Worldwide debt has exploded in the eight years since the beginning of the fiscal crisis from an already unsustainable level of $142 trillion to a crushing $200 trillion. The reason? To help paper over gaping holes in national economies, and because our financial system makes it too easy to just "create" money from nothing.
Now one small nation is looking at a radically different way of doing things. Although the approach is conservative, there are still some risks.
The situation provides an appealing investment opportunity, no matter the outcome, if the position is implemented correctly. Here's how…
First, Let's Revisit the Impetus
In the last financial crisis, Iceland was arguably the most damaged country in the Western world. Its banks had gone on an unbridled lending spree, feeding an environment where asset prices inflated until there were no more "greater fools" left.
Iceland was the first Western nation in 25 years to request an IMF bailout. It's a topic I covered last fall in these very pages. By 2008, overextended Icelandic banks collapsed under the weight of their inflated mortgage "assets." Its financial sector shrank to a mere fifth of its former self.
The country let its banks fail and imposed capital controls. Deposits held in Iceland by foreigners were stuck. Foreign-held bank debt was sacrificed. After several years of harsh austerity and a swollen national debt, the economy appears to be improving.
But the ordeal has scarred the nation's psyche such that its leaders are exploring a radically different approach to its monetary system, one they hope can lessen the extreme boom-bust cycle.
In practice, some 98% of the money supply comes from private sector banks. Through a process known as fractional reserve banking, they create money by making loans to borrowers (by crediting their accounts), and keeping only a small fraction of depositors' funds on hand as reserves. But now a recent report titled "A Better Monetary System for Iceland" is being proposed by Iceland's ruling party member Frosti Sigurjónsson.
If implemented, it would be revolutionary in the context of modern finance.
Under this "Sovereign Money" scheme, only the Central Bank of Iceland (CBI) could create money. It would remove the ability of commercial banks to create money through fractional reserve banking. Instead, consumer and business deposits would be stored at the central bank, while commercial banks would serve more as intermediaries between savers and lenders.
Their role as service providers would focus instead on issuing debit cards, reporting, and Internet and mobile banking. Now, that's pretty radical. And here are some of the possible implications…
The basic idea is that with only the CBI creating money, the parliament would determine how much the government needs. Mr. Sigurjonsson wrote in the proposal that "Crucially, the power to create money is kept separate from the power to decide how that new money is used… as with the state budget, the parliament will debate the government's proposal for allocation of new money."
The overriding goal is to reduce risk and promote financial stability, while massively cutting debts. Income generated from loans would go to the state rather than to private commercial banks. There are numerous details to work out, but it would be a fascinating experiment to watch from the outside.
Could it work closer to home? I doubt it would have more than a snowball's chance in hell.
A Precedent Much Nearer at Hand
With the power wielded by commercial banks in much of the West, and the immense profits they can generate from fractional reserve banking, it's nearly impossible to imagine such a system ever being allowed to take flight here. That said, there is an interesting precedent in Canada.
Until 1974, the Canadian government used to borrow from the Bank of Canada… interest free.
Today, the federal government instead issues bonds and borrows from private banks at current interest rates at a major cost to taxpayers. Fascinatingly, that's being challenged right now in Canadian courts, with an action aimed at restoring the Bank of Canada to its original purpose of making advantageous loans, where appropriate, to federal, provincial, and/or municipal governments.
This sounds very similar to what Iceland is contemplating. For that reason, the result of the current Canadian court challenge will be watched in earnest, especially from Reykjavik. Still, the bank lobby's muscle might work to keep the status quo, upon which the industry is so dependent for its gargantuan profits.
Ironically, Iceland's proposal might be a beacon of hope. There's of course a risk in parliament deciding how much money to provide to its treasury and currency system. Parliament is comprised of people… and those in government have proven themselves time and time again to be both fallible and corruptible.
Changes of the magnitude Iceland is contemplating are only likely to come following a (sadly) even greater crisis than the last.
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About the Author
Peter Krauth is the Resource Specialist for Money Map Press and has contributed some of the most popular and highly regarded investing articles on Money Morning. Peter is headquartered in resource-rich Canada, but he travels around the world to dig up the very best profit opportunity, whether it's in gold, silver, oil, coal, or even potash.