Iceland Ponders Radical Banking Plan to Eliminate Fractional Reserve Lending

By: Mike_Shedlock

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

1. Would a panel be any better than the Fed?
2. Would it be politicized?
3. 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.

By Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com

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Mike Shedlock / Mish is a registered investment advisor representative for SitkaPacific Capital Management . Sitka Pacific is an asset management firm whose goal is strong performance and low volatility, regardless of market direction.

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