in the fall and the odds of reform will depend on what parties are elected. The current government, formed by the Progressive Party and the Conservative Party, have not reached consensus on reform. The Conservative Party has opposed it.
And in the world?
Small countries like Switzerland and Iceland may lead the way, and larger countries could follow later. Perhaps a bigger crisis is needed for them to make real changes. Muslim countries could be among early adopters of sovereign money, as it may be more compatible with Islam than fractional reserves are.