Iceland and reform of the Monetary System

by George Hatjoullis

The Prime Minister of Iceland commissioned a report of reform of the monetary system of Iceland which can be accessed here ( The key recommendation is the Sovereign Money Proposal (p.69) and this is based on a book, Modernising Money by Jackson and Dyson (which i confess i have not read but may well do now). The report is 101 pages but very accessible, especially to a regular reader of my blogs. Many of the themes and discussions have been central to my own thoughts and the most striking thing about the proposal is how close wider monetary reform is to the same outcome. The idea is important because it may find expression in a national monetary system but also because the monetary systems of the rest of the world are heading in the same direction. Rather than take you through the report it is more instructive to suggest how the wider monetary system need be modified to end up in the same place as this Sovereign Money Proposal. This would highlight how close we are and the implications of making the transition. You can judge whether it is desirable.

Let us assume that central banks adopt my suggestion to the Bank of England of introducing a Transaction Account into the banking system ( See blog Bank Deposit Protection in the UK, 7/10/2014). In terms of the Iceland report this account would be held at the central bank but intermediated by a commercial deposit taking institution ( a bank). The account could take any amount and is perfectly safe because it is a liability of the central bank, and not the intermediating institution. There is no need for deposit insurance but the account carries no interest and may even incur certain charges which could be applied as a negative interest rate. It would be operated by the deposit institution just like a current account. This would be money because it is a liability of the CB. However, it is not available to commercial banks as liquidity to fund loans or other asset acquisitions.

Commercial banks would also operate another class of deposits which I shall call Risk Accounts. These would pay interest and be the liability of the commercial bank to the depositor. They would not be insured or guaranteed. Once a deposit is made into a risk account from a transaction account it becomes the property of the bank. In exchange the depositor gets a promise to repay with interest. It is explicitly a loan to the bank. The transaction account is effectively an insured deposit in todays terms and the risk account an uninsured deposit. The difference is there is no limit to the insurance and the guaranteeing agency is not the FSCS (in the UK) but the central bank. There is no deposit insurance levy on deposit taking institutions because, as the Iceland report notes, this is farcical in a systemic crisis. In the event of systematic crisis it has been typical for even uninsured deposits to be protected because of the to-big-too-fail ‘rule’ and for the taxpayer to underwrite these uninsured deposits. As I never tire of reminding my readers, the UK government did not bail out the banks, it bailed out the uninsured depositors. However, since the Cyprus crisis and EU banking reform, this ‘rule’ has already started to be phased out in developed country banking systems. This is why the BoE is looking at deposit protection anew.

Commercial banks can continue to make loans using the risk deposits. They can share these deposits via the interbank market. However, the big change is that they can no longer expect liquidity from the central bank. The lender-of-last- resort function of the CB is removed in the Iceland proposal. This is the main innovation that the report is proposing. This suggestion is indeed radical. In the present system banks basically control the money supply. If they do not have enough capital then they raise some in the market. They make whatever loans they wish subject to some restrictions from the regulators. Ultimately, the central bank will not let solvent banks fail because of liquidity problems. It may charge the banks a penalty rate to discourage liquidity becoming an issue but in the last analysis it will provide the liquidity. The report notes that this underwriting of liquidity creates moral hazard and leads to excessive and irresponsible lending behaviour by banks and this is the source of crises. This is not without some validity however the real problem is that this system creates leverage. The amount of bank debt is an uncontrolled multiple of the liabilities of the central bank (money stock). Removing the liquidity link between the CB and commercial banks causes dramatic deleveraging.

If the Iceland reform were to be implemented overnight the degree of deleveraging would make the current deflationary bias catastrophic. However, this is not being proposed. It would be a phased adjustment though even this could be dangerous. It is less dangerous than it might be because the system is already moving in this direction. Banks have deleveraged since 2008 and this, as my recent blogs have repeated ad nauseam, is in part why the global system is experiencing deflationary pressures. However,the existence of the transactions account would see a great deal of the uninsured deposit base move into these transaction accounts and thus deplete bank liquidity further. Recall the transaction accounts are with the CB and cannot be used to fund lending. So how does the CB expand the money supply if not through the banking system?

The CB is of course independent of the government of the day. It expands the money supply by limited monetary financing in the Iceland system. This suggestion has also been repeated ad nauseam in my blogs. The CB estimates the nominal GDP growth appropriate for the economy based on estimated potential GDP and some inflation target and then gives the government of the day a sum, consistent with this nominal GDP target, to spend. It can do so by buying government debt and then cancelling the debt. State spending moves the CB money into the economic system. In principle a phased introduction of limited monetary financing and elimination of CB funding of commercial banks could be achieved without mishap, especially as bank deleveraging is already creating a deflationary bias. Put differently, the banks do not want and do not know how to use the liquidity presently on offer which is why the CB’s have resorted to Quantitative Easing. The Iceland proposal is merely suggesting that limited monetary financing (debt cancellation) is more effective and valid if the liquidity link between the CB and the banks is phased out permanently. Obviously, I agree.

Once the transition to the new state of the world is achieved there would be less systemic risk arising from excessive leverage and moral hazard. If enterprise is constrained by finance then new forms of finance would inevitably emerge and old forms take on more prominence. New money might also emerge and be leveraged (e.g. Bitcoin ‘banks’).Too the extent that debt finance is replaced by equity the system would be more stable. However, to the extent that private monies emerge and are leveraged, systemic problems could still arise. The Iceland solution only works in a world where the only money is CB money. In a free market, global economy, this is never the case. However, the Iceland proposal does highlight some important limitations of the present system and does suggest some useful innovations. In particular, substituting unlimited CB liquidity to the banking system with limited monetary financing. The present economic conditions (what I have termed The Great Deflation) may soon require this innovation .