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Iceland’s approach strikes a chord we should all listen to

July 9, 2015

So said Alberto Gallo, head of macro credit research at RBS, in the FT recently. He referred to Iceland’s reform proposals, written by a lawmaker from the ruling Progress Party, Frosti Sigurjonsson, ‘businessman and economist’ and featured on this site in April.

Gallo summarises: “Under its proposal to reform its monetary system, Iceland’s central bank would take exclusive powers to create money. It would not just set interest rates, but also control the quantity of credit: commercial banks would be allowed to lend within a maximum range, reviewed each month . . .

“Icelanders have recognised one of the core problems facing monetary policy in developed countries: central banks cannot control money (credit) creation by commercial banks. As a result, private debt has grown exponentially over the past decades.

He covers a well-trodden path

“Remember that credit is money,” said Benjamin Franklin. And contrary to “popular misconceptions”, it is commercial banks — not central banks — that create money and deposits, by issuing loans, as the Bank of England explains in a 2014 report.

“The limits to credit creation are demand from borrowers and supply constraints: bank regulation, capital ratios and investors’ judgment of banks’ operations. And with deregulation starting from the 1970s, commercial banks increased their ability to lend, securitise loans and optimise their capital ratios.

“From roughly the same size as the economy, private credit grew to more than four times bigger over the same period in the US and Europe. Government subsidies like today’s Help to Buy programme in the UK also contributed. . . “

Then expresses reservations:

  • Iceland’s proposal is too centralised to work in an open economy and
  • overly constraining credit may choke growth.

He continues: “Central bankers have reacted. Realising that monetary policy alone is not enough, they have deployed new “macroprudential” measures to control credit and preserve financial stability. These include limits to risky loans and floors for bank capital. But these measures are largely untested and focus on containing the problem rather than preventing it . . . “ And ends:

“Iceland’s approach may go too far, but it strikes a chord we should all listen to. To build a stronger financial system we must rethink the role of monetary policy. Central bankers need to weigh any boost in confidence today with the long-term collateral effects that come with it . . . Macro-prudential tools need to be at the core of their mission, not a side game”.

 

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