World Economics Association on Sovereign Money

The World Economics Association (WEA) has published in its June 2014 newsletter following article by Mark Joób, PhD, Professor at the West Hungarian University, Faculty of Economics and Researcher at the Institute for Business Ethics, University of St. Gallen, Switzerland and member of the managing committee of the Swiss Association for Monetary Modernization (MoMo):

The Swiss Association for Monetary Modernization wants to solve the most severe malfunctions of the present money system by a fundamental reform. On 3rd June the association officially launched the Sovereign Money Initiative. The aim is to give a governmental monetary authority the exclusive power to create money, both cash and current account holdings. Commercial banks would be prohibited from creating account money and restricted to give loans from money they have previously borrowed from customers.

Now, which are the malfunctions of the present monetary system?

1. Money is created as debt. Today, money comes into existence by debt creation when commercial banks borrow from central banks and when governments, producers or consumers borrow from commercial banks. Thus, the money supply of the economy can only be maintained if the private or public economic actors get into debt. Economic growth requires a proportionate increase in the money supply in order to avoid deflation that would paralyze business, but an increase in the quantity of money involves a simultaneous increase in debt. This way, economic actors run into danger of excessive indebtedness and bankruptcy. It is not necessary to say that overindebtedness causes serious problems to societies and individuals in the face of the ongoing debt crisis.

2. The money supply is under private control. Only a small fraction of the money circulating in public has been created by central banks. Central banks issue coins and banknotes which in most countries account for just between 5 % and 15 % of the money supply. The rest is created by commercial banks in an electronic form as account money when granting loans to customers or buying securities and goods. Therefore, commercial banks de facto control the money supply. Commercial banks principally bear the credit risk for the loans they grant, which should induce them to carefully examine the creditworthiness of their customers. However, commercial banks decide which customers are granted loans and which investments are made according to their interest in maximizing their own profits. Whether an investment is socially desirable is not the decisive criterion for commercial banks. This way, investments serving the common good but not being profitable enough are not supported by the banking system and have to be financed by government spending that depends on tax revenues and public debt creation. Instead of financing long-term investments in the interest of society as a whole, commercial banks with their credit business support short-term financial speculation and over the last two decades have actually established a gigantic global casino beyond any public control.

3. Bank deposits are not secure. Bank deposits refer to account money which in contrast to cash is not legal tender although it is handled as if it were legal tender. Account money is a substitute for money, just a promise from the bank to disburse the corresponding amount of money in legal tender if requested by the customer. In the present fractional reserve banking system, usually only a very small proportion of account money is backed by legal tender. Banks hold only a few percent of their deposits as cash and reserves at the central bank. That is the reason why banks are reliant on the trust of their customers. In the case of a bank run, when too many customers demand cash at the same time, they would run out of cash and such a shortage of liquidity can lead to sudden bankruptcy. Hence deposit insurance systems have been established to avoid the loss of bank deposits. In the case of chain reactions and large-scale bankruptcy as in 2008, however, government bailouts of commercial banks may be necessary, eventually with the assistance of the central bank as lender of last resort.

4. The money supply is pro-cyclical. Commercial banks grant loans by creating account money in order to maximize their interest revenues. The more money they issue, the higher their profits – as long as the debtors are able to pay. In times of economic growth, banks most willingly grant loans so as to profit from the boom, while in times of economic decline they restrict granting of credit in order to reduce their risks. This is how commercial banks induce an oversupply of money in booms and an undersupply of money in recessions, thus amplifying business cycles as well as financial market fluctuations and creating asset bubbles in real estate and commodities. Such asset bubbles may cause heavy damage to society and to the banking system itself when they burst. Again, the 2008 mortgage-triggered banking crisis after the burst of the US real estate bubble is the most illustrative example.

5. The money supply fosters inflation. Besides its pro-cyclical character in the short term, in the long term the money creation of commercial banks induces an oversupply of money that leads to consumer price inflation as well as asset price inflation. An oversupply of money arises if the increase in the quantity of the money in circulation exceeds the growth of the production of goods and services. The long-term oversupply of money results not only from traditional granting of credit to governments, corporations and individuals but also from credit-leveraged financial speculation of hedge funds and investment banks. Due to inflation, consumers usually face an annual loss of purchasing power, which means that they have to increase their nominal income in order to maintain their level of consumption. Since the ability to gain compensation for the loss of purchasing power by increasing one’s nominal income varies among individuals, inflation causes a redistribution of purchasing power to the disadvantage of those individuals who are not in the position to effectively advocate for their own interests.

6. The privilege of creating money is a subsidy to the banking sector. Since money is debt, it carries interest. Therefore, interest has to be paid on all the money in circulation and virtually nobody can escape paying interest. Interest is primarily paid by customers who take loans from commercial banks and thereby ensure the money supply. Secondly, everybody who pays taxes and buys goods and services makes a contribution to the interest payment of the original borrower, because taxes have to be raised partly in order to finance the interest payments on sovereign debt. Furthermore, corporations and individuals providing goods and services must include the costs of their loans in their prices. This way, by using money, society pays an enormous subsidy to the commercial banks, though the banks pass on a part of this subsidy to their customers as interest payments on deposits. Interest is a subsidy to the banks because the account money they create is handled as legal tender. The magnitude of the subsidy society pays to the banks is reflected in the disproportionately high salaries and premiums of bankers as well as in the disproportionately large banking sector.

These are the negative monetary effects the Swiss Sovereign Money Initiative (“Vollgeld-Initiative”) wants to alleviate. On June 3rd the supporters of the initiative officially started to collect signatures in order to launch a referendum on the establishment of a sovereign money system in Switzerland. They want electronic money to be declared legal tender and remain in the possession of the bank customers by changing the Swiss constitution. The initiative also wants the central bank to have the exclusive power to issue electronic money as it has the monopoly over the issuance of cash today. This way the monetary system could serve democracy and the common good with the possibility of reducing national debt and financing the social safety net.

In a sovereign money system the unnecessarily complicated two-level banking system would be replaced by a single-level system, in which money is no longer backed by reserves, but money itself is the reserve. This way, a transparent, well ordered monetary framework could be established instead of the existing bad framework that governments attempt to straighten out with evermore complex regulation consisting of the fractional reserve system, deposit insurance and equity rules (Basel I-III).

The sovereign money concept aims to establish a sovereign public authority with total control over the money supply, both cash and electronic money on current account holdings. This monetary authority would represent a fourth separate and largely independent section of the state besides the legislature, the executive and the judiciary. The monetary authority would be bound by law to expand the money supply according to the growth potential of the real economy. The money created by the monetary authority would be transferred to the Treasury and would come into circulation by public spending; thus, it would benefit the public purse and contribute to the reduction of national debt.

Public revenue would be especially high in the moment of transition to the sovereign money system when the money owed to commercial banks becomes owed to the monetary authority, which would significantly reduce public indebtedness. In the transition period, commercial banks would be given a bridging loan from the monetary authority so as to avoid a credit crunch.

A great advantage of the sovereign money system is that money would be issued debt-free by the monetary authority and would therefore not carry interest – unless, in a following step after being created, it is lent by its owner as an investment, for example to a commercial bank. Debt-free money issuance would considerably alleviate the current social and ecological problems arising from interest, such as forced economic growth and redistribution in favour of capital. Commercial banks, on the other hand, would not be allowed to create electronic money any more. They would become what they are supposed to be today: financial intermediaries which can only grant loans from money that they have previously collected, i.e. borrowed from customers or earned by income.

The sovereign money system faces some problems. The goal of establishing public control over money creation could be thwarted by the emergence of new financial instruments, especially bank-created securities, taking over the function of money. This is a serious danger to a sovereign money system, in particular with regard to the interbank market. Financial regulations would be needed to prevent the emergence of near monies which would impair the monetary authority’s control over the money supply, for instance by prescribing a minimal holding period for financial instruments.

Another problem that needs to be resolved in a sovereign money system is how to secure the independence of the monetary authority. Since governments generally seek to increase public revenue in order to enlarge their scope of action, they would be tempted to put pressure on the monetary authority to issue more money than the potential of the real economy and the principle of sustainable development in a given situation allow. In the same way as the independence of the judiciary is guaranteed today, the monetary authority’s independence from short-sighted political interests could be secured by an adequate institutional arrangement, which simultaneously warranted transparency in monetary decision-making and democratic accountability of those who rule the monetary system. The leaders of the monetary authority could be elected by the Parliament. A central aim of the sovereign money concept, after all, is to restore democratic control over the monetary system.