So Right and So Wrong

Iceland had a monetary crisis a few years back; same as most countries around the world, except in Iceland a) the banking sector was pretty large relative to the size of the economy, and b) they said “too bad” for foreign depositors in terms of any reimbursement (both, as I recall).

So they commissioned a study:

MONETARY REFORM: A BETTER MONETARY SYSTEM FOR ICELAND: A REPORT BY FROSTI SIGURJONSSON, COMMISSIONED BY THE PRIME MINISTER OF ICELAND

A quick glance at the table of contents offers both hope and…well, barely-beyond-mainstream economic analysis.  Like much of what passes for alternative or outside-the-box analysis, the author describes many of the symptoms properly, but comes nowhere near the proper cure.

I will leave the serious, scholarly analysis to those qualified to provide same; Philipp Bagus & David Howden, two Austrian-trained economists, wrote a book published in 2011 entitled “Deep Freeze: Iceland's Economic Collapse.”  I will say they qualify (although I have some differences with at least one of them regarding 100% reserve banking).

Instead, for those interested, you are welcome to my smart-alec views on the matter.  From the abstract:

This report is a study of monetary problems in Iceland and in what part they may be caused by the current monetary mechanism, the fractional reserve system.  There is indication that the fractional reserve system may have limited the Central Bank's ability to control the money supply while giving banks both the power and incentive to create too much money.  Indeed, commercial banks expanded the money supply nineteen-fold in the fourteen year period that ended with the banking crisis of 2008.

I will say, a very promising start.

There is also indication that the fractional reserve system may have been a long term contributing factor to various monetary problems in Iceland, including: hyperinflation in the 1980s [check], chronic inflation [check], devaluations of the Icelandic Krona (ISK) [check], high interest rates [check], the government foregoes income from money creation [this is a problem?], and growing debt of private and public sectors [check].

Not perfect, but still pretty good so far.

In a Sovereign Money system, only the central bank, owned by the state, may create money as coin, notes or electronic money.

Woops.  So, what little competition there is within the cartel known as banking is going to be eliminated?  And this is going to make things more stable?

Let’s get to the details.  The author adds to the list of shortcomings in the current system.  Due to the fractional reserve nature of banking, the author suggests that “The government is forced to guarantee bank deposits.”

Forced?  By whom?  This is an interesting concept.  I don’t believe the government is “forced” to guarantee that my plumber will do his job, or that I can buy a cup of Pete’s Coffee when I want, or that the airbags work in my car.  The government is not forced to guarantee that the mechanic who repaired my car even remains in business to honor the warrantee.  Why does the government have to guarantee my bank deposits?

At least the author can see one of the problems of the state guarantee: “The implied state guarantee on deposits encourages risky lending.”  He adds another: “A state guarantee on deposits gives unfair competitive advantage,” when compared to intermediaries that do not have this support.

So why not eliminate the guarantee?  Why not treat banks like any other business, subject to being disciplined by the market?  That would solve these problems.  Is it possible that private banks could multiply “the money supply nineteen-fold” in a “fourteen year period”?  Would the market allow such behavior?  How much sooner would the warning signs have been visible had there simply been no state guarantee?

No guarantee would ensure prudence – prudence on the part of both the depositor and the bank.  No guarantee ensures mistakes will be dealt with while relatively small.  Would we see only four or five major banks in the US control the overwhelming majority of deposits – then leverage them 30-fold or more? (I am making up the numbers – go see the scholars if you want better.)

A bank run or two has remarkable palliative effects.  Keep everyone on their toes.  Offer the best check on excess reserves – without having to mandate 100% or any other centrally-planned ratio (don’t believe me?  Ask Mises and Rothbard).

He then suggests alternatives to the current system.  Thankfully, he does not see further regulation as a solution – only adding more complication.  Instead, he suggests:

Various alternatives have been proposed: 100% Reserves, Narrow Banking, Limited Purpose Banking and Sovereign Money. Of these proposals, only Sovereign Money transfers the power to create money to the state and effectively separates the creation power from the allocation power, and provides a transition to debt free money.

This is an interesting list of recommendations, when compared to the actual analysis in the paper.  In the details, he mentions nothing about a free market in money, and gold is mentioned only indirectly (“That made good sense when a bank note was indeed a promise to pay the bearer in gold or silver, but today a bank note is no longer a promise to pay the bearer anything but an identical note.”)

He also doesn’t mention Mises, Rothbard, Sennholz, or Austrian.  He covers only the acceptable range within the allowable conversation.

As noted, he settles on the “Sovereign Money” model.  This will sit well with the “ban interest” crowd and the Ellen Brown contingent.  It won’t do anything for creating a robust financial system, as it only further monopolizes a monopoly (well, close enough for government work).

Why not a free market in money, banking, and credit?  Frankly, money and credit are some of the simpler products offered by modern markets – try building a car or a passenger plane – now that’s complicated.  Money?  This was invented and functioned well almost since the beginning of recorded history.  It isn’t rocket science.

Just leave it to the market, enforced by contract.  Any other “solution” only offers only more central planning and crony capitalism.