Opinion

The Swiss referendum on Sovereign Money

Standard theories of money and banking are a veil that covers the reality of how the financial system works

Dr Asad Zaman December 06, 2015

The writer is vice-chancellor of the Pakistan Institute of Development Economics. He holds a PhD in Economics from Stanford University

While money and banking plays an extremely important role in the economy, economics textbooks teach the opposite. According to the quantity theory of money (QTM), money plays no role in the economy at all; it is a veil which covers the workings of the real economy. An increase or decrease in the money supply will cause an increase or decrease in the prices, and will have no long run real effects on the economy. According to QTM, money is neutral: we must look beyond the veil of money to understand how the economy functions.

The truth is that the standard theories of money and banking are themselves a veil, which covers the reality of how the system works. This veil was penetrated briefly following the Great Depression of 1929, which was completely incomprehensible according to standard economic theories of the time. To explain the Great Depression, Keynes invented a new economics, in which money was not neutral. He argued that shortages of money would lead to unemployment and recessions, while excess would lead to inflation. At the same time, leading economists such as Irving Fisher, Frank Knight, Simon Schultz and many others realised the crucial role played by excessive credit creation by banks in precipitating the Great Depression. In 1933, they came up with the Chicago Plan, which takes away the power to create money from the banks and gives it back to the government. The Banking Act of 1935 created deposit insurance and many other regulatory measures to control banking, but did not implement the Chicago Plan. Keynesian insights about money and Chicago insights about banking were gradually forgotten. The eerie resemblance of the Global Financial Crisis of 2007 to the Great Depression led two IMF economists to dust off the bookshelves of history and revisit the Chicago Plan. Since then, it has been gathering momentum in terms of public awareness, but has been mostly invisible in the dominant media and politics, which are controlled by big finance. However, the Iceland government recently published a report that proposed a variant of the Chicago Plan. Most recently, on December 1, 2015, the Swiss public created a successful petition with 112,000 signatures to ensure parliamentary hearing on the proposal for Sovereign Money, which is a core element of the revised Chicago Plan. Since powerful interests have been blocking and opposing the Chicago Plan, it is up to the public to learn about the issues and create a movement for change. In this connection, interested readers may look up “Corrupt Banking System explained by twelve-year-old” on the internet for an entertaining and informative detailed video of explanation. We provide a very brief explanation of the central issues below.

In the fractional reserve banking system, banks are only required to keep a small fraction of cash against the demand deposits outstanding against them. For example, in order to create grant a loan of 10,000,000 to Mr X, Mozoon bank only needs five per cent of the amount, only 500,000 in the form of cash deposits. The bank grants the loan simply by creating an electronic entry in its accounts. In advanced economies, money travels electronically between financial institutions, and cash reserves are little needed. When necessary, they can be borrowed from many sources; the Central Bank in particular, is under obligation to cover cash shortfalls of banks. At 10 per cent interest on the loan, Mozoon Bank will make a cool profit of 1,000,000 based on its meagre cash reserves of only 500,000. Where did this profit come from? It came from the money created out of thin air by Mozoon Bank and then lent out to the borrower at 10 per cent interest. Because Pakistan is financially primitive, banks keep larger reserves (nearly 30 per cent) and cannot leverage their cash deposits to the extent possible in more advanced economies.

The conventional wisdom, taught in textbooks of monetary economics, is that the government creates money, not banks. Furthermore, banks are financial intermediaries: they lend money which they gather as deposits. The reality is that the banks invent the money that they lend. This means that the banks, and not the government, are in control of the money supply in the economy. Bank creation of money acts in ways that are opposite to Keynesian prescriptions, and destabilise the economy. According to Keynes, when the economy is in a recession, the government should expand the money supply. In a booming economy with full employment, the government should cut back on money supply to prevent inflation. However, banks lend less in recessions, reducing the money supply. They lend more in a booming economy, adding to inflationary forces. Following the Global Financial Crisis, theories of Hyman Minsky, called the Financial Fragility Hypothesis, have become very popular. Minsky adds details to this crude picture, and shows that banks systematically destabilise economies, leading to crises and crashes. The empirical record showing more than 200 banking crises over the past 30 years bears out the theories of Minsky. The Global Financial Crisis, like most others, was caused by excess money creation by banks, which fueled the fires of speculation, leading to a crash.

The solution to this problem is the proposal for Sovereign Money, which has been detailed in the Iceland Plan, and will now be up for discussion in Swiss parliament. Instead of fractional reserve, banks must keep 100 per cent reserves, preventing them from creating money. Instead, the central banks will create money in the right quantity, designed to stabilise the economy, according to the Keynesian prescriptions. IMF economists Benes and Kumhoff have shown that this radical reform of money and banking will bring multiple benefits. It will eliminate banking crises, increase growth, eliminate debt, and create more fiscal space for development projects. It will also decrease the massive inequality, which allows a tiny minority to control the political and economic system. The present system enslaves the majority in chains of debt only because a large number of deceptive claims about its benefits are widely believed. If we learn the truth, it can set us free.

Published in The Express Tribune, December 7^th, 2015.

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COMMENTS (10)

Mike G | 8 years ago | Reply @ John B: your economics model is out of date, many of the points you make are factually incorrect. 1) Local banks create money by double accounting: you sign a loan agreement for 10M, that document is worth 10M and is lodged on the asset side. Then they type 10,000,000 into an account in your name: that 'demand deposit' is the balancing liability. It was new money created out of thin air. It is not a misconception; it is exactly how money works in most economies today. 2) after the bank makes the loan it goes looking for its reserve requirements. If all banks make loans together then they need very little in the way of central bank reserves .... 3) which are NOT lent out to the public, they are used only for inter-bank settlement. If one bank runs short then the central bank will step in and provide reserves to prevent a liquidity problem and a run on that bank. This is why the central bank does not really have control over the money supply. 4) So the private banks are entirely in charge and the system is not restricted by central bank reserves or fractional reserve ratios. This is very clear from the quantities of money across economies. Look at M0 Narrow Money vs. M3/4 Broad Money at the time of the crash. In your model this is a fixed ratio but in reality is very much is not. 3) The Central Bank can both borrow and create its own money: this is Quantitive Easing, or a Sovereign Fund, or just notes and coins (very small %). 4) The USD Gold standard was dissolved by Nixon in 1971 and since from the Bretton-Woods agreement in 1944, most other major currencies were pegged to the US Dollar, there has been no major commodity backed currency in the world for 44 years. However, prior to this (1785 on) the USD was silver or gold backed. So the Capitalist USA was built using commodity backed money, Communism & Capitalism have nothing to do with the money system in use. Both Russia and China use Fiat currency. Further: Parliaments have previously enforced full reserve banking, they just didn’t anticipate the damage the industry could do once computers came along: see the 1844 Bank Charter Act in the UK. 7) No one is 'forced' to use a money system, look at Bitcoin or Paypal. Money is a social construct that works because people trust it. When Zimbabweans finally quit with their dollar they started using USD instead: both just bits of paper, one trustworthy. 5) Any country with a central bank could decide to use either or both of a Sovereign fund or Full Reserve banking. Various countries already have a Sovereign fund, such as Norway. Most major currencies have used QE, which is the same as a Sovereign fund except that the QE tends to go (via Bonds) into financial markets and asset bubbles. 6) QE hasn't worked in most countries because the banks failed to loan out the money made available to them, they used it to shore up their balance sheets and then put it into assets. In the UK, of £375bn QE, only 8% went into the productive economy and M3 still contracted, hence the lengthy recession exacerbated by money contraction. It is ironic that the crash wasn’t big enough to cause more countries to review whether the quantity of money should be left in the hands of private companies for the purposes of maximising their profit, which from (1) above you will see involves getting everyone into as much debt as possible. The facts support Dr.Zaman. Pakistan is fortunate to have someone in a significant position who does understand where money comes from.

Uzma | 8 years ago | Reply The depths of ignorance revealed in remarks of John B are amazing, though some other commentators also come close. Sovereign money refers to one position in a complex current debate raging among advocates of Chartalist Money, MMT -- modern money theory, Circuit theory of money, Austrian school and some other schools of thought. Look up sovereign money on the internet for references. These controversies have emerged because of the widespread realization that current system of private money creation by banks is deeply flawed and some alternative is needed. This has nothing to do with Jefferson, nor has anyone in their right mind ever suggested any theory which would make one US Dollar equal in value to one Pak Rupee. As several authors have said about money creation: people do not understand it, nor is it meant that they should understand it -- the workings of the system are deliberately hidden from the people.These misunderstandings are reflected in several comments. The mechanism discussed briefly in Dr. Zaman's article is described in great detail in the Bank of England paper entitled "Money Creation in the Modern Economy". For a brief explanation, see article by David Graeber on the Truth about Money in the Guardian:

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FZ | 8 years ago | Reply this gentlemen does not know how banks create money. No bank I know of takes a 10 rupee deposit and then turns around and lends a 100 (or any other multiple of that) out (creating money out of "thin air"). The banking system creates money, but that is not how he does it. How in the world this guy has a PhD, that too from Stanford is amazing.

Shahid | 8 years ago | Reply Oh dear, Dr. Zaman again goes off the lines of logic. He writes one or two reasonable articles, and then slides towards illogical thinking. John B. has aptly deconstructed his completely wrong logic of fractional reserve banking. I have a few more lines to add. First of all, QTM never implied that money has no effect. In fact, it implied that money has a very powerful effect on economic activity in the short run in the form of expansion of output. It is only in the long run, when prices have risen, that economic activity dampens. In the long run, further expansion of money supply won't make much of a difference because economic activity won't respond to it. That's why, in the long run, money becomes 'neutral'. But by that time, economy has moved onto a new equilibrium, with a new price and out put level. So its absolutely plain wrong to say that QTM predicts that money won't have any effect.Only a person bereft of economic history would say such a thing. And i am so surprised that a person who is heading PIDE does not know that it is the central bank that controls the supply of money through Open Market Operations (OMO's) and tinkering with the interest rates. Banks are closely supervised by the central banks around the world. Its really sad to read all this from a person who is holding such a high seat in Pakistani economics. As for expanding money supply to counter recessions, governments and central banks around the world have poured in trillions of dollars (implying substantial increase in money supply) since 2008, but the economies have yet to recover,. Interested readers may read this story http://www.thenews.com.pk/Todays-News-9-354243-Looming-depression (by yours truly) in order to understand what i am trying to imply. So, with sadness, i proclaim this article to be absolutely devoid of facts. Let's hope ET staff is generous enough to publish my remarks (they never do) for the sake of intellectual discourse and righting some wrong conceptions in this article.

Amin Jan Naim | 8 years ago | Reply A misleading and inaccurate description with deleterious implications. John B's analytical comments above on the article are very correct

Abdullah | 8 years ago | Reply Islamic banking system is the best solution for fractional money system as Islamic bank never lend.

Abdullah | 8 years ago | Reply Thank you sir, the article was informative, however, Islamic banks are the best solution for fractional money system because Islamic banks never lend.

Sheraz Khalid | 8 years ago | Reply That was impressive! Thank you, Sir.

John B | 8 years ago | Reply In a fractional reserve banking, local banks create money out of thin air is a misconception. The actual fiat money the local bank needs in fractional banking comes from the reserve bank , which has the power to supply money based on government decree. The reserve bank base this money supply based on initial capital deposited by local banks plus the policies instituted by the government. If the government wants more money for spending the central bank borrows from other capital markets, and borrowing ability of the government is dependent upon the credit worthiness of the government. The Chicago plan is essentially Jeffersonian plan that says that money creation power is with government and is not based on private capital acquitted through taxation /borrowing by the government. This is the hallmark of capitalism Vs Communism /socialism. Since the wolrd economy operates on capitalism, which based its monetary value on initial capital (gold) deposited /available in banks and private capital pool, it is unlikely the world will revert to Soverign money. Sovereign money never existed in human history since it is hard to value In sovereign money, One US $ must equals to one Pak rupee.. In an ideal world that will be a good place to start if all are starting at the same level and at same time. But that is not the case. Money of today's world is based on strong powers to insist on its value and the weak nations agreeing to accept that value. The money value of today is / was determined by the cabal of european and U.S. powers based on gold value which was agreed upon by all the rest. when the cabal dropped the gold standard value, the rest of the world were powerless to resist. Unless all nations agree on sovereign money concept, the present artifical value of money will continue and one hour labor of poorer nation is worth less than the one hour labor of cabal nations, leading to economic disparity between cabal nations Vs others. The losers of sovereign money introduction will be traditional capitalists, who are not going to remain silent and therefore mankind will remain a slave to the very money he created and the strong will determine its value. Sovereign money = Marxist principle = socialism = communism and therefore it is not going to happen. The time for that has passed when Wilson signed Federal reserve Bank act in the US, while the English and other colonial powers were already operating under that principal. In short, all major economies of the world that were involved in transnational commerce were running on Fractional Reserve Banking even before WW1. USSR tried in sovereign money concept, but the governmental approach to implementation was flawed and therefore it failed in its concept.

Amir | 8 years ago | Reply Thank you. This was informative.

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