Sovereign money: between utopia and banking reform

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In Switzerland it is proposed to end the fractional reserve system and prohibit banks from creating money through credit. What is sovereign money?

On June 10, Swiss voters are called to the polls to vote in a referendum on the sovereign money proposal, a novel initiative promoted by civil platforms and economists opposed to the current banking system.

While most polls predict a clear "No" victory, a hypothetical electoral victory could lead to profound changes in the financial sector of a country that has made banks its hallmark. In this article we will analyze in detail the proposal of sovereign money, and how it could radically change the way in which we have always understood the monetary system.

What is the fractional reserve?

The current fractional reserve system consists, broadly speaking, of allowing banks to reserve only a small percentage of their clients' deposits, known as the cash ratio or bank reserve requirement. Consequently, entities can create money through credit, since they end up lending more than they really have in reserve. This is how a process is started that has its origin in the credits granted by the Central Bank to financial institutions, and continues when they lend money both in the interbank market and to individuals. Naturally, with each new loan, the debt increases, but also the volume of money, at a growth rate that we commonly call the monetary multiplier.

We can explain this process with a simple example. If the Central Bank establishes a reserve coefficient of 10% and lends 10 monetary units to an entity that has just received 100 in customer deposits, it will be able to lend the 100 in the interbank market since it will have the minimum required reserve of 10 in cash. In turn, the bank that has borrowed 100 may create up to 1,000 in credit. In this case, the monetary multiplier would be 10, since with each new loan the total volume of money will be multiplied by that amount.

For this reason, it is easy to observe that under the fractional reserve system most of the money creation corresponds to credit institutions. This is undoubtedly an important advantage for central banks, since it allows them to increase the money supply with minimal effort on their balance sheets. At the same time, a direct correlation between money supply and demand is ensured, by entrusting its creation to the agents closest to the market, knowing first-hand and in-depth both its structural conditions and its conjunctural fluctuations.

On the contrary, the fractional reserve system also has some drawbacks. First, it puts banks in serious trouble if, for some reason, a significant portion of customers decide to withdraw their deposits at the same time. As has already happened in some countries (Greece, Cyprus, Argentina) this can lead to financial corralitos that directly affect citizens' savings.

On the other hand, the creation of money through credit can lead to unwanted alterations of the monetary base in times of financial speculation. This means that if the financing conditions are artificially favorable, the excessive expansion of credit will not only translate into distorted financial markets but also into inflation, assuming that the money supply is directly related to the general price level.

The Swiss alternative: sovereign money

On the contrary, the sovereign money project supposes a total rupture with respect to the traditional banking systems that we know. In this sense, perhaps its main novelty is the prohibition of fractional reserve, forcing banks to keep 100% of their clients' deposits. The result would be the impossibility of increasing the monetary base through credit in the private sector and the transfer of this responsibility to the central bank (which would create money by transferring it directly to financial institutions without a debt counterpart, as is currently the case).

As for private credit activity, it would suffer a severe adjustment since it could no longer be financed with customer deposits but exclusively with financial instruments such as equity issues, corporate debt, etc. In this way, the financial capacity of the entities would depend directly on the confidence they generate in the markets, since the volume of debt they can assume would determine the amount of credit they could grant.

Additionally, the sovereign money proposal obliges entities to keep 100% of liquid assets as reserves and to deposit them with the central bank. This is how this institution would not only act as a monopolist in the issuance of money but also as a guarantor of all current accounts and deposits in national currency.

In the same way, it is important to mention the impact that sovereign money would have on monetary aggregates: taking into account that the creation of debt would be completely decoupled from that of money, the aggregate M3 would simply become an indicator of the capital stock at short-term, while the 100% cash ratios would equal the aggregates M1 and M2. Consequently, there would be a single monetary base, fully insured and at the same time controlled by the central bank.

Safer money?

Proponents of the sovereign money initiative often argue that their proposal could substantially improve the financial security of citizens, whose savings would be fully guaranteed by the central bank. For this reason, a bank failure would only affect holders of variable or fixed income securities issued by the entity, but never those who have checking or deposit accounts.

On the other hand, the end of the fractional reserve would represent a major brake on credit expansion, which could prevent the formation of financial bubbles since it would limit the available capital of bankers and encourage them to be more prudent in their investments. . At the same time, this restriction could also affect a better solvency of the entities.

Finally, the consideration of money as a liability of the central bank would no longer make sense since its issuance would not lead to the appearance of an equivalent financial obligation. In other words, the exclusive possibility of the central bank to create an unlimited amount of money would not have to translate into a proportional increase in debt, as is currently the case in fractional reserve systems. According to the defenders of sovereign money, this would allow to carry out more effective monetary expansion policies, since they could boost the economy without affecting the solvency of financial markets.

A proposal that generates many doubts

Monetary policy could end up being one more appendix to fiscal policy, and the safeguarding of citizens' purchasing power would be overwhelmed by the whims of the political class.

Unfortunately, there are also multiple objections to the sovereign money proposal that will soon be voted on in Switzerland. In the first place, the detractors of this system argue that handing over the monopoly of money creation to the central bank would imply centralizing in one authority the functions that the market agents themselves could perform more efficiently. After all, it is the banks who know first-hand the financing needs of the economy, but their ability to supply the necessary financial capital would depend on the will of a body that would not even operate in the markets. This would run the risk of suffering deep imbalances between the supply and demand of money, since while the former would be arbitrarily determined, the latter would continue to respond to traditional patterns (that is, it would reflect market movements of goods). In turn, these imbalances could cause serious distortions in the rest of the economy, through periods of excess or lack of financing.

On the other hand, the possibility of issuing money without creating a debt counterpart could easily be translated into another form of public spending, since it would allow the central bank to unilaterally increase the monetary balances of an individual or financial institution that it wanted to favor. Naturally, it would not be an expense financed with taxes collected directly from taxpayers, but it would not for this reason fail to impose a sacrifice for all citizens: inflation. In this way, monetary policy, which in principle should be detached from the influence of governments, could end up being one more appendix of fiscal policy, and safeguarding the purchasing power of citizens (its primary objective) would be overwhelmed by whims of the political class of the moment.

Regarding the increase in the solvency of institutions, this point also raises many doubts: it is not clear that banks would become more prudent in their investments, since the relative scarcity of capital could encourage them to the contrary, that is, to finance more risky projects to compensate with higher profit margins what they would stop gaining due to the reduction in business volume. At the same time, creating debt-free money would allow the central bank to bail out troubled entities out of debt, removing the last incentives they might have to reduce their risk levels.

Finally, the strong restriction on credit expansion could significantly tighten financing conditions (with higher interest rates or higher solvency requirements), which would be a drag on economic growth. At the same time, banks may try to compensate for the lack of loan interest income with a sharp increase in fees, creating even more inefficiencies in the system.

Perhaps all these objections will help us to understand the rejection that, according to the polls, the sovereign money will suffer on the part of the Swiss voters in the referendum of June 10. In any case, not even a hypothetical (and unlikely) victory at the polls could ensure that the initiative is carried out, since it is a non-binding consultation and would have to pass through the filter of Parliament, which could moderate the proposal or simply reject it (remember that most of the political parties have spoken out against it). However, sovereign money may serve to warn us about the weaknesses of the fractional reserve system. In this way, the Swiss initiative may fail at the polls but perhaps it will end up becoming one of the many ideas that have existed in economic theory, and that are currently remembered not for having been successful in their time but for having prepared the way for other advancements in the future. In any case today it is difficult to know: only time (and the Swiss voters) will tell.

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