Tomorrow Swiss voters will decide if the central bank is to take over total control of the country’s money supply.​ The Swiss sovereign money initiative calls for all credit issued by commercial banks to be backed with real money — ‘Vollgeld’ — created by the Swiss National Bank (SNB). But although we all justifiably fear the occurrences of new financial crises, there are strong reasons to doubt ‘sovereign money’ would save us from such crises:

vollgeldFor some the crisis calls for a much more radical cure: the elimination of fractional reserve banking altogether. The argument is that financial instability is inherent in the current system and is directly caused by the capacity of banks to create credit and thus money beyond the direct control of the central bank, and the effect of the lender-of-last-resort facility in protecting banks from the ensuing risks. Priority is placed on ensuring the provision of a safe money asset without the need for costly bank bail-outs. A sharp distinction is drawn between safe money assets (issued, or completely backed by, the state) and all other assets …

There are important differences among the various plans in terms of the transition to the new regime, how banks are then allowed to operate and the form of state involvement in the setting of the money supply level. What they all have in common is the fundamental point that banks will no longer be able to create money through credit and not face the associated risks; in order to achieve this, the focus of all the plans is on the supply of money and ensuring that imprudent banks fail without threatening the rest of the banking system or the public purse.

In the current monetary system almost all money is created by commercial banks via the creation of loans, thus the key question is whether money should continue to be a prerogative of the (mainly) private banking system. For these plans the simple answer is no. What these reforms propose is to remove the ability of banks to create money by separating money and credit, thereby creating a public money system distinct from the private, market allocation of savings and loans. In brief, a bank’s reserve ratio (i.e. public money over current accounts) must be 100%. Alternatively, current accounts are removed from banks and placed at a public institution or in a separate special bank. Central independent institutions (set up by a central bank or the government) would then directly control the quantity of money in circulation. In these systems banks have to borrow from creditors before being able to lend it out and would not enjoy special public sector support in the event of failure.

Clearly the crisis called for a policy response with respect to the structure of the financial system … But here we argue that, for all their good intentions, full-reserve banking plans have serious shortcomings which derive from their assumptions about money and about the financial sector. Even if it were feasible for the state to establish control of the money supply, there would be little scope for credit intermediation or maturity transformation. Were banks to find it profitable to continue to trade, they would come to resemble investment trusts and fund managers or even money shops. More importantly, the impact of these proposals on the financial system and on the overall economy might result either in a stagnant economy or in the growth of the unregulated provision of money in the private sector; full reserve banking might not in fact prevent a resurgence of financial instability.

Sheila Dow, Guðrún Johnsen and Alberto Montagnoli