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Iceland has a radical plan to redefine money

A pilot flies his plane over a volcano in Iceland as red-hot lava bursts into the sky. (Baldur Sveinsson / Rex Features via AP)
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Icelandic officials are thinking about redefining money and ending banking as we know it, Agence France-Presse reports.

Iceland's prime minister commissioned a report from Frosti Sigurjónsson, a parliamentarian, that argues banks shouldn't have the power to create money. It sounds strange to say it, but creating money is indeed something that banks do all the time. Say you take out a loan to start a business from your bank. You write checks to your workers and your rent and you buy goods wholesale. Eventually, your suppliers and employees deposit that money at their banks, which can in turn make new loans. One of those banks might extend a mortgage to help someone buy a house, and the cycle repeats.

As the checks change hands, the total amount of money out there actually multiplies with each cycle. Even though the homeowner has paid for the house she's now living in, your employee can still withdraw her cash from her bank account. And although you have money to pay all your expenses at your business, your bank's depositors can still take out their money as well. Money has been created.

Sigurjónsson's report argues that this system is unstable. And it is. If the homeowner defaults on her debts -- as many of them did during the years before and during the financial crisis -- then everyone is in trouble. The banks have promised to take care of people's money, and they find they can't keep their promises.

Sigurjónsson argues instead for a system in which the government would essentially run checking and savings accounts. No bank would be able to make a loan without taking the money out of some other account ahead of time, so instead of multiplying with each cycle of borrowing and saving, the money in this kind of system would just move around from place to place. The central bank would be entirely responsible for creating new money for people to use as the economy expands. In the current system, the central bank shares that responsibility with commercial banks.

If the central bank was concerned about a bubble forming, about people making unsound loans, policymakers could easily tighten the spigot of new money. Everyone else would be forced to carefully examine their lending and borrowing.

On the other hand, it's far from clear that the system Sigurjónsson argues for, sometimes called "sovereign money," would be more stable. Central bankers can make mistakes just as easily as private bankers can. They might be reluctant to deflate bubbles if things seem to be going well outwardly, and they might respond too slowly in a crisis. Of course, these are problems with the existing banking system as well, but they'd be exaggerated under sovereign money.

"You essentially don’t have a banking system. You would have, actually, an almost Soviet-style banking system," said Ted Truman, a former Federal Reserve economist. "It's a monobank, in the terms of Russia, the former Soviet Union."

Truman argued that Icelandic officials risked drawing the wrong lesson from the country's recent financial travails. In his view, it wasn't that the central bank needed more authority to prevent the crises, but that central bankers failed to do what was necessary, and giving them more authority would only exacerbate the problem.

"Fundamentally, I think that they’re wrong in their analysis," said Truman, a fellow at the Peterson Institute for International Economics. "It’s not that the central bank couldn’t control the expansion of credit. It’s that they didn’t control the expansion of credit."

The debate over sovereign money, or other alternatives to the modern banking system, is an old one. Sigurjónsson cites the economist Irving Fisher advocated for something along these lines during the Great Depression, and the system would in some respects be similar to how banks worked before the 20th century.

One major advantage, as Martin Wolf has argued in The Financial Times, would be that this system would be enormously profitable for the government. He writes that if the United Kingdom operated according to this plan, the government could basically operate without taxation and without borrowing money, as long as it didn't spend more than 4 percent or so of gross domestic product.

Larry Kotlikoff, an economist at Boston University and a proponent of systemic reform, argues the Icelandic proposal doesn't go far enough. While banks wouldn't be able to create money, they'd still be able to borrow it, leaving the system vulnerable to defaults.

"This is not going to do anything to deal with the reality of what happened in Iceland," Kotlikoff said. "What they're doing is a substitute for real reform."

Kotlikoff argues that banks should be replaced with a network of mutual funds with publicly listed assets, which would move money around the economy by buying and selling shares in one another. These shares could lose value, but the goal would be to eliminate default and crisis entirely.

The most prominent critic of the current banking system in the United States is probably Sen. Rand Paul (R-Ky.). Paul's views on monetary policy are unclear, but his recent comments suggest he supports something like a return to the gold standard, which has been his father's goal for decades.

Both Pauls would certainly bristle at being connected to a "Soviet-style" banking system that gives central bankers an enormous amount of power. Ironically, though, their proposals to limit the power of the Federal Reserve do have a certain affinity with sovereign money. Both sovereign money and the gold standard give money a simpler and clearer meaning that it has now, and both severely limit the ability of the private financial sector to respond to a crisis.

Some observers say that if the younger Paul decides to run for president, he'd have a reasonable chance of winning the G.O.P. nomination. Maybe radical reform of the U.S. financial system along the lines of Iceland's proposal isn't that far-fetched.