Iceland Thinks About Stripping Banks of Money Creation Power

by Dirk Ehnts, Econoblog101

As Positive Money reports, Iceland is considering “ending lending” – for banks:

Frosti Sigurjonsson, Member of the Parliament of Iceland and Chairman of the Committee for Economic Affairs and Trade, today published a report outlining the need for a fundamental reform of Iceland’s monetary system.

The report, commissioned by the Prime Minister, considers the extent to which Iceland’s history of economic instability has been driven by the ability of banks to ‘create money’ in the process of lending.

While there are a lot of uncertainties with this proposal, I think that it is a very good idea to think outside the box and consider all alternatives. The report, which can be downloaded via Positive Money, answers some very interesting questions in ways that are completely different from the standard macroeconomics textbooks (which might be a good thing!):

The gross demand for money is affected by various factors such as the size and growth rate of the real economy, and the financial sector.  Demand for ISK is also affected by the fact that taxes can only be paid in ISK, thereby creating an underlying demand for ISK by taxpayers.

This is something I definitely agree with. This is also why I do not understand how the IMF can circulate a paper in which they predict hyperinflation should Greece return to a domestic currency. The state, via taxes, can set the demand, and this will have an influence on the exchange rate! Of course, it would not make sense for the Greek currency to be expensive, but if government would think that is the way forward they can tax Greek neo-drachmas away until only one is left – which surely would have more purchasing power than a euro.

Anyway, here is the real problem:

While banks have an incentive to create money, the costs of an overshooting money supply, in the form of inflation or bubbles, are borne by society in general. This separation of benefit and cost may explain why banks have not created an optimal amount of money for the economy

This has been discussed for centuries almost. Are we better of with credit bubbles and business cycles or are we better of without? Schumpeter’s creative destruction in his theory of economic development would be a good starting point, because money has real consequences!

Anyway, I recommend reading the report. A cursory reading has left me impressed, the analysis of the monetary system that we usually have is pretty good. I would disagree/have reservations on many issues, like this sentence:

“This means that in order to create new money for a growing economy, households and businesses must go deeper in debt. ”

Let us not forget that government can create money, too. They call this deficit spending, and we already have decades of experience. Not the Keynesian era, but the neo-liberal era, too! Government debt has exploded, pundits all over the world would tell you, and … government bond yields approach zero.

This is should give you something to think about.