The Swiss solution to the Euro crisis

On Sunday June 10 2018, the Swiss vote for a radical reform of the money system. Switzerland doesn’t really need this revolution. However, it could be the last resort for the Eurozone.

An opinion piece by Daniel Stelter translated, by Manuel Klein (Monetative). It was published on Positive Money Europe, while originally being published in Manager Magazin in german.

?Daniel Stelter is the founder of the online forum “Beyond the Obvious” which is specialized in strategy and macroeconomics. Before, Stelter worked as a senior partner, managing director and member of the Executive Committee at the Boston Consulting Group (BCG). Stelter published a bestseller ?Debt in the 21st Century“ in which he summarizes the key aspects of Thomas Piketty’s cornerstone “Capital in the 21st Century” and shows that Piketty misses out to include the dramatic effects of debt on society and the economy. This article does not necessarily reflect the opinion of Positive Money Europe.

Switzerland can be considered as a happy country. Its direct democracy with plebiscites and citizens votes might create some results that the political establishment does not favor but the majority of the citizens do. However, topics that would never come to the political agenda in most of the countries without this instrument, get a chance to be discussed – especially when they are worth to be discussed.

This is also true for the upcoming referendum this Sunday. The Swiss citizens are asked to decide whether the current money system – prevalent in all capitalistic systems – should be changed fundamentally. Nothing less than the ending of the privilege of commercial banks to create money is at stake.

If the Swiss vote in favor of the initiative, the revolution that Henry Ford foresaw more than 100 years ago would become reality:

It is perhaps well enough that the people of the nation do not know or understand our banking and monetary system, for if they did I believe there would be a revolution before tomorrow morning.

Our Money System should be scrutinized

The fear of this revolution should be the main reason for the consistent political concealment we witness in our society. Our money system is not discussed openly and many wrong stories of how the money system works and how money is created are being told. This highly successful concealment has even led bankers not to understand what they are actually doing nor do mainstream economic-theories understand the pivotal role commercial banks play in the economy.

However, it is of major importance to understand the functioning of our money system since this foundation of all capitalist economies periodically produces financial crises, the euro crisis, speculative bubbles and ever bigger crashes and economic crises.

Even though central banks all around the world create the impression that they can control the money supply, they only have a very indirect and weak influence on it. Central banks use the interest rate at which banks can borrow money from it and the minimum reserve ratio the banks have to hold in their accounts at the central bank as their main tools. However, counter to the still widely prevalent theory, central banks follow the banking system and not vice versa. The minimum reserve ratio and the myth of a money multiplier as a policy instrument is therefore effectively useless. 90 percent of all the money we citizens use is produced by private commercial banks. Only the residual 10 percent are actually produced by central banks – in retrospect.

In the current money system, a bank can grant a loan without holding savings deposits from other depositors. A common misconception among economists is that investments require savings. However, saving does not finance investment, financing and money creation do. Banks simply create the deposit in the bank account of the borrower by typing numbers in its computer system – out of nothing – when they make loans or buy other assets. In Latin, this is expressed by “fiat” which has led to the name “FIAT-money system”. As long as the loan is granted against adequate securities as collateral, the newly created money is backed by these assets and thus remains unproblematic.

When not thinking of commercial banks as neutral intermediaries between savers and investors like many of the current economic textbooks and macroeconomic models still do, one notices that banks have a substantial procyclical influence on the economy. In the good times, when income is stable and asset prices are high and keep rising, banks are keen to grant loans. In bad times, however, they are reluctant to do so. This procyclical behavior not only regularly produces booms and busts but also bigger and greater crises.

When looking at the past 40 years, we witness a constantly rising indebtedness of the west which still rises in an unrestrained manner. This can be explained as follows: Commercial Banks firstly grant loans to solvent debtors with adequate securities which leads to an extension of the money supply. The economy is thriving, incomes are growing and asset prices flourish. When the economy decelerates, banks realize that they had excessively granted loans but do not understand that they actually created excessive money by doing so. When their first losses kick in and assets lose value, they become risk averse and thus reluctant to grant additional loans. Since the change in the money supply is explained by the net-lending of commercial banks, more money is destroyed then newly created. This results in a stagnation or contraction of the money supply – banking- and financial crises are an inevitable result.

In order to prevent crises, central banks were established to step in as a lender of last result in the event of a crisis. However, their mandate was based on strict restrictions. The banking expert Walter Bagehot, who was the publisher and editor in chief of The Economist from 1861 to 1877, set up strict rules already in 1873: Central banks should only help solvent banks in the event of a crisis and only against a high penalty interest rate. By setting up these rules he wanted to ensure that banks don’t abuse their power to create money and act irresponsibly by granting loans to reckless debtors and against inadequate securities.

When looking back on the financial- and Euro crisis and especially on the current “euro rescue policies”, we observe that all these principles have been neglected. The ECB grants loans to banks that are effectively insolvent, accepts highly dubious collateral to an interest rate of zero. This shows how bad the condition of the money and financial system really is, 10 years after the recent crisis.

2. Swiss initiative wants to end the banking privilege to create money

An ever-growing part of economists come to this conclusion – not only the leftists. The Financial Times (FT), surely not an anti-banking newspaper, recently published an article saying that if we were to create a new money system, we would certainly not choose the current, fractional reserve system. Martin Wolf, the renowned chief economics commentator of FT titled already in 2014 “Strip Private Banks of their Power to create Money“. He now repeats his claim by explaining “Why the Swiss should vote for ‘Vollgeld’”. The main idea behind this alternative system by the name of “Sovereign Money” or “Vollgeld” in German is to remove the power to create money from the banks and transfer it to the central bank.

This is where the Swiss Vollgeld-Initiative steps in. Under the reminiscence of the traumatic bailout of the globally operating Swiss bank UBS, the initiators want to prohibit any form of money creation by commercial banks. In such a system, banks would be forced to hold all of their deposits in central bank money. They would then manage customer sight deposits but could only grant loans if they collected savings from their customers first. The decision of investing in the bank must be made consciously by the customers of the bank.

The idea behind Vollgeld or monopolizing the issuance of money is not new and, in the past, had very prominent supporters such as Benjamin Franklin, David Ricardo, Thomas Jefferson and more recently, the Nobel prize winner Milton Friedman. In 1936, in the aftermath of the great depression, the transition to such a system was developed by the Chicago based professors Henry Simons and Irving Fisher as the “Chicago Plan”. In such a system, the professors saw a possibility in stabilizing the increase of the money supply of an economy and to flatten the boom- and bust-cycles of the real economy. Excessive bank lobbyism of the banking industry and the recovery of the economy prevented this system to be implemented.

Good arguments pro and contra Vollgeld

Technically, our money system can be considered as an ingenious concept whose economic efficiency gains can only hardly be measured. The current FIAT-money system worked as the motor behind all developed economies. The idea behind it was that banks should be more able to assess and evaluate risks than any central institution. By granting loans only against adequate collateral, the newly created money should be of high recoverability and scarce at the same time. Since banks had an intrinsic interest in their own economic survival they should act cautious, always hold enough equity to offset potential losses and only create credit cautiously for investments in the real economy. This is the theory which many of the opponents of the initiative use.

However, practically, our money system is completely perverted. The risks of going bankrupt were almost entirely abolished. In the last decades, the vast majority of the loans were granted for the transfer of ownership rights of already existing assets – especially real estate – which led to excessive speculation and asset price inflation. Nations and their central banks have done everything they could to unleash the system which led to a massive expansion of credit creation by commercial banks. In order to finance these loans, more credit needed to be created – by the same banking industry.

Of course, we could try to stop this “financial doomsday machine” (Martin Wolf) by imposing higher capital ratios, by stronger regulations and lastly by letting banks go bankrupt. However, against all of the assurances of the politics, nothing really happened. Especially in Europe, banks are still as dangerous to the economy as they were ten years ago. Why that? The money was created by the same banking industry like before which still has the bad debts in its books.

Due to the frustration about these policy failures, one can very well understand the motives of the proponents for introducing an alternative money system. Indeed, it would be a superior system since a safe and sound money system is a public and common good. The debate about de-privatizing money creation results in the direct control of the growth of the money supply. Since this system would replace a system in which commercial banks inherently procyclical create credit, it deserves to be debated. The central bank could grow the money supply steadily while orienting itself on the growth potential of the real economy. This would end excessive Booms and Busts; customer deposits and the payment system would be safe in the case of an insolvency of banks and the threat of a bank run would be eliminated since all deposits would be guaranteed by the central bank. The technological advancements during recent years could actually make such a system possible.

I myself am torn between the pros and contras of a switch to a sovereign money system. While recognizing the big benefits of the Vollgeld system I am also reluctant to trust central banks. In the past 30 years, they have done everything they could to reward and support the procyclical behavior of commercial banks. Without the explicit and implicit bailouts and the steady cuts in the interest rates, we would never have witnessed the past financial crises. I don’t see why these central banks should in the future do a better job of providing the liquidity, the economy needs to thrive. However, it is indisputable that the current money system has to change.

3. Debt relief for the Eurozone

The Swiss economy and its citizens don’t need the positive effects of the transition to a sovereign money system as urgent as the Eurozone. This can be summarized in two major reasons: firstly, the banking sector is financed considerably more solid than during and after the recent crisis. Secondly, the economy doesn’t rely on the positive financial side effects of the transition – namely the one-time conversion-gain in the trillions that could be used by the state for debt redemptions.

However, exactly this relief is urgently needed in the Eurozone. As I already stated several times in other articles, the Eurozone needs a public and private debt relief of three to five trillion Euro. Since this sum is not easy to acquire, all proposals of the “Saviors of the Euro” are based on the following two ideas:

1. Increasing the capacity for further debt by burdening the German taxpayers (Euro budget, European Finance Minister, banking union, etc.)

2. Monetization of the debts by the ECB which buys government debt in the Trillions

Strategy 1 will be impossible to implement and strategy 2 simply takes too long. Before we see strategy 2 in action, we will see populist governments taking over in all other European member states.

A transition to a sovereign system can help to solve this problem. Already in 1936, the authors of the Chicago Plan expected a massive one time gain due to the realization of the seigniorage of the money supply. In 2012, two researchers at the IMF put forth research regarding the transmission to such a system and came to similar conclusions. In the example of the USA, the transition would lead to a complete redemption of sovereign debt and a drastic reduction in the outstanding private debt.

How is this possible? In the first step, banks have to hold central bank money against all of their loans. Since this is not the case in the current money system, they would have to borrow it from the central bank. Instead of only a small fraction (Minimum liquidity ratio) in the current system, they would have to refinance themselves at a 100 percent. This would result in a drastic balance sheet extension of the central bank.

Since the state is the owner of the central bank, it would be its debtor and creditor at the same time. As most of the government bonds are held by the banking system, the claims of the banks against the state and the liabilities against the central bank would offset against each other which in turn contracts the balance sheets of the central bank. If government bonds not held by the non-financial sector are incorporated, the state could effectively become debt-free. In the case of the US, this would also lead to a partial redemption of the private sector debt since the American financial sector holds liabilities of approximately 200 percent in relation to GDP. In Europe, this effect would be substantially greater since the banking sector is much more inflated as in the case of the USA (approx. 300 percent in relation to GDP).

Ultimately, this equals to a monetization of the existing debts which by no means produces inflation. Inflation results only from an additional increase in demand and therefore credit extension. The current strategy of the central banks to uphold the current money system by buying government bonds and other securities – formally called “Quantitative Easing” – results in a monetization of the debts in any case.

Through the transition to a sovereign money system, the central bank could signal more credibly that this is only a one-time effect and not a permanent financing of the government through the printing press. Solely the ongoing growth in the money supply would be handed over to the states and channeled into the economy by government expenditures, adding to the seigniorage of the coin issuance that is already prevalent. Another, maybe superior alternative of injecting liquidity into the economy would be to hand it out to each of the citizens directly.

4. A Trick that works

Understanding all of this reveals a trick that could actually work. At this place, I want to underline that I do not wish that all of this happens. I am only a realist that believes that politics will do everything possible to ensure that the political project Euro survives against all economic principles. When stating this, I think about damage control.

Politics could reason this system change well:

1. The Euro crisis would never have happened if the massive extension of credit by the banks didn’t take place. Many CEOS of too big to fail banks did not know what their business model was and banks create the money supply profit oriented and without thinking of the effects on the economy as a whole.
2. It was impossible for the ECB and politics to take countermeasures because, in the prevalent FIAT-money system, the only institutions that can create money for non-banks are commercial banks.
3. The current system privatizes profits but socializes the losses. This status should come to an end.
4. Banks should be constrained to act as pure intermediaries, collecting money and lend it out. They already have this sophisticated competence. The huge prudential regulation of banks and the financial system could drastically be reduced leading to a liberalization of the financial system.
5. Under Vollgeld, only the ECB (and the member central banks) decide how much the money supply should grow. They base their decision on the sustainable change of real economic output. In such a system, there is no need for macroprudential monetary policy.
6. The Euro banking sector would be completely safe and Europe would not need a banking union, nor a mechanism to rescue entire member states.
7. The transition would produce a one-time profit due to the realization of the full seigniorage. This profit is the fair compensation of all taxpayers for having to pay for all the bailouts of the banking and financial system so far.
8. This profit could be used to pay down all government debts of the member states of the European Monetary Union (EMU). The outstanding profits could be used to reduce all private debts by an equal percentage level.

Afterwards, the usual Blabla of political explanations would continue.

Is all of this a possible future event? I think so. Because it could actually work. The question remains if the citizens of the EMU would put trust into such a system. A Prerequisite for this trust is that the state runs his monopolized supply of money sustainable. The risk that politics cannot resist the temptation to use the printing press to finance their budget is big.

The authors of the IMF-paper put forth two arguments that this will not happen: firstly, in a sovereign money system, monetary policy could not be surrendered to criminals like it has happened in the past. In France, for example, between 1717 and 1720, the Scotsman John Law sold completely inflated shares for alleged goldmines in the colony of Louisiana where in fact only moors and swamps full of alligators existed. Secondly, in a sovereign money system, the government should never run wars or especially lose them. In both cases, the increase in the money supply would be far too large which would result in endless inflation and devaluation of the currency. Personally, I would add that the government should not promote promises for excessive social welfare and pension provision.

Since the last point is prevalent, the only sober appraisal is that the transition to a sovereign money or Vollgeld system in the Eurozone could enable a reset but would not change the incompetence of the politicians.