Should Iceland abolish fractional reserve banking?

You are all familiar with their recent financial mishaps in Iceland, note also theirs is not a history of financial stability:

It is fair to say that Iceland’s monetary history has been a turbulent one.  Currency controls in the 1920s to the 1950s were followed by chronic inflation in the 1970s to 1980s, with annual inflation reaching a high of 83% in 1983.  In 1981 it was considered necessary to redenominate the krona with 100 units being replaced by 1 new unit.

That is from a new Frosti Sigurjónsson report (pdf) advocating 100 percent reserve banking for Iceland.  In the “good old days” we had so many arguments against this arrangement — “disintermediation!” — but do those critiques hold up when so many nominal interest rates are in any case negative or close to zero?  In many countries banks may be fated to become money warehouses as it is.

An interesting question is whether Iceland can, with its current size and export profile, ever have monetary and financial stability.  With their exports and thus gdp so depending on fish and aluminum smelting and tourism, no other country shares their economic fluctuations, even roughly.  A fixed rate thus means a non-optimum currency, but a floating rate for 323,002 people may mean perpetual whipsawing from international capital flows, not to mention the risk of acquiring an oversized, hard to bail out banking system, as Iceland did before its Great Recession.

Should I file under Department of Why Not?  What if Scott Sumner asks me how to do this without inducing a collapse in nominal gdp?  If I interpret p.78 of the study correctly, the government will create new money by printing and injecting it into the economy through fiscal policy, as a means of forestalling this problem if need be.  Under this scenario, how powerful does the state become?  On what do they spend the money?

Frosti’s report, by the way, was commissioned by the Prime Minister and it is being taken very seriously.

I believe I first saw notice of this link from Stephen Kinsella.  Here are some responses to the idea.  Zero Hedge seems sympathetic.

Comments

"With their exports and thus gdp so depending on fish and aluminum smelting and tourism, no other country shares their economic fluctuations, even roughly. "

What? What about the Gulf states where fossil fuels make up 95%+ of exports? Petroleum is a far more volatile market than fish or tourism.

It is much easier to forego fish and tourism than it is to do without petroleum.

Those are all in dollars though, aren't they?

Those darned Icelanders. They may be the descendants of Vikings, but, financially they are not "Very Serious People." They might as well be a bunch of statues on the Acropolis, :-).

Some people are arguing that the claim of the Greeks starting the first democracy is fraudulent, due to the large fraction of population that were slaves, whereas the Icelanders were much closer to a real democracy,

https://en.wikipedia.org/wiki/Althing

coming up on 1100 years in a mere 15 years. Thus, grouping Greeks and Icelanders together might be appropriate.

My Greek history teacher ( http://history.yale.edu/people/donald-kagan , MOOC/book on tape, http://oyc.yale.edu/classics/clcv-205) has lots of libertaian ideas, but to my shame as a libertarian, he seems to defend slavery.

I'm not familiar with Kagan's exact views but if he is pointing out that great civilizations like that of ancient Athens owed most of their greatness to the plunder, taxation and enslavement of their neighbors, that's a fact that's been known to generations of history students. Modern economic growth with its dependence on high density forms of energy (e.g. fossil fuels) and manufacturing simply did not exist in the ancient world. Cities like ancient Athens and Rome could only exist in the ancient world through conquest and plunder and, by becoming rich in this manner, they became centers of high culture, political innovation and philosophy. The modern world isn't zero sum but the ancient world, to a rough approximation, was.

Shouts of: Genius! x3. Spectators shower TC with gold coins or their digital equivalent (bitcoins?). TC should have a link button so that if posters agree with him, they can donate money. But then TC might end up 'playing to the gallary' of public opinion, just to make money, and he would sell out, which we know TC will never do!

Yes, fiat money fractional reserve banking is a root of some evil*, and another is compound interest, which must be either paid off or defaulted on, depending on whether an economy is growing or not. If not, as now, then this debt must be hyperinflated away or defaulted on.

*Further, 100% reserve banking would not necessarily constrain lending in any way, see this: http://en.wikipedia.org/wiki/Reserve_requirement#The_endogenous_money_view

("Jaromir Benes and Michael Kumhof of the IMF Research Department report that the “deposit multiplier“ of the undergraduate economics textbook, where monetary aggregates are created at the initiative of the central bank, through an initial injection of high-powered money into the banking system that gets multiplied through bank lending, turns the actual operation of the monetary transmission mechanism on its head. Most times when banks ask for replenishment of depleted reserves, the central bank obliges.[2] [THAT IS, THE FED RESPONDS TO THE MARKET THE VAST MAJORITY OF TIMES--RL] Reserves therefore impose no constraints as the deposit multiplier is simply, in the words of Kydland and Prescott (1990), a myth. And because of this, private banks are almost fully in control of the money creation process.[3]")

Shouldn't you be in church?

It would be the opposite of our current system, in which the central bank has the primary (and by default sometimes the only) responsibility to respond to financial and economic crises and with the limited tools it has at its disposal (monetary stimulus or contraction); in other woods, it would shift from mostly (or exclusively) monetary stimulus to mostly (or exclusively) fiscal stimulus for overcoming financial and economic instability. How do I distinguish monetary stimulus and fiscal stimulus: both are redistributive, it's just that the former is redistributive upward while the latter is redistributive downward. Goodbye excessive inequality! Or not. As Cowen asks: "On what do they (the government) spend the money?" It's an interesting question. We already know whose interests the central bank has as its top priority - he who has the money makes the rules. Whose interests would the government, in a democracy, have as its top priority? I would assume that Cowen would say its own interests (i.e., to maintain power and control). Is that worse than the system we have now, a system in which the top priority is to preserve the wealth of those who already have it.

they are one in the same.

I'd like to see them try it. Of course, if it didn't work, it would be used as an example of a stupid policy. If it succeeded, it would be ignored.

The problem of excess leverage and financial instability is due in part to the fact that we depend on banks to create credit so we can have an electronic money supply. If the central bank provided emoney this problem wouldn't exist. The demand for credit would be lower because the central bank could expand money though emoney heli drops leading to less credit and financialization. Emoney heli drops would also stimulate without reducing rates which would also reduce credit and financialization.

"Credit" is always available... anytime anyone with actual "saved" money is willing to lend it. Banks have no natural monopoly on credit.

And no fractional-reserve banks are really sound anyway. Every fractional- reserve bank depends upon public deception that all is honest & open and that it will redeem its notes or deposits whenever its clients demand. Since this is fundamentally untrue & fraudulent (fractional reserves)-- long term confidence in these banks is a psychological wonder. The central role of central banks is to keep this charade going.

True 'financial stability' is impossible under fractional-reserve banking regimes in Iceland or anywhere else. And GDP is an extremely poor metric for assessing core financial stability risks.

Honest credit prospered long before the mass introduction of fraudulent fractional-reserve banking.

According to Google Translate, Frosti is the Icelandic word for frost. I don't have any comment on that. I just think it is interesting.

They should try free banking.

The proposal is rooted in naive monetarism, and naive anything is not a good start.

Henry Simons and Milton Friedman: 100% reserves plus a monetary growth rule solves the monetary and fiscal problem. What to buy? Butter, not guns is my suggestion.

Just read the report. It is, in my opinion, shockingly simple-minded and misleading:

1) Monetary control. The suggestion that "fractional reserve banking," rather than the CBI, was responsible for monetary expansion u to the crisis, is as bad as anything one might come across among the internet Austrians. In fact, the base-money to M2 multiplier is fairly predictable and constant, allowing for a doubling following the halving of the required reserve ratio in 2003 or so, which raised it from an average of 10 to one around 20. The claim that 91 percent or so of monetary expansion (before the doubling) was due to FRB is just misleading word-play: M2 growth was in fact pretty clearly linked to B growth allowing for the reserve ratio change.

"Money multiplier" analysis may not be trendy, but its dismissal in the report is highly misleading. Yes, banks now often anticipate reserve acquisition, making loans and then looking for the funding. But it hardly follows that they aren't constrained by the total availability of B! If they don't find the needed reserves, or find them at a prohibitively high price, they will back-off on credit. That the lending sequence may not be +reserves then +loans does not itself prove that loans aren't constrained by available reserves. That the author gets his understanding of money creation from J.K.Galbraith also isn't terribly reassuring.

Since B growth has in fact tended to govern Iceland's broader aggregates, there is no reason to expect nationalization of those aggregates to improve monetary control all that much.

2) The Viability of FR banking: the report just ignores the success stories. It is in this respect very parochial--as has been the case of most condemnations of FR banking throughout history.

3) Seigniorage. The author assumes that banks earn monopoly profits unless there is "perfect competition." That's an old canard, of course. In fact consumers will bear a loss of surplus equal to some significant part of the seigniorage gains to Iceland's government.

4) Options: the author simply assumes that the only solutions worth considering are those that would end fractional reserve banking.

There's much more to be said about the report, none of it good. I plan a blog on the topic.

I am currently setting up a blog on this subject and would be interested in reading your blog when you get it going. Please email the link or visit my blog and leave the link there.

Will do, Mark.

The last parts of the report are, in my opinion, truly shocking. If it doesn't quite qualify as quackery, then it is certainly too close for comfort!

This report isn't taken very seriously in Iceland as well, it has become in fact a bit of a laughing stock.

Originally Mr. Frosti (a member of parliament for one of the ruling parties) was commissioned by the Prime Minister along with two professional economics to author this report. Half way through, one of the economics had to take a maternity leave and Mr. Frosti said he would put the finishing touches on it and wrap it up. When time came to release the report (some months ago) he showed the final result to the economist who apparently were shocked enough by the wholesale changes Mr. Frosti had done to the report they asked (and were granted) to have their names removed from it.

Only person to take it seriously is the prime minister (member of same party as Mr. Frosti) and both have meekly suggested it might become a ground for "further discussion" on the banking system.

Everyone else just wants to forget this piece of paper.

Magnús, I am much relieved by your remarks--and I hope I might be allowed to quote them as those of an anonymous but informed person (or as you otherwise prefer). Alas, the internet has been giving the report a great deal of attention (as this example illustrates). Worse still I have now heard praise for it from several erstwhile market-oriented types.

Because of all this attention I still plan to reply to the report at some length at my own Center's new blog.

Im a lousy quote for this, Im a web programmer that works for a bank. But here is a news report that documents some of the key facts. It is in Icelandic but Ill give you the bullet points.

March 2014: The Prime Minister reports that a group has been commissioned to go over the monetary system and to suggest possible reforms. It is headed by Frosti Sigurónsson, member of parliament and includes Þorgeir Sveinsson, economist at Straumur Investment Bank and Kristrún Frostadóttir, economist at Viðskiptialbaðið, an icelandic publication on economic matters that styles itself after the Financial Times. The mandate is to go over the history of the monetary system in Iceland and to make suggestions on how to limit monetary expansions/contractions in the future. The committee is given 6 months to finish the report.

Very soon, Þ. quits the committee and is replaced by Davíð Stefánsson, as far as I can tell also an economist at Straumur Investment Bank.

August 2014: K. has to leave the committee because she is going to the US to study for her Phd in economics at Boston Uni. (not maternity leave as I wrote above). At this point, the report is almost finished (according to K.'s statement to the press) and the 6 months are up, so she suggest that F. hire an assistant to help him with finishing it. He decides that it is not needed and he will finish it himself.

February 2015: F. presents a very different report (again, according to the statement by K. sent to the press) to his fellow committee members. K. and D. both ask to have their names removed from the report because of changes F. had made to it since August.

Thanks very much for this info.

switzerland might vote on a similar proposal.
http://www.vollgeld-initiative.ch/english/
however the committee is struggeling to get the 100,000 signatures corum.

I have written a much more favourable column on the idea. http://www.breakingviews.com/edward-hadas-iceland-may-have-cure-to-bad-banking/21193324.article . The basic concept of treating deposits as equivalent to notes - units of account with central banks - is not, in my view, stupid. The financial system is easily the most dysfunctional part of the modern economy - causes more trouble, is less resilient than any industrial or service sector. Outsourced money creation is part of the problem.

Yes, banking is to a considerable extent dysfunctional. But it doesn't follow that central banking isn't, or that letting central banks take command of all deposits is the right solution.

Paper notes, by the way, began and remained through most of history circulating liabilities of private banks. The treatment of notes as "different" from deposits began when note issue was monopolized. I, too, favor treating notes and deposits the same way--not by centralizing both, but by leaving them both to the private sector, and doing away with destabilizing distortions many of which are traceable to the presence of currency monopolies. There is a long history bearing on this perspective; see for starters Vera Smith's The Rationale of Central Banking.

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