The Telegraph reported last week that “Switzerland will hold a referendum to decide whether to ban commercial banks from creating money.” The article continued to say:
The campaign… is designed to limit financial speculation by requiring private banks to hold 100pc reserves against their deposits.
“Banks won’t be able to create money for themselves any more, they’ll only be able to lend money that they have from savers or other banks,” said the campaign group.
The Swiss have long been a beacon of relative monetary sanity in our world of chronic credit expansion and a view of monetary policy which encourages the manipulation of interest rates and looks down upon the very idea of a sound money. Indeed, it was earlier this year, in fact, that the Swiss went to vote on a return to a type of gold standard. While this effort failed, it is astonishing that they came so close in our world of heavy political pressure towards inflationism (I should mention here at the outset that I use inflation to mean an expansion of the money supply, not rising prices).
What the Swiss plan does is initiate a movement against fractional reserve banking by requiring 100% reserves against deposits. What does this mean? If you remember my taxonomy on money, you’ll remember that there is a distinction within the umbrella of “money in the broader sense” between “money in the narrower sense” and “money substitutes.” Money substitutes are those money instruments which trade through the economy in the place of the money itself. So if we were on a gold standard and we had paper bills that could be redeemed at the bank for gold, the paper bills would be money substitutes and the gold would be the money.
Definitionally (again see the taxonomy), we refer to any money substitute that is not backed up by money as fiduciary media. So if there were 100 ounces of gold in a bank and there were bank-issued money substitutes that could claim 120 ounces of gold, 20 ounces worth of the substitutes would be fiduciary media.
If Switzerland adopts this plan, this means that fiduciary media will no longer be issued.
Does this mean that Switzerland is pursuing an Austrian-approved sound money standard? Not at all. While they should be praised for recognizing the dangers of fractional reserve banking and the expansion of fiduciary media, they are actually pursuing the old Chicago school plan first popularized by an economist named Irving Fisher. The Fisher plan revolved around the idea of stabilizing the price level via the power of the central monetary authority. What this means is that Fisher believed that the central bank needed to expand the money supply at the first sign of a general fall in prices, which in his mind was the cause of economic depressions. In other words, the Fisher plan— and the later Friedmanite plan which followed in its footsteps— does nothing to address the fact that inflation would still play a prominent role in monetary policy. And in fact, such inflation was a main feature of the plan. Milton Friedman even suggested that the Fed have an automatic rate predetermined to constantly and day-by-day seep more money into the economy; which he suggested be done at a growth rate of between 3 and 5 percent.
What is implied above is that, rather than the banks operate on a 100% gold (or other commodity) standard as per the Austrian recommendation, the 100% reserve plan in Switzerland is a full fiat money standard. In other words, the money in the narrower sense (per the taxonomy article) is not a commodity, but is rather the unit created and controlled by the central bank.
So then, rather than the gold acting as money and paper notes acting as money substitutes, in the Swiss plan, modeled after the Fisher/Friedmanite plan, the paper money is the money in the narrower sense while electronic digits are money substitutes. This is a bit harder to picture. It is easier to understand the idea of a paper bill having the ability to be redeemed in gold. But in the modern electronic age, it is usually the paper that is the money and the money substitutes are what we see in our checking accounts, accessible via a debit card or perhaps something like Apple Pay.
Under a fractional reserve system, which most countries in the world operate with, the individual commercial banks actually have the ability to add to the money supply. They do this by loaning out money. Every time a fractional reserve bank lends out money, it gets that money by creating it out of thin air. Under the Swiss plan, this would be outlawed. And the only institution that can add to the money supply is the central bank. This central bank can then loan to commercial banks, which can then lend this very same money out to borrowers.
Unfortunately, just because fractional reserve banking may come to an end in Switzerland, this does not mean that the boom-bust cycle will be suppressed. Fractional reserve banking has been a powerful influence on the creation of booms and busts, but at the end of the day, the core cause of these booms and busts is the creation of new money that comes into existence without being demanded by the market.
The creation of money out of thin air causes a plethora of nonproductive activities as a result of the interest rate fall attracting business investment into areas which appear to be productive, but in reality are not. As the Austrians have shown, the suppression of the interest rate as a result of fiat monetary expansion leads to mass discoordinations in the structure of production. The first receivers of the new money are able to claim scarce resources and capital goods that they otherwise would not have been able to claim. This strains the stock of these resources and misallocates them into areas where they are not most needed. This is the foundation for the eventual bust, which acts as a painful yet necessary liquidation of the bad investments.
While we are on the subject, we should mention that, contrary to the message of the news media, this is not the fault of “greedy investors.” It is the fault of a central bank that thought they could adequately manage the economy from the top and produce prosperity via their monetary tools.
In the end, what we really need is a sound currency provided by the market process rather than an unsound money managed by bureaucrats.