Let’s see what happens when the Swiss get radical
This Sunday Swiss voters will decide whether to try what may be the boldest financial experiment ever contemplated — dismantling their orthodox banking system and building a new one based on so-called sovereign money, or Vollgeld.
The proposal is probably far too radical to have much chance of success. Yet that’s a pity. The idea of sovereign money isn’t crazy. It has a long and distinguished academic pedigree and, as a practical matter, there’s a lot to recommend it. Switzerland would do the world a favour by giving the plan a try. At the very least, give the Vollgeld sponsors some credit (forgive the expression) for reviving an interesting debate.
Vollgeld, the Chicago Plan, narrow banking, limited-purpose banking — these and other variants of the same basic idea start from the fact that in a conventional financial system, banks as well as governments can create money. How so? Consider what happens when a bank issues a loan. It credits the account of the lender with a deposit, and that deposit is by definition money. In this way, banks can expand their balance sheets, simultaneously adding to their assets (loans) and liabilities (deposits), expanding the supply of money at will.
Vollgeld’s big idea is that this power to create money should be taken away from banks and strictly reserved for the government.
What would this mean in practice? Banks could not lend out the proceeds from on-demand deposits; instead they’d have to hold an equal amount of reserves at the central bank. Lending would be done by different institutions raising funds in other ways — by issuing equity, say, or selling mutual funds or bonds. Financing loans this way does not create money.
In a conventional system, there’s a fundamental mismatch: Supposedly safe deposits are used to finance risky loans — and if the loans go bad, the government is typically expected to step in and make depositors whole. In a sovereign-money system, deposits are safe because they’re backed one-to-one with reserves — and risky loans are financed with explicitly risky liabilities. If the loans go bad, the supporting investors (equity holders, mutual-fund purchasers) expect to bear the loss.
On the face of it, this sharp separation of money and credit would have many advantages. For a start, there could never be a run on a narrow bank, because the deposits would be backed in full. You wouldn’t need deposit insurance, and you’d eliminate the resulting subsidy to risk-taking. Boom-and-bust credit cycles would be damped without (in theory) throttling the supply of credit. As the economy expanded, the government would issue new money in return for goods and services, or perhaps by sending checks to citizens; its fiscal position would be stronger, so it could lower taxes.
On plausible assumptions, and without going into technicalities, there’d be less debt, lower interest rates, faster growth — and the central bank could target zero inflation without needing to worry about the “zero lower bound”.
Not bad — so what’s the catch? Essentially, this plan to reduce financial risk demands of policymakers an extraordinary appetite for risk. A restructuring as radical as this would drastically disrupt an industry that, for all its faults, is a vital and deeply integrated part of the modern economy. The scope for unintended consequences is vast.
In addition, one of the biggest purported benefits of Vollgeld might fail to fully materialise. You could make narrow banks safe by requiring them to back their deposits one-for-one — but that wouldn’t stop moral hazard migrating to the new suppliers of credit. One can easily imagine circumstances in which these new lenders would be deemed too big to fail, or their creditors too politically salient to be left to their fate. Regulating these institutions might not be that much easier than regulating the current system.
Nonetheless, let’s hope that Switzerland goes ahead, dismantles the financial core of its rather successful economy, and rebuilds the system from the ground up on these new and possibly superior principles. It would be great to see the idea tested at long last — preferably somewhere else.