Swiss say Nein to Vollgeld

On Sunday June 10th the Swiss, in a binding referendum, massively said ‘no’ to a proposal to introduce ‘Vollgeld’, whereby the ability to create money is given solely to the central bank. A yes-vote would have brought large uncertainties to the Swiss economy in the short-term and would have hurt the Swiss economy through a more deflationary monetary policy by the Swiss National Bank (SNB). It wasn’t a narrow escape, as a 75% majority refuted the proposal[1]. The discussion about forms of full-reserve banking is unlikely to die down soon, though, so we might see more proposals like this in other countries in the future. Don’t be led astray by the rhetoric, as most of these ideas simply boil down to old wine in new bottles: handing the central bank a monopoly on money creation is the same as full-reserve banking.

[1] Another proposal to stop the effective liberalising of the Swiss gambling law did pass on the same day.

When the central bank has a monopoly on money creation banks would not be allowed to create money anymore, they are forced to hold 100% (liquid) reserves against the current accounts on their balance sheets. If they want to extend a new loan, they need to finance this with already existing savings and/or their equity. Banks are thereby narrowed to pure intermediaries. This so-called Chicago-Plan has its origins in the 1930s in the US. Its major champion was Irving Fisher, a famous monetary economist. The context was deep depression, deflation, a severe decline in the money supply and a central bank, the Federal Reserve, that was slow to react. Against this background, Fisher’s support for full-reserve banking is understandable. Today’s situation, however, is completely different.

Many think that banks create ‘money out of thin air’ and that fiat money is therefore not covered by assets. This is a fallacy. All fiat money that is issued by banks is covered by the assets of the bank, as the Fisher already pointed out in his book ‘The Purchasing Power of Money’ in 1911. The issue is not that money is not covered by assets, but problems can arise as a bank’s assets (e.g. loans) in general are less liquid than a banks liabilities (e.g. deposits), especially money. This brings liquidity risk and makes them vulnerable for bank-runs. Therefore, full-reserve banking is not about solvency, but about liquidity reserves. It obliges banks to hold 100% liquidity reserves with the central bank against their most liquid liabilities, bank accounts.

The motivation of the Swiss proposal is that it would prevent bank-runs and create ‘100% safe’ fiat money. This is more or less correct. But the idea also has several major negative side-effects, some of them rather serious. As a first side-effect, banks lose their ability to create money. The so-called ‘money-creation privilege’ is taken away from them, under full-reserve banking only the government (in practice the central bank) is allowed to bring more money into circulation. The past has shown that this is a potentially dangerous situation, which is the reason why in the European Treaty such a monopoly is explicitly forbidden. There are more negative side-effects, however.

For instance, as the government would have to defend its monopoly on money creation with all means, all private initiatives in this field would have to be killed. So any innovation, be it cryptocurrencies, LETS-currencies or money market paper starting to act as near-monies will have to be suppressed. Free cross-border financial flows are also incompatible with full-reserve banking, at least as long as the system is not implemented on a global scale. It would be much more expensive for consumers to hold a bank account, as today these are partly financed by the income from the ‘money creation privilege’. This point was already made by Fisher in 1935, but is systematically overlooked by today’s supporters of the Chicago Plan. Finally, the idea that a central public institution is better in deciding on the amount and allocation of new money than private actors brings up memories of the old Sovjet Union, where central committees decided on the production and allocation of newly-produced orange Lada’s.

The impact of the Vollgeld on the real economy of Switzerland is hard to predict, but it likely would have been very negative. In the short-term uncertainty would prevail as both the Swiss parliament and the SNB’s president were against the proposal and there would be questions on how to interpret and implement the result, as many of the details were left vague. Assuming the SNB would keep its current inflation target in place, it would likely be highly conservative in providing money or loans to the real economy, as it will be very hard for them to withdraw the money later if needed to rein in inflation. This creates a deflationary tendency. The Swiss Franc would probably appreciate as a result, further harming Swiss’ competitiveness. In the longer run financial stability issues may arise as lending will probably shift to the non-banking (shadow banking) sector. In this respect it is important to recall that the 2008-2009 sub-prime mortgage crisis originated in the American shadow banking-sector.

The Chicago Plan was launched in a deflationary context, as explained before. In that context, which was also in a world of short-term loans, absent of long-term lending and a payments system that was still overwhelmingly cash-based, it was a defendable proposition.

But in today’s situation it is not. Many modern supporters of this idea seem to have an additional political agenda. They want to issue new money to finance public spending, which, as said before, can be dangerous. Many people don’t realize that financing public spending by newly printed money is also a tax for society, just as formal taxation, as explained by John Maynard Keynes in his Tract on Monetary Reform in 1924. The difference is that the first can be done without consulting parliament. One should realize that the government/central bank can create money in unlimited amounts and that this money is not necessarily covered by assets. This in contrast to money created by commercial banks.

However, the most important lessons from the 1930’s and the Chicago Plan have already been learned. In the current crisis, the central banks worldwide stepped in and created the liquidity that was necessary to successfully prevent a collapse in the money supply. Banks already operate under much higher liquidity requirements than ever before, thanks to new Basel-requirements. There are efforts to limit the procyclicality in bank lending by the introduction of anti-cyclical capital buffers, introducing so-called capital floors in risk-weights and by the newly introduced macro-prudential supervision. Maybe this is still not enough. But today’s situation is already very different than during the 1930s or even 2008.

It is of course a good idea to try and improve the financial system. This is a continuous process and since the crisis of 2008 major steps in the right direction have been made. Further improvements are certainly possible. But is does not make sense to completely overhaul the system and introduce a completely untested idea that has its origins in the 1930s and that will have major negative side effects. The Swiss made a wise decision and prevented an acute crisis in Switzerland, that could potentially have sent strong shockwaves through the global financial system. Some old wines may age well while others in the meantime have turned into vinegar, making them hard to swallow.