Home > The Economy > The Iceland plan for monetary reform

The Iceland plan for monetary reform

from Asad Zaman (and the WEA Pedagogy Bog)

A long time ago, Ibn-e-Khaldoon noted the tendency of conquered nations to unthinkingly imitate the conquerors in all dimensions of life. After achieving freedom from colonization, the former colonies have tended to imitate or retain the colonial institutions, without reflecting on whether or not these institutions are suitable for them. In his classic, “Small is Beautiful,” Schumacher showed that appropriate technology for developing countries was often small and low-tech production techniques which empowered the people. Imitating the highly capital intensive and large scale industries of labor short capitalist countries is like trying to run before learning to walk. Today, large dams are being built all over the world at enormous financial and environmental costs, while smaller scale agile energy producing technologies which deliver quick results cheaply are being ignored. Similarly, we have retained colonial institutions which were designed to be top-down, hierarchical, and non-democratic; people being heavily taxed and exploited cannot be allowed to have a vote in the matter. Transiting to democratic institutions requires many reforms. For instance, the “police force” which maintains order by force, needs to be re-conceptualized as the police service, responsible for the security and protection of citizens. 

Banking is another institution that has been copied without a cost benefit analysis. The Great Depression of 1929 was caused by a banking crisis which wiped out lifetime earnings and led to prolonged misery for millions. Stringent banking regulations prevented major crises for fifty years. Financial liberalization in the 1980’s led to the Savings and Loan crises; the bailout was more than the profits of banks for the entire century. Since the 1980’s financial de-regulation has been extended and globalized, resulting in more than 200 banking crises globally, with huge economic costs. The latest and greatest is the Global Financial Crisis of 2008, which cost trillions of dollars, and led to the highest levels of homelessness and hunger seen in the USA since World War 2. Overall, when we add up the benefits and subtract the costs of current banking systems, the net result is tremendously negative.

Many have analyzed the reasons for repeated banking crises, and found that the root cause is the fractional reserve banking system. In this system, banks holding a billion Rupees can freely create a large multiple – like five or ten billion Rupees – from nowhere. They only need to have a small fraction of the money that they create to give to lenders. The inherent injustice of a system which allows certain wealthy private parties to create money at will is hidden from public view. Henry Ford said that “It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.” An inherent feature of the system is that the claims on banks are far greater than their assets. When too many depositors wish to withdraw money, there is bound to be a crisis. In the words of Lord Mervyn King, the former Governor of the Bank of England “Of all the many ways of organizing banking, the worst is the one we have today – change is I believe inevitable. The question is only whether we can think our way through to a better outcome before the next generation is damaged by a future and bigger crises.”

The excellent documentary “Inside Job” shows that Iceland was badly mauled in the GFC 2008. Financial de-regulation crashed a small stable and robust economy, due to wild and excessive lending. Iceland Bankers, utilizing their powers of money creation, expanded the money supply by a factor of twenty over the decade leading upto the GFC 2008. The bloated money supply led to soaring prices of stocks and lands, and ultimately crashed the economy. The Central Bank of Iceland found that, contrary to what is written in monetary theory textbooks, it was completely unable to control the money supply. It utilized all the tools at its disposal, including raising the discount rates to extremely high levels, but could not prevent the private banks from creating excessive money.

Chastened by the experience of helplessness, watching an impending crisis without being able to do anything about it, the Iceland government has recently formulated a plan for monetary reform. The key ingredient of the plan is that the power to create money is taken away from the private banks. The proposed system of “Sovereign Money” puts the power of money creation in the hands of a panel of specialists at the Central Bank. They would use economic theory to create money in quantities which would allow for full employment without creating inflation. Specialists can download and read the Iceland proposal for monetary reform, full of fascinating details and information about the defects of our current banking system. The question of ‘why only Iceland?” when this reform is needed everywhere was addressed briefly in my previous article on The Shifting Battleground. A much more detailed historical explanation of the power and craftiness of the financial lobby is given in the writings of Ellen Brown.

The main problems of current banking system are that it is unjust, crisis prone, and anti-growth. Private money creation leads to a rentier economy, where the largest profits are made by owners of wealth, who invest in stocks and land, and earn interest on bonds. The producers, laborers, and farmers who make up the real economy, get very little reward for their labors. Instead, rewards accrue to the financiers who provide money – created from nothing – to all the real sectors. Not only is this unjust, but it causes growth prospects to shrivel, since all investment is directed towards financial sectors, and away from the productive sectors. Studies show that growth of GDP is very strongly correlated with the amount of investment in the real sector, and in human beings. This is only natural: growth is directly tied to how much we invest in our future. Although it is radical, the Iceland Plan for monetary reform offers the possibility of a dramatic increase in real investment and real growth, very much needed today in Pakistan.

Endnotes:
1. See also an intelligent critique of the Iceland Proposal at Re-inventing Money

2. See also my paper on “An Islamic Version of the Iceland Plan for Monetary Reform” — this extends the plan by adding the elimination of interest from the banking system.

  1. Hepion
    June 5, 2015 at 12:21 pm

    Summary of Icelandic plan: changes that do not work to system that does not exist.

    • Hepion
      June 5, 2015 at 12:30 pm

      Their plans fail on multiple levels. For one thing, it would not prevent banks from expanding money supply. See analysis here: http://bilbo.economicoutlook.net/blog/?p=30833

      For an another, not that achieving that would be a good thing. If money is not available for loans, interest rates would be higher and investment, and therefore growth, would suffer. And higher interest rates would mean rentiers would collect even more income.

  2. June 5, 2015 at 5:47 pm

    Why are you promoting this monetarist nonsense?

  3. blocke
    June 5, 2015 at 6:35 pm

    “A long time ago, Ibn-e-Khaldoon noted the tendency of conquered nations to unthinkingly imitate the conquerors in all dimensions of life.”

    I’ve spent the last forty years explaining how Germany, a “conquered” nation has not followed the Americans or the English in their management methods. The Rhineland model, which has been talked about very much, especially in the late 20th century, is an example of this. So what need need to explain is why some conquered nations are so heavily influenced by the mentality and methods of their conquers and why others are not.

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