Yesterday (November 29, 2023), the Australian Bureau of Statistics (ABS) released the latest - Monthly…
In Part 1, I briefly outlined the Sovereign Money System proposal (SMS) advanced by the Icelandic government as a way forward in banking reform. I also demonstrated that the banking collapse in Iceland in 2008 could hardly be seen as being caused by the banks having the capacity to create credit. Much more was in play including the fact that banks had stopped behaving as banks and were serving the doubtful aspirations of their owners rather than any notion of public purpose. While the Icelandic report claims that the commercial bank lending destabilised the growth cycle in Iceland the reality is that it was other factors that led to the explosion of their balance sheets. The money supply did expand faster than “was required to support economic growth” but that is because the financial system was deregulated and the banksters and fraudsters were allowed to serve their own interests and compromise the national interest. As we will see that sort of duplicity can be reigned in with appropriate structural regulation without scrapping the capacity of the private banks to create credit. In this Part 2, I consider some of the mechanics of the SMS and argue that essentially we cannot get away from the fact that a central bank always has to fully fund a monetary system. If it tries to restrict funds yet maintain private bank lending then recession would surely follow and interest rates would rise beyond the control of the central bank. I also provide some ideas on where more fundamental monetary system reform is currently needed.
The Sovereign Money Proposal – flawed paradigm underpinnings
The SMS report is written in the context of an erroneous belief that the national government is ‘financially constrained’.
We see that when it claims that:
By delegating the creation of money to private commercial banks, the Central Bank of Iceland, and thereby the state, foregoes considerable income that it would otherwise earn from creating new money to accommodate economic growth.
First, banks do not have to be profit-making if they are publicly-owned and motivated to serve the public interest.
Second, there is a curious anomaly in the proposal in that it appears to be okay for the private banks to leverage profits from the ‘money’ created by the state (more of which later) but not from credit. I fail to see why we should make that distinction.
Third, and more importantly (to ensure this discussion doesn’t hinge on the ownership status of the banks), a national government and its central bank does not need income in order to spend the currency of issue.
It is simply a nonsense to worry about ‘income lost’ when considering the operations of a currency-issuing government.
We also see it when the Report claims the government has to “guarantee bank deposits” under the current system. This is alleged to promote ‘moral hazard’ – risky lending. Again this is really a regulative matter of limiting what banks can do with the assets creates.
It makes much more sense to regulate the asset side of the bank rather than the liability side.
This should also mean that the government should ensure the banks observe their ‘public’ responsibilities to advance public interest. I would ensure that through public ownership.
But it can also be done within a private banking system just as easily through appropriate regulation (see later).
But, the ultimate point the Report makes here is that:
Should any one of them fail, the insurance fund will not suffice to bail out all depositors. In such circumstances, the government will have to step in with taxpayers’ money to guarantee deposits.
Please read my blog – Taxpayers do not fund anything – for more discussion on this point.
The taxpayers use the government’s currency – they do not supply the spending capacity of the government.
A sovereign government is never revenue constrained because it is the monopoly issuer of the currency. The government is always capable of underwriting the deposits in the banking system.
In the case of a private bank failure, the government can always nationalise the bank, eliminate the shareholder interest (as recognition of the loss) and trade on as usual with all deposits intact.
The Sovereign Money Proposal – in brief
The Sovereign Money System (SMS) proposed by the Icelandic report has several features, which are shared with longer-standing positive money type proposals. In the following quotes CBI refers to the Central Bank of Iceland but generalises to any central bank.
First, “money creation and the payments system is separate from the risky investing and lending of banks”. The “private banks do not create money” and “all money, whether physical or electronic, is created by the Central Bank.”
The SMS private bank remains a speculative institution, however. They would offer two types of accounts:
- Transaction accounts – Individuals and firms will have “Transaction Accounts” held at the central bank with funds created by the central bank. Banks cannot invest these funds and there is no interest paid on them. They are not liabilities of the banks and therefore their status is independent of the viability of the bank administering them.
- Investment accounts – Banks will create “Investment Accounts” for individuals and firms which can accept funds from the Transaction Accounts. If then invested they are like a fixed-term deposit.
The bank makes profits by levying fees on the administration of the Transaction Accounts and by taking speculative positions with funds lodged in the investment accounts. So it is clear, that a bank can become insolvent under this plan if its investment portfolio fails.
The Transaction Accounts are different to the current system in that the funds are not “backed by risk-bearing assets and can only be withdrawn as long as the bank correctly manages its small stock of liquidity”.
In a currency-issuing nation, however, there is no fundamental improvement. Depositors’ funds are safe irrespective if the government is of that will.
However, in the SMS, the depositor is unable to earn interest on their savings unless they expose the funds to risk via lodgements to bank Investment Accounts.
Individuals will have to pay the banks (fees) to lodge their savings in Transaction Accounts. There is no change there as most banks currently levy account keeping fees.
Second, while the “commercial banks will no longer create money, they will continue to administer payments services for customers and will make loans by acting as intermediaries between savers and borrowers”. The Investment Accounts serve this purpose.
The banks will compete for custom and offer interest to those who wish to transfer funds from their Transaction Accounts into risky Investent Accounts, which provide the banks with the funds to engage in speculative bets.
Should the bets fail, the depositor loses. There would be no guarantees on these funds.
The fixed-term nature of these funds means they are no able to be used “to pay or settle transactions through the payments system, meaning that they are unable to use Investment Account balances as a form of money.”
The difference between the SMS in this regard and the current system is that loans do not create new deposits in the SMS:
… commercial bank lending in the Sovereign Money System does not increase the quantity of money in circulation; the act of making loans merely transfers pre-existing money from the bank’s Investment Pool to the borrower’s Transaction Account.
At first blush, a lot of people think that this means that bank lending becomes constrained and controlled by the central bank because the latter would determine the total pool of ‘money’ in the system.
But as we will see, the central bank would still be beholden to ‘fund’ the system through loans to the commercial banks should there be insufficient ‘money’ in the system at any point in time relative to the demand for loans from households, organisations, and firms.
The Money Creation Committee (MCC)
A crucial part of the SMS proposal is that:
The power to create money will be held by the CBI while parliament will decide how any new money is allocated. The power to create money is thereby separated from the power to allocate new money.
So you immediately see that the conservative mistrust of elected democratic government persists in this proposal.
The SMS proposal says that:
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.
I do not support frameworks where key economic decisions are handed to an essentially unaccountable body which then constrain the Parliament we elect to be our agents.
This would continue the voluntary system of constraints (albeit change the type) that conservatives place on governments to hinder their capacity to generate full employment.
I find it odd that we design systems that undermine our collective well-being and punish individuals severely (via unemployment and the resulting poverty) because we don’t believe our governments will act honestly or competently.
There needs to be much more work done at the grass roots level to ensure our political processes are improved. The process of candidate selection needs to be improved and local communities should resist any central imposition of preferred candidates to act on their behalf.
I would argue that political funding should be publicly provided and no lobby group funding accepted. Major electoral reforms are needed to to eliminate the influence of lobby groups, to reduce the power of media concentration etc.
Then we come to the Monetary Creation Committee.
The proposal says that:
Decisions on money creation will be taken by a committee that is independent of government and transparent in its decision-making, as is the current monetary policy committee.
So the central bank would increase the money supply in line with its inflation forecast and the target economic growth rate. So if they wanted to maintain inflation, say at 2 per cent per annum, and to support a 3 per cent real GDP growth rate, they would allow the money supply to expand at 5 per cent (which in theory would permit nominal GDP to grow at that rate).
I am told that complaining about the anti-democratic nature of this arrangement is moot given the current system has central bank boards determining monetary policy anyway.
However, the SMS extends that unaccountable technical expert syndrome further. The idea of independence is interesting in this regard.
The concept as used means it is not sensitive to the political process. But who would appoint the MCC? Further, like the current arrangements with central bank boards, fiscal advisory bodies (CBO in the US, OBR in the UK etc) the appointees are typically ideological warriors.
In the current system, there is no diversity of opinion or paradigm on these bodies. Straight-down the road neo-liberalism. Which means the decisions of the MCC will reflect the prevailing ideology of the day which is a different thing to promoting society well-being.
The fact that nations tolerate entrenched mass unemployment as a ruse to fight inflation, when superior inflation-fighting job creation strategies (for example, the Job Guarantee) are available indicates where the biases lie and who would bear the costs.
The MCC would likely, under current ruling ideology, promote a growth rate that was too low and adopt ‘cold turkey’ adjustment paths following the Friedmanesque “short sharp shock” approach.
It is also likely that cycles would intensify under this arrangement because if the economy was overheating somewhat (with inflation accelerating), the money supply would be restricted to reflect that.
It takes time to discipline an inflation cycle and real output changes much more quickly than the price dynamics.
What if the MCC made a mistake? The previous point would suggest that the MCC would be subjected to conservative biases in the current situation and restrict the money supply unnecessarily.
This is a different point to the usual criticism that the MCC would make errors as a result of ignorance (not enough information etc). The SMS proposal acknowledges that possibility but asserts that:
… 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.
Unaccountable organisations such as the IMF have made massive errors costing billions and causing millions to lose their jobs in the past.
Policy mistakes are part of living in an uncertain world but if fiscal policy (including money creation) is in the hands of the government then as part of the democratic process we are able to punish the decision-maker who errs, should we choose to do so.
Arrangements (such as the SMS proposal) which divorce decision-making from political responsibility and accountability do not allow us to exercise that choice.
Perhaps a rule whereby the members of the MCC had to pay a significant fine if the unemployment rate strayed from it true full employment level would concentrate minds and improve accountability!
But then I would apply that rule to government ministers as well and leave the decision-making power in their hands.
The possibility that the MCC will make errors also leads to another aspect of the SMS proposal.
The Report says:
The concern has been raised that removing the banks ability to create money for lending may cause a reduction in availability of loans compared with the present system and the reformed system would be too constrained.
This is highly likely unless there is an additional source of money available.
And, to be sure, in the SMS proposal there is the capacity for the central bank to make loans to the private banks – that is, provide funds to allow the banks to extend credit “to meet demand for loans from creditworthy borrowers and businesses”.
At this point you will appreciate that nothing much changes then.
Banks can still get funds from the central bank without the need to first try to get funds from the wholesale or retail markets to ensure they can continue to create loans.
The central bank remains responsible for fully funding the system just as now.
The alternative is that the credit market would become tight and banks would be competing among themselves for depositors with the consequence being that the interest rate would rise.
In that sense, the central bank would lose control of its monetary policy target. By setting the quantity (money supply) it would be forced to allow the ‘price’ (interest rate) to go to whatever the market determined.
If the MCC underfunded the economy and a credit squeeze occurred, then rates would skyrocket and presumably stifle economic activity (to whatever extent total spending is sensitive to interest rate changes).
The alternative is as is the case now – the central bank provides the funds to ensure the rate remains at its target levels and the demand for liquidity in the economy is satisfied.
All the smoke and mirrors about stopping banks creating money falls aside as soon as we understand that the central bank always has to fund the monetary system or else face the fact that recession and financial instability would follow.
We also see that the SMS proposal still allows the private banks to leverage off the net financial assets (‘money’) created by the State and profit accordingly. So all the moralising about preventing the private banks from determining the allocation of credit should be seen for what it is.
Further, while the SMS proposal says that such loans to the banks will not be able to be on-lent to financial or property companies, it is naive to think that an individual or firm who borrows the funds will not engage in speculative behaviour themselves which are not in the public interest. Just as now.
Fundamental reform is required
Drawing lessons from the Icelandic bank collapse and the GFC generally, tells me that more fundamental approaches to financial market reform are required and that the problem is not related to the credit-creation capacity of the banks.
In September 2009, I wrote this blog – Operational design arising from modern monetary theory – which provided some ideas on such reforms.
I followed it up in October 2009 with this blog – Asset bubbles and the conduct of banks.
The ideas can be distilled down to:
1. Government treasury and central bank operations should be brought under the “one roof” and the sham of central bank independence abandoned. Please read my blog – The sham of central bank independence – for more discussion on this point.
This aligns the major arms of macroeconomic policy making with the democratic responsibility and accountability.
2. All voluntary constraints on net spending and the institutional machinery that has arisen to implement these constraints, which have lead to unsustainable outcomes with the costs of the dysfunction being borne mainly by the less advantaged groups in the society, should be abandoned.
That is, I would recognise the differences and advantages that a government in a fiat monetary system has over one operating in a convertible currency system (Gold Standard) and create behaviours and institutions that allowed the the government to exploit those advantages to advance public purpose and generate full employment and environmental sustainability.
Specifically, I would stop issuing Treasury debt instruments – that is, stop public borrowing.
Such borrowing is unnecessary to support the net spending (deficits) given that the national government is not revenue-constrained and does not advance public purpose.
This would mean that the net spending would manifest as cumulative excess reserve balances at the central bank.
I would maintain that excess liquidity in the system and keep short-term interest rates at zero or just about. All adjustments to aggregate demand are better made using fiscal policy.
I would abandon all tax incentives, which push speculative behaviour in property markets.
3. Central bank lending to its member banks (those who have reserve accounts with the central bank) should never be constrained and should be priced at whatever the current rate for lending to banks is. By rejecting the “money multiplier” view of the world, we learn that commercial bank lending is not reserve-constrained.
Please read my blog – Lending is capital- not reserve-constrained – for more discussion on this point.
The trick is to change the way the banks operate not restrict their capacity to be banks.
4. The only useful thing a bank should do is to facilitate a payments system and provide loans to credit-worthy customers.
Attention should always be focused on what is a reasonable credit risk. Banks should only be permitted to lend directly to borrowers. All loans would have to be shown and kept on their balance sheets.
This would stop all third-party commission deals which might involve banks acting as ‘brokers’ and on-selling loans or other financial assets for profit.
It is in this area of banking that the current financial crisis has emerged and it is costly and difficult to regulate. Banks should go back to what they were.
5. Banks should not be allowed to accept any financial asset as collateral to support loans. The collateral should be the estimated value of the income stream on the asset for which the loan is being advanced. This will force banks to appraise the credit risk more fully.
6. Banks should be prevented from having “off-balance sheet” assets, such as finance company arms which can evade regulation.
7. Banks should never be allowed to trade in credit default insurance. This is related to whom should price risk.
8. Banks should be restricted to the facilitation of loans and not engage in any other commercial activity.
9. Eliminate the vast majority of speculative trading in financial products by declaring them illegal. Almost all (around 97 per cent) of speculative activity in financial markets does nothing to advance public well-being. Financial market regulation should always be motivated by allowing activities that improve our collective lives and scrapping the rest.
By eliminating much of what we now call the FIRE industry, the life of the banker becomes much simpler and safer.
10. Make banks public institutions and make their non-profit mission to unambiguously pursue public benefit.
On March 23, 2010, Warren Mosler wrote a similar article on the topic of banking reform – Proposals for the Banking System. It is worth reading.
Once these changes were made (among others), then much of the concerns about financial instability arising from the banking sector would disappear.
The topic is vast and I have provided some ideas as to where Modern Monetary Theory (MMT) sits in this regard.
I would also read the excellent critique from regular reader Neil Wilson (November 24, 2014) – The Sovereign Money Illusion.
There are many other points that could be made but these suffice to show that the SMS is not a model for a better financial system. We could go into deeper discussions about what is money etc but I avoided that level of technicality because the proposal fails much earlier than that.
More fundamental reforms are required.
That is enough for today!
(c) Copyright 2015 William Mitchell. All Rights Reserved.