Submitted by Ash Navabi via Mises Canada blog,

A recent proposal out of Iceland has been making the waves around economics blogosphere. In it, Frosti Sigurjonsson critiques the current fractional-reserve banking system and proposes instead a system he calls “Sovereign Money”. But what is “sovereign money”, how is it different from the current system, and how will it work? In this post I’ll first explain how the current system works and the problems it has from an Austrian perspective, then go through the sovereign money proposal to see how it solves any of the short-comings of the current system.

How is money created in the current system?

Before we can analyze the sovereign money proposal, we need to understand how the current system operates. This can be demonstrated in a 4 step process. But first understand that a central bank (like the Bank of Canada or the Federal Reserve) is a lot like any other bank: it offers deposit accounts and loans to clients. The difference is that you can only become a customer of the central bank by invitation only.

The central bank decides to increase the amount of money in the economy To entice private banks to borrow from it, the central bank lowers the interest rate for its loans Private banks then borrow money from the central bank It’s important to realize that the central bank got the money for these loans by literally creating them out of thin air. How this works is as follows: a private bank, like Goldman Sachs, wants a $1000 loan from the central bank, so the central bank types in their computer that private bank now has an extra $1000 in their account. In short, the central bank basically tells the private bank that it has a thousand bucks in its account, and as if by magic, a thousand bucks appear in the private bank’s account with the central bank. The private banks then lend out to regular customers this new money (at a higher interest rate than the central bank is lending to them) via a system called “fractional-reserve lending”. Here is a very simple version of how it works: Let’s say that Goldman Sachs loans out the entire $1000 it got from the central bank to one customer, Alpha. Goldman then write a cheque to Alpha for $1000. Alpha then goes to another bank, let’s say Scotia Bank, to deposit his cheque. But Scotia knows (really he’s assuming) that Alpha won’t be spending his thousand all at once. He might really only need 10% ($100) for the next little while So Scotia now has a choice to make: they can either let the $900 that (they assume) Alpha won’t use just sit and collect dust in their vault… or they could loan it out—at interest!—to someone else. Because there is lots of legislation that allows them to do it, Scotia chooses to go with the second option—keeping only a fraction of the original deposit as a reserve, while lending the rest to, say, Beta. Beta now has a cheque for $900. He then deposits this at Royal Bank, but Royal knows that Beta will ever really need just 10% of that. So now Royal Bank now has a choice to make… And so on. If this process goes on, with every bank keeping 10% (or 1/10th) as a reserve while loaning the rest, then eventually there will be 10 times the original $1000 amount of new money. If the banks keep 20% (or 1/5th) then the system will create 5 times as much new money as had initially entered the system.

That is the standard, textbook exposition of the fractional-reserve system. Because new money is created whenever there is a new loan, this system is sometimes called the “debt-based money”. The benefits are obvious: for banks, they get to increase their revenue by using money that otherwise would not be in use. As well, consumers and producers benefit because all the new money will lower interest rates, meaning getting loans will be a lot easier.

To the mainstream, the major problem is that if someone wants more than 10% of their money back, then problems start to occur. Banks would have to start calling in loans, maybe start selling assets, and if they can’t raise the money quickly enough, then they become bankrupt. The mainstream solution to this is to give the central bank the power to be the “lender of last resort”, to give emergency loans to banks that facing this kind of trouble.

Fractional-Reserve and the Business Cycle

But to many economists, for example Ludwig von Mises, Friedrich Hayek, Murray Rothbard, and Roger Garrison, there are other problems as well. To these economists, it’s vitally important to understand that interest rates give information about the economy. Namely, they tell how willing and able people are to lend and borrow money.

Recall that supply and demand represent willingness and ability. When it comes to loans, the supply of loans represents a willingness and ability to lend, while the demand for loans represents a willingness and ability to borrow. Other things equal, as interest rates go up, savers can supply more loans (by being willing and able to save more) but borrowers demand less (because they are unwilling or unable to pay more for a loan).

Furthermore, interest rates tell us how savers and entrepreneurs are investing their money. High interest rates tell us that savers would much rather spend their money now than to put it in a bank to collect interest later. So entrepreneurs will then make goods that can be consumed now as opposed to in the future.

Low interest rates tell us that savers are willing to put off some consumption now, in order to consume more in the future. So entrepreneurs start investing in long term projects financed by the savers’ savings, in order to satisfy the savers’ future wants.

But when central banks lower interest rates, they muddle up this signaling. Savers, thinking there isn’t as much demand for their money, save less; while borrowers, thinking that there is a glut of savings, decide to borrow more. Because savers are saving less, they are spending more in the present. Because borrowers have to pay back their loans at interest, they decide to make investments that have payoffs in the future. During this time when consumers are spending and investors are investing, the economy will appear to be booming.

But because of the mismatch between savers’ wants and borrowers’ expectations, eventually someone is going to ask for more money from their bank than the bank has in reserve. This will lead to bank runs, which will collapse the entire system. This is the story of the so-called “Austrian business cycle theory.”

The Sovereign Money Approach

What the Icelandic report suggests as a solution to this problem is a system it calls “sovereign money”. According to the report, the sovereign money system will require commercial banks to keep 100% reserves, and so ending the private practice of fractional reserve lending.

However, the central bank remains and retains the right to create money out of thin air based on its whims and fancy. The central bank also can just create money without simultaneously giving out a loan. So if the government needs $1 billion, instead of the current system where they have to raise the money by selling $1 billion in bonds, the central bank will literally just grant them the money without needing anything in return.

The report says that this system will have several benefits, but for the purpose of brevity I will focus on one claim: that sovereign money will result in greater economic stability.

Will a Central Bank-Controlled a 100% Reserve System Prevent Economic Instability?

There can be no question that if private banks are operating on a 100% reserve system, the loans they make will be a true reflection of the supply and demand conditions in the market. If a bank is limited to only loan out what its customers have designated exclusively for lending—i.e., the amount of money that savers have demonstrated they are willing and able to supply—then borrowers can make better informed decisions about the long-run interests of society.

In other words, under 100% reserve, there will no longer be systemic mismatches between how savers are spending their money and how investors are investing their money. So there will be no Austrian business cycle story.

But if the central bank still can create money out of thin air, what ramifications will it have on the rest of the 100% reserve economy? The issue lies in how the new money is introduced.

Imagine if you suddenly found a $100 bill that fell from the sky. You then spend it on something you don’t usually buy; let’s say an exotic book collection from an online auction. If you never found that money, you would not have participated in the online auction, and so someone else would have ended up with the book collection for less money. You are obviously richer, and no one else is obviously poorer, because you found and spent $100 that materialized out of thin air.

But your new found riches caused the price of the books to be higher than they otherwise would be. So the organizer of the auction now also has more money to spend than he otherwise would have. Let’s say he pays a little more for auctions on leather gloves and DVDs. Now the leather glove and the DVD sellers have a little more than usual to spend, while conversely other people can afford fewer leather gloves and DVDs.

Note that the effect of the new money diminishes after each transaction. At first only the price of books went up, then the price of leather gloves and DVDs. So people can now buy less books, gloves, and DVDs then previously.

Thus whoever got the new money first got the biggest benefit, and whoever got the money last has probably missed out on several things that he was outbid on earlier. What new money does is it distorts the relative prices of goods in the economy in such a way that benefits the people who get the new money first, and harms the people who get new money later. This is called a Cantillon Effect.

If the money creation power lies exclusively with one agency in society, then that agency will stand to greatly benefit from Cantillon effects. As a consequence, there will be massive incentive for private businesses to get as close as possible to the agency, so they too can take advantage of the Cantillon effects.

Thus, by entrusting money creation to one extremely powerful entity, you are in fact ensuring that there will be a lot of goods and services aimed at the agents controlling that entity. If the politicians are in charge, then it’s likely infrastructure groups and others promising “jobs” will be at the forefront. If it is the central bank, then financial institutions will be the most likely to get closest to the money printing.

Having a “money creation committee” (as the Iceland report proposes) where technocrats will decide how much money will be created while bureaucrats decide what it’s spent on, will only complicate the incentive structure for cronyism in the slightest possible way.

Additionally, if the new money is used in a way that will affect interest rates—for example, by buying bonds—then (despite the 100% reserve banking in the private sector) once again the economy will be susceptible to having a mismatch between what savers want and what investors are doing, thus leading to another Austrian business cycle.

Conclusion

The central bank-controlled 100% reserve system of sovereign money will indeed mitigate much of the fluctuations associated with modern day fractional-reserve banking. However, it is not a panacea against systemic distortions of economy. Centralizing any power, especially one as important as the creation of money, will inevitably lead to cronyism. And while perhaps less likely to occur than under the current system, there still will exist a risk government manipulation of credit markets which will lead to the business cycle.