Monetary Reform: Iceland.
One does not think of Iceland for monetary policy reform or innovation. With a population of around 300,000 and a currency as far removed from reserve status as one can get, it is would seem a quiet backwater for such thinking. Not any longer. In today’s US print edition of the Financial Times there is a marvelous article title, “Iceland’s daring raid on fractional reserve banks“.
Fractional-reserve banking is the root of credit. It is the process by which a bank (central or commercial) takes in deposits and then creates a loan far in excess of the original deposit and lends it onward to another customer (that may then deposit it etc.). The deposit is the ‘fraction’ of the reserve whereby money is literally created out of thin air. The license to cycle, recycle and continuously recycle this money is at the heart of credit and monetary policy and also what drives inflation. It evolved from, and became standard operating practice in support of, fiat money- once government’s left gold and created their own paper money.
It turns out that between 1994 and 2008 (in the run up to the financial crisis) the supply of krona grew an astonishing 900 per cent. That is a bubble all right, but at the time it was floating on many other similarly floating bubbles. Out entire economies are built on the premise of fractional reserve banking. All this convoluted and complex financial regulation (think Basel III and more) focuses on the “reserve” level banks should keep on hand to protect against a run. Iceland is considering a simple 100%. In essence the government is considering taking back from its independent central bank and commercial brethren the ability to create money out of nothing. While not a true innovation (this is in fact back to the future) it is heresy in today’s world.
This does not prevent the bubble in question; It changes whose hands are in the till at the time bubble grows, should it grow. It might be that a central government might still authorize some fractional reserve at a later date. There is, of course, no more likely restraint in politicians than in financial leaders. But the fact that independent banks were not able to regulate themselves suggests we need to try something else. The elimination of fractional reserve banking, if executed, would certainly reduce the amount of money flying around the place and also it would mean loans and credit would be traded off with equivalent flows of money extracted from the economy. It might hamper growth – so a 100% might be just a tad too high. In fact, that sounds like a great project: to what degree does various fractional reserve levels hamper or help economic growth?
We should watch Iceland to see how this plays out. And we should look to a larger, more sizable economy to try this as well. If not a 100% fractional reserve, what about 75%?
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