Sovereign Money System

Introduction

The proposal for a Sovereign Money System starts from the position that the current money and banking system is inefficient, undemocratic and unjust. Money is currently created when banks make loans, which they do motivated by profit. Having this fundamental part of our society and economy be determined by the self-serving interests and the pursuit of profit by a handful of corporations is highly problematic.

A Sovereign Money System (SMS) is a proposal for a systemic change of money and banking. A SMS would give the public access to the central bank’s balance sheet and provide an alternative payments infrastructure. It would take away the privilege of banks to produce money, creating a more reliable and effective foundation for our economy to operate upon and ensuring the power of money creation is used democratically in the public interest.

The Sovereign Money Proposal

The sovereign money approach is based on the view that:

1. Money creation can be conducted more effectively and appropriately by publicly accountable officials based on the needs of the economy than by commercial banks.

2. The payments system would be safer if it were separated from the lending activity of banks, which, amongst other things, would end ‘too big to fail’ banking.

Overview

The structure of banks in a sovereign money system would be designed to meet certain requirements:

1. The payments system should be protected from risks taken by the lending business. Payments would be made through Transaction Accounts, which would be held as risk-free liabilities of the central bank, rather than liabilities of a commercial bank. Consequently, Transaction Account holders would not be exposed in any way to the risks taken by the bank’s lending business. Lending institutions could fail without any risk to payment services. This would create a clear distinction between a risk-free payments system (in which payments would be made using digital currency issued by the central bank), and the risk-bearing liabilities available at commercial banks.

2. Commercial bank lending should not create additional money or purchasing power. The mechanisms of lending in a sovereign money system would work by transferring existing sovereign money from a lender to a borrower, rather than creating new money and purchasing power when banks extend loans to borrowers. This would turn banks into true intermediaries (middlemen between savers and borrowers).

3. Investments should be explicitly risk-bearing. Accounts that fund risk-bearing assets should not be guaranteed by the government. Explicit guarantees and deposit insurance such as the UK’s Financial Services Compensation Scheme (FSCS) or USA’s Federal Deposit Insurance Corporation (FDIC) should be removed. The government should take steps to remove the public perception of any implicit guarantees. This is intended to address the moral hazard that comes from guaranteeing almost all bank liabilities regardless of the underlying risk taken by individual banks.

4. The risk of investments should be shared by banks and savers/investors. If losses fell entirely on customers, banks would be sheltered from the consequences of taking excessive risk. But if losses fell entirely on the banks (up to the point of bankruptcy) then customers would have no economic interest in the level of risk taken by their bank, and so would chase the highest offered interest rate, without regards to risk. To avoid this, the regime should be designed to ensure that both the bank and the customers have ‘skin in the game’.

5. Savers/investors should be able to choose the risks they are exposed to. Those who want low-risk, low-return products should not face losses as a result of investments made on behalf of customers who wanted high-risk, high-return products. So the risk-bearing assets of the bank should be grouped together on separate balance sheets according to the (approximate) level of risk.

6. Failures should happen in ‘small ways’. What came out of the last crisis was an understanding of the systemic risk posed by banks. Due to the interlinked nature of the banking and financial sector, if a large bank has solvency issues (i.e. a certain proportion of loans or investments go bad or people try to withdraw their deposits en masse), it is likely that this will have a knock on effect on the whole financial system. In contrast, credit institutions in a sovereign money system would be designed so that if they failed, they would ‘fail in small ways’. For example, individual Investment Funds at individual banks that went bad, would be frozen and liquidated in an orderly fashion, rather than entire banking entities failing overnight.

Transition to a Sovereign Money System

The transition to a Sovereign Money System could be conducted through a phased-in approach, where the central bank would start to create money directly, transferring this money to the government for spending into the economy. However, banks would still be permitted to operate as they currently do, creating money in the process of making loans. Over time, the amount of money that banks could create would be progressively restricted. A larger proportion of new money needed to replace the money cancelled out by loan repayments, and any necessary additions to aggregate demand would come from money creation by the central bank.

Another way through which the transition could happen – currently under research – is through the introduction of a central bank digital currency (CBDC). CBDCs present a promising path for a transition, as their implementation could be accompanied by public payment system and public access to the central bank’s balance sheet. They could be designed to become increasingly competitive to privately issued bank money, making it possible for a CBDC to gradually eclipse the use of bank created deposits: their introduction and their design would determine the degree to which this new reformed system would be ‘sovereign’, based on the usage of CBDC in the economy in comparison to that of bank issued deposit money. Eventually, this could lead to a system which is fully sovereign.

Benefits of a Sovereign Money System

 

Current System Problem
Sovereign Money Solution
1. Creating a safer banking system and reducing moral hazard:
The reliance of the current payments system on bank liabilities and liquidity exposes the financial foundation of the economy to the risk of bank failures and bank runs. Deposit insurance causes the liabilities of banks to become contingent liabilities of the state, which creates moral hazard and undermines efficiency in financial markets. The SMS system features a payment system which is separated from the risky investing and lending of banks, to a great extent insulating the rest of the economy. This reduces the imperative for state guarantees for bank liabilities and reduces moral hazard as banks know that they can be left to fail, imposing market discipline.
2. Increasing economic stability:
Bank lending is procyclical, leading to ever higher levels of private debt and provoking asset price bubbles, and consequently causing financial crises. In post-crisis, they do not create enough money leading to debt deflation/balance sheet recession. Banks no longer create money, and therefore have less ability to generate financial instability. The central bank can act in countercyclical fashion, using its money-creating ability to finance recovery (directly or indirectly). Better control over the rate of growth of the money supply will moderate the rise of asset price bubbles and private debt, reducing the risk of crises.
3. Reducing the dependency on private debt:
Currently, there is a fiscal and monetary policy dilemma. Debt is needed to grow the economy, but debt also makes the economy fragile, which can lead to crises. New money made available to finance additional spending could to a large extent cease to be created with debt.
4. Supporting the real economy:
Banks determine to a great degree which type of spending is financed by new money creation, the majority of which has gone into property markets and the financial sector. The Government and CB would have more influence over where money is spent or lent and the ability to channel it toward the productive economy. This will have a much higher impact on output, employment and how our economy is shaped.
5. More effective monetary policy:
The CB must use its influence over interest rates in an attempt to influence the lending decisions of banks and the demand for loans from businesses and the public – this is a blunt and ineffective tool. The central bank has direct control over money creation to influence the economy. This constitutes a more targeted tool which should be more effective than the use of interest rates to achieve its targets.
6. Better government finances:
Systemic instability leads to recurrent crises and recessions, reducing tax revenues and increasing government deficits and debt. Seigniorage receipts for government, more stable economy and less risk of deficit-inducing recessions.
7. Tackling unaffordable housing:
Over 40% of bank created money by mid 2018 in the US, UK and the Euro Area1 (Bank of England, FED and ECB data) has been used to fund mortgage lending contributing to rising house prices. Removing the ability of banks to create money should remove much of the fuel for rapid house price inflation.
8. Improving democracy:
A very small number of people in unelected positions in the banking sector make decisions that shape the entire economy. An SMS would lead to democratic control over money creation and the reduction of the political power held by the banking sector.

1 Calculations based on: Bank of England series: LPQB9Y3, LPQBF36 and RPQZ932. FED, Z.1 statistics: FL704023005.Q and FL703065005.Q. ECB, series:
BSI.M.U2.Y.U.A20A.A.1.U2.2200.Z01.E and BSI.M.U2.Y.U.A22.A.1.U2.2250.Z01.E

Thought Genesis

The Sovereign Money system proposal by Positive Money shares its academic roots with ‘full reserve banking’ (FRB) detailed in ‘Economic Perspectives’. FRB was first proposed by David Ricardo in 1823 with his ‘Plan for the Establishment of a National Bank’. The plan required private banks to cease money creation; however, unlike sovereign money proposals, the money was to be backed 100% by gold.

Throughout the 20th century, a number of academics proposed different variations of FRB. Mises (1912) endorsed FRB involving commodity backing (a view later reiterated by Hayek (1937), although this is FRB the proposal is radically different from the SMS proposal.

Chemist and economist Frederick Soddy (1926) distinguished between real wealth (physical assets) and ‘virtual wealth’ (money & debt) a distinction made earlier by Marx with so-called ‘fictitious capital’. Soddy viewed the compounding effects of virtual wealth to be highly dangerous and proposed FRB without commodity backing – a close relative to the SMS proposal.

Reform movements usually become more prominent in times of economic distress such as during the 1870s Long Depression, the 1930s Great Depression, and since the 2008 financial crisis. After the 1930s Great Depression in the USA, there was the political impetus to improve the state of banking which led the Secretary of the Treasury Henry Morgenthau Jr. to establish a study group of distinguished academics. As part of this group, Lauchlin Currie proposed a 100% reserve system:

“In Currie’s (1934) proposal banks would initially meet the 100 % reserve requirement with a non-interest-bearing note from the Federal Reserve Banks. The note could be left outstanding indefinitely or alternatively the note could be retired over a period of time from 5 to 20 years by turning over government bonds to the Federal Reserve Banks. As the discount window would be abolished, the money supply could only be affected with open market operations. Currie (1934) was against an independent monetary authority as he argued that democracy should apply to monetary policy as well”. (Laina, 2015)

Alongside this, the Chicago Plan (1933) (and Irving Fisher’s later book ‘100% Money’ (Fisher, 1935)) attempted to introduce FRB. The Chicago plan’s FRB proposal required demand deposits of the public at commercial banks to be matched by bank holdings of currency and central bank reserves, backed by government debt in the books of the Federal Reserve Banks.

“I have come to believe that the plan, properly worked out and applied, is incomparably the best proposal ever offered for speedily and permanently solving the problem of depressions; for it would remove the chief cause of both booms and depressions, namely the instability of demand deposits, tied as they are now, to bank loans.” (Fisher, 1936)

The Positive Money proposals are often mentioned alongside the Chicago plan, full reserve banking and 100% reserve proposals. They do indeed have the same goal: to stop banks creating money in the process of making loans (or buying assets) albeit, the method is different. In the case of the Chicago plan, they do it by forcing banks to hold reserves against their deposits. As some people have pointed out, this doesn’t necessarily stop banks creating money – that is, it is quite possible for there to be money creation by the banking sector with 100% reserves (incidentally for exactly the same reasons a 10% reserve ratio doesn’t constrain deposit creation, although it does require the central bank to play along).

At the turn of the millennium, Huber & Robertson’s (2000) new currency theory formed the basis of the Positive Money SMS Proposal. Huber & Robertson (2000) made the case in their detailed proposal that seigniorage revenue should go to the government. Under such a monetary system only the central bank, as a state’s monetary authority under public law, may create money as coins, notes or digital cash. Under such a system commercial banks would be prevented from creating money.

Once again, with another economic crisis in 2008, the idea of monetary reform reentered academic debate with new vigour and in 2010 Positive Money was formed with a detailed proposal by Jackson & Dyson (2012) presented in this section. An updated version of the proposal was published by Dyson et al (2016).

As we can see, there are a number of historical examples and developments of proposals for monetary reform which have been inspired by FRB, which now constitutes an umbrella term capturing radically different approaches to monetary reform that are at odds with one another. Positive Money’s proposal draws from the history full-reserve banking proposals of Ricardo, Soddy, Currie and the Chicago Plan but shares the most in common with Huber’s proposal of Sovereign Money.

Critiques & Responses

There are critics of Positive Money and the Sovereign Money System proposal from both mainstream and other monetary reform schools of thought (Fontana & Sawyer, 2016 and ibid., 2017; Nersisyan & Wray, 2017). Some of the main criticisms of the proposal are related to:

• The impact of the proposal on government finances and fiscal policy
• The impact of the proposal on the supply of credit to the real economy
• The danger of private money creation re-emerging in the shadow banking sector
• The argument that shadow banking, not commercial banking, is the real source of financial instability

Positive Money has responded to critics directly, published a report addressing the supply of credit, and a report addressing flexibility.

Positive Money Traction

Positive Money has helped progress the monetary reform debate, and has gained increasing mainstream support: from Martin Wolf, 70,000 members of the public, and from Members of Parliament, who had their first debate on money creation in UK parliament for 170 years in 2014, as well as spreading into an international movement for monetary reform (IMMR).

References

Bank of England. (1999). The Transmission Mechanism of Monetary Policy. London, Bank of England

Currie, Lauchlin (1934): A Proposed Revision of the Monetary System of the United States. Cambridge, MA: Harvard University Press.

Dyson, B., Hodgson, G. and van Lerven, F. (2016). A response to critiques of ‘full reserve banking’, Cambridge Journal of Economics.

Dyson, B., Hodgson, G. and van Lerven, F., 2016. Sovereign Money: An Introduction. Positive Money.

Fisher, Irving (1935): 100 % Money. New York, NY: Adelphi Company.

Hayek, Friedrich (1937): Monetary Nationalism and International Stability. London: Longman.

Fontana, G. and Sawyer, M., 2016. Full reserve banking: more ‘cranks’ than ‘brave heretics’. Cambridge Journal of Economics, 40 (5), pp.1333-1350.

Huber, Joseph & Robertson, James (2000): Creating New Money: A Monetary Reform for the Information Age. London, UK: New Economics Foundation

Huber, J., 2016. Sovereign money: Beyond reserve banking. Springer.

Jackson, Andrew & Dyson, Ben (2012): Modernising Money: Why Our Monetary System is Broken and How It Can Be Fixed. London, UK: Positive Money

Laina, P., 2015. Proposals for full-reserve banking: A historical survey from David Ricardo to Martin Wolf. Economic Thought, 4 (2), pp.1-19.

McLeay, M. Radia, A. and Thomas, R. (2014). Money creation in the modern economy. Bank of England Quarterly Bulletin, Q1. London, Bank of England

Mises, Ludwig von (1912): Theorie des Geldes und der Umlaufsmittel. Munich and Leipzig: Duncker and Humblot. [Published in English in 1980 as The Theory of Money and Credit. Translated by H.E. Batson. Indianapolis, IN: Liberty Classics.]

Nersisyan, Y. and Wray, L.R., 2017. Cranks and heretics: the importance of an analytical framework. Cambridge Journal of Economics, 41(6), pp.1749-1760.

Ricardo, David (1951): The Works and Correspondence of David Ricardo. Volume 4: Pamphlets and Papers 1815-1823. Cambridge: Cambridge University Press

Soddy, Frederick (1926): Wealth, Virtual Wealth and Debt: The Solution of the Economic Paradox. London: George Allen & Unwin.

Turner, A. (2012). Monetary and Financial Stability: Lessons from the Crisis and from classic economics texts. Speech at South African Reserve Bank.

Wolf, Martin (2014): “Strip private banks of their power to create money”, Financial Times, 24 April 2014.