The Swiss central bank and Sovereign Money.

Thomas Jordan, Chairman of the Governing Board Swiss National Bank published an article recently entitled “How money is created by the central bank and the banking system”. Actually the article is the transcript of a speech.

“Sovereign Money” is a quite widely used phrase which means the same as “full reserve” banking, or what Milton Friedman called “100% reserve” banking (which Friedman supported).

I have no criticisms of the first half or so of Jordan’s article: it sets out the basics about how central and commercial banks work, and in very clear language. (I’ll refer to commercial banks henceforth simply as “banks”).

But there are several points in the second half I don’t agree with. Under the heading “Why the image of creating money out of thin air is misleading”, Jordan starts by criticising the idea that banks are “privileged” in any way through reason of their ability to create money. The answer to that is that banks, at least under UK law, are very definitely in a privileged position as explained by Richard Werner in his article “How do banks create money, and why can other firms not do the same?” (published by Science Direct, 2014).  That is, banks can lend on money deposited with them, but no other type of firm can do that. And it is precisely that lending on of customers’ money that enables banks to create money.

As to the law in countries other than the UK, I’m no expert on that, but it is bound to be ROUGHLY similar to UK law: for example, I doubt lawyers in other countries are allowed to lend out clients’ money deposited with them (except in as far as depositing money at a reputable bank equals a loan to that bank).

Another way in which the ability to create money puts banks in a privileged position is that that ability enables them to come by money in a costless manner (unlike non-bank corporations) and hence artificially expand the size of the bank industry. That is, non-bank corporations and firms can only obtain money by borrowing it or earning it. Banks have a third and entirely costless way: creating or “printing” money. As Joseph Huber and James Robertson explain on p.31 of their work “Creating New Money”, lending out money you have created yourself at no cost is more profitable than lending out money you have had to earn or borrow. For more on that see my article “The Bank Subsidy No One Mentions”.

Indeed, the proto-bankers in Britain in the 1600s and 1700s discovered that lending out “home made money” in the form of receipts for non existent gold was cheaper than lending out receipts for gold which actually existed.

Next, under the heading “Comments on Sovereign Money” (p.7), Jordan makes three criticisms of Sovereign Money. First he says “the switch to Sovereign Money would be a move away from the historical distribution of responsibilities between the central bank and commercial banks. In this tried and tested two tier system, commercial banks compete with one another to supply households and companies with credit and liquidity, while the central bank acts as the bankers’ bank and conducts monetary policy.”

Well certainly under Sovereign Money, the split of responsibilities as between central banks and governments does change a bit. But the idea that any change in responsibilities is inherently undesirable is not a brilliant argument. Moreover, advocates of full reserve were making it plain some time ago that a change in responsibilities was  involved, e.g. see here. So the “change in responsibilities” point is not news.

As for “tried and tested”, that rather implies that banks have “passed the test” so to speak. In view of the 2007/8 bank crisis, it might be more appropriate to say “tried and found to be severely wanting, as demonstrated in the 2007/8 bank crisis.”

Also it is not true to say banks cease to “compete with one another to supply households and companies with credit…”. The basic change when switching to Sovereign Money is that banks have to fund their loans via equity rather than via debt (e.g. deposits). Apart from that, they compete as they always did.



Monetary policy.

As for the idea that the central bank no longer “conducts monetary policy”, that is not entirely true either. Certainly under Sovereign Money, monetary policy becomes less potent in that interest rate adjustments become less effective.  However, under Sovereign Money, central banks and governments still manage stimulus, which of necessity is at least to some extent monetary in nature.

To be more exact, assuming the sort of stimulus advocated by Positive Money is implemented instead, i.e. having central bank and government create new money and spend it (and/or cut taxes) that form of stimulus has a monetary element. That is when central bank and government create and spend fresh money, there is an initial fiscal effect: jobs are created for example in state schools or via building state owned infrastructure. Second, that spending results in the private sector’s stock of money rising. That’s monetary policy of a sort. (Incidentally Positive Money is a UK based organisation that backs the Sovereign Money idea.)

Next, Jordan says that Sovereign Money , “..calls for the Swiss National Bank to guarantee the supply of credit to the economy by financial services providers. In order to carry out this additional mandate, the SNB could provide banks with credit, probably against securitised loans. Depending on the circumstances, the SNB would have to accept credit risks onto its balance sheet and, in return, would have a more direct influence on lending. Such centralisation is not desirable. The smooth functioning of the economy would be hampered by political interference, false incentives and a lack of competition in banking.”

That idea, namely that the central bank should oversee the total amount of credit offered, and boost it if necessary is actually an OPTIONAL EXTRA, at least under Positive Money’s system.  Moreover, it’s an optional extra I don’t care for, thus I agree with Jordan in a sense there. Put another way, I see nothing wrong with simply insisting that loans are funded via equity, and then leaving it to the market to sort out.

Moreover, the idea that economists, whether working for the central bank or not, have superior judgement to the free market is very debatable. For example is the amount of lending to SMEs under the existing system adequate or not? There are arguments both ways on that one.


Interest rates would rise?

Jordan’s second criticism starts: “…Sovereign Money limits liquidity and maturity transformation as banks would no longer be able to create deposits through lending. Sovereign Money thus restricts the supply of liquidity and credit to households and companies. The financing of investment in equipment and housing would likely become more expensive.”

Well the first problem with that idea is that arguably interest rates are too low, with the result that we have excessive amounts of debt. Certainly if the popular idea that debts are excessive is correct, then a rise in interest rates would do no harm.

Another big potential problem with Jordan’s latter claim is the Modigliani Miller theory. According to the MM, the cost of funding a bank, or indeed any corporation, is not influenced by the method of funding. I.e. according to MM, funding via equity is no more expensive than funding via deposits. MM does have its critics, but I’ve been through the criticisms and I’m not impressed. (See section 1.4g here)

As for the point that Sovereign Money “limits maturity transformation”, I suggest that is an understatement. I.e. the truth is that Sovereign Money means the end of maturity transformation. Reason is that maturity transformation and money creation by private banks are the same thing. So if private money creation is banned, then so too is maturity transformation. Reasons for that are as follows.

Starting with the simplest possible loan, i.e. a loan from Mr A to Ms B, A loses access to his money until B repays it. In theory A can sell the loan, but for a person to person loan like that, A would not get a good price for the loan. That is, there no very effective way for A to transform his long term loan into a short term one (i.e. engage in  maturity transformation).

In contrast, a bank can take deposits from dozens of people, lend the money on to B, at the same time as promising the depositors they can have their money back whenever they want. I.e. the sort of long term loan that is involved where A lends to B, in the case of bank, involves funding a long term loan via loans to the bank (i.e. deposits) which have a time to maturity of zero. And a liability of a bank which has zero maturity is money.

To summarise, the bank lends £X to B, so B has the use of the money, while the depositors who deposited £X with the bank still have access to their £X. Lo and behold £X has been turned into £2X.

Disallowing maturity transformation certainly has a deflationary effect, but that doesn’t matter because the state can print and spend any amount of money it wants into the economy to compensate.

So Jordan’s claim that “Sovereign Money thus restricts the supply of liquidity and credit to households and companies” isn't quite right. That is, the amount of “liquidity” is not affected in that the loss of commercial bank created money is approximately compensated for by an increased supply of state issued money. Secondly, there is less credit creation, i.e. less lending, but that doesn’t matter in that everyone has a larger stock of base money and thus they do not need to borrow so much. In short, Sovereign Money results in less loan based economic activity, and more non-loan-based activity.


The third criticism – financial stability.

Jordan’s third criticism starts “Third, it would be naive to hold out too much hope on the financial stability front Investors and borrowers will always make misjudgements. A switch to Sovereign Money would thus not prevent harmful excesses in lending or in the valuation of stocks, bonds or real estate.”

Well the advocates of Sovereign Money have never claimed that by some magic, creditors’ ability to assess debtors is transformed. In fact that ability will remain much the same.

One of the crucial differences between a Sovereign Money system and the existing system is that however bad those misjudgements, a bank cannot possibly go bust as a result. E.g. if a bank’s loans turn out to be worth say 75% of book value (and that’s far worse than anything that happened to large banks during the recent crisis) all that happens is that the value of the shares that fund the bank drop to about 75% of book value. It is quite common for shares of non-bank  corporations to drop to 75% of the value over a period of weeks or months, either  because of a general fall in stock exchange indices, or because of poor performance by particular corporations. That sort of event does not cause finance crises.

Next, in his third criticism of Sovereign Money, Jordan claims “So the Sovereign Money initiative, with its focus on payment transaction accounts does not resolve the too big to fail issue.” My answer to that is: “yes it does”. As explained just above, under Sovereign Money, banks cannot fail. That solves the too big to fail problem!

Jordan then says, “The initiative (i.e. Sovereign Money) requires that the SNB manage the money supply, an idea we abandoned some 20 years ago. Today, the SNB steers monetary conditions via money market rates, a strategy which has served it well over the years. A switch to monetary targeting would therefore be an unnecessary step backwards from our perspective.”

Well I’m not acquainted with all the details of the Swiss Sovereign Money movement, but in the case of the equivalent movement in the UK, i.e. Positive Money, interest rate adjustments are not replaced SIMPLY with adjustments to the money supply. What happens is that the state, to repeat, creates and spends new money (and/or cuts taxes) when stimulus is needed. And the mere fact of that spending (e.g. on infrastructure, state schools, etc) creates jobs. I.e. there is an immediate fiscal effect there, followed by a longer term monetary effect stemming from the increased money supply. As distinct from increased public spending, government can choose to cut taxes, an option that a relatively right wing government might prefer.


Reversibility.

Jordan then queries the reversibility of stimulus, Sovereign Money  style, and certainly that’s a valid point to raise. That’s in his next paragraph, starting “Another problem for monetary policy would arise….”.

There are actually two or three possible forms of reversibility under Sovereign Money. First, all economies have a form of built in and totally automatic form of reversibility via the 2% inflation target. That is, if inflation is running at 2% a year, then the real value of the country’s stock of base money and government debt declines at 2% a year.

At some point that decline is guaranteed to lead to the private sector having what it regards as an inadequate stock of the latter two assets (which are actually so similar that they almost amount to the same thing, as explained by Martin Wolf in the Financial Times). The private sector will then begin to save, and as Keynes pointed out via his “paradox of thrift” metaphor, that leads to deficient demand, at which point, far from reversibility being needed, the opposite, i.e. stimulus is needed.

A second possible form of reversibility is tax. As explained above, under Sovereign Money, stimulus can be implemented by cutting taxes. Likewise, a “reverse” can be implemented by raising taxes (and “unprinting” the money collected).

Third, interest rates can be raised. As explained above,  interest rate adjustments do not have as big an effect under Sovereign Money as under the existing system, but they would nevertheless have a  finite effect.


Uncertainty.

Jordan’s next objection to Sovereign Money (para starting “Finally, a more general….”) is that there would be “uncertainty” and “turmoil” if Switzerland shifted to a Sovereign Money system while other countries did not.

Certainly it would be better for a significant group of countries, like the EU, to make the switch rather than just one country make the switch. But there are Sovereign Money movements in most countries nowadays, thus if the basic Sovereign Money idea is valid, then hopefully several countries will make the switch at the same time. Put another way, the fact that a solution to a problem is most effective where several countries or all countries adopt the solution at the same time is not a good argument against that solution.

Also Jordan does not spell out exactly what the above “uncertainty” and “turmoil” would consist of. Well here is a suggestion: where one country alone implements Sovereign Money, that could raise interest rates, i.e. make loans more expensive, which would be an artificial advantage for foreign banks.

Well the answer to that is that loans are relatively cheap under the existing system because under the existing system banks are subsidised. First there is the well known TBTF subsidy. The TBTF subsidy derives from the belief that under no circumstances can large banks be allowed to fail, and to that end, the Fed loaned around $600bn at a near zero rate of interest for around 18months to various banks. The $600bn comes from figure 11 here. As to the near zero rate, I have not been able to confirm the average rate, but all the individual loans made by the Fed that I’ve looked at were at either a zero or a near zero rate. That compares to the 10% that Warren Buffet charged Goldman Sachs at the height of the crisis for a $5bn loan, so 10% is presumably the realistic rate approximately.

And for another example of the sort of subsidy that bankers manage to wheedle out of politicians, the UK government has always provided deposit insurance for banks for free till quite recently.

Now if some foreign country wants to provide goods or services at an artificially low rate, why not let them? I.e. if Switzerland or any other country implements Sovereign Money, and finds that foreign owned banks eat into the market in the Switzerland or wherever, what is there to worry about? To take an extreme example, if any country out there wants to sell me a brand new car for $1, please get in touch with me.


Why don’t base money backed accounts already exist?

Finally, in the first paragraph of his conclusion, Jordan asks why banks have not already set up CB money backed accounts if such accounts are so wonderful.

Well the first answer to that is that in some countries, governments (rather than banks) actually have set up such accounts. For example there is National Savings and Investments in the UK. And NSI accounts are quite popular in the UK. NSI does not offer the full range of services offered by a normal bank, but it comes quite close to doing so.

Second, Jordan points to the fact that banks under the existing system offer everything a bank customer could want: interest on deposited money plus total security.

Well the flaw in that argument is that the security only comes thanks to taxpayers standing behind bank accounts. Put another way, taxpayers enable depositors to have their cake and eat it: depositors can have their money fund relatively risky loans, with taxpayers picking up the pieces when that goes wrong. Why should any depositor say no to that arrangement?

If taxpayers compensated me for losses at the local casino, but let me keep the winnings when I won, I’d be in the local casino every other night of the week.