The Swiss Vollgeld proposal

On 10 June, the Swiss electorate will be asked to vote on the question of whether the National Bank will be the only institution allowed to create money within Switzerland (the Vollgeld initiative). This is not a vote sanctioned by the government: It is a so-called people’s initiative which allows any changes to the Swiss constitution to be put to a vote so long as the supporting petition contains 100,000 signatures. Indeed, the government’s official position is to oppose the initiative and in all likelihood it will be rejected by the electorate. But it is nonetheless a subject worthy of debate (if not a vote).

The motivation for the vote is simple enough: Since banking crises throughout history have tended to be propagated by a fractional banking system that creates money as a sizeable multiple of that created by the central monetary authority, stripping banks of their money creation powers will enhance the stability of the financial system. The idea is far from new: Indeed, one of the first intellectually coherent forms of the plan was drawn up in the US in the 1930s (the so-called Chicago Plan). The Chicago Plan envisaged the separation of the monetary and credit functions of the banking system by requiring 100% reserve backing for deposits and by ensuring that the financing of new bank credit can only take place through retained earnings. The Vollgeld initiative applies the same principle.

It is all very radical and the SNB wants nothing to do with the idea. It argues that the Swiss financial system has a proven track record and regulation put in place over recent years has made the system more secure. In its words: “There is no fundamental problem that needs fixing. A radical overhaul of Switzerland’s financial system is inadvisable and would entail major risks.” It also points out that forcing the central bank to be the single issuer of money would erode its independence by subjecting it to undesirable political influences. This arises from the fact that the SNB would have to make a decision about the desired quantity of money in the economy, which will undoubtedly be subject to political influence at times when government wants to curry favour with the electorate. In any case, introducing a Vollgeld experiment in a small open economy such as Switzerland will do little to reduce the risks to a banking sector which operates across a whole range of international jurisdictions.

Whilst the Vollgeld proposal is generally viewed by the mainstream of the economics profession as a left-field idea, it does have some support from sane commentators such as Martin Wolf at the FT. Wolf is not exactly an unbiased observer, having served on the UK’s Independent Commission on Banking back in 2011, which was tasked with making the banking system less vulnerable to shocks that could propagate throughout the rest of the economy. There is a belief in many quarters that the ICB’s recommendations were ignored as governments rushed back to business-as-usual so Wolf’s views may be coloured by this experience. But he has long believed that under the current system, banks have an incentive to cram their balance sheet full of risky assets which ultimately require a public guarantee in the event that the economy turns south. And there is truth in this. As a consequence, banks are now required to have much greater capital buffers than in the past. However, it is one thing to raise capital requirements but another thing entirely to require 100% reserve backing.

For all the advantages associated with curbing the powers of private sector monetary creation – it would after all limit the private sector’s involvement in what is essentially a public good – I  am struggling to get my head around how much money the central bank should be allowed to create. Milton Friedman once advocated a k-percent rule in which “the stock of money [should be] increased at a fixed rate year-in and year-out without any variation in the rate of increase to meet cyclical needs.” In such an instance, it is difficult to avoid the conclusion that a slower rate of credit growth will impose limits on the pace at which living standards will rise. For example, there will be limits on the central bank’s ability to create sufficient credit to match demand for mortgages. And someone will have to make a decision on how to prioritise one category of borrowing over another.

In any case, as the Swiss government points out, banks cannot increase the supply of credit indefinitely. The price of credit in the form of the central bank interest rate acts as a constraint on both demand and supply. Although full deposit coverage of credit creation has not been tried before, the UK experience of limited credit rationing prior to 1971 was not good and was perceived to be one of the factors restraining UK growth compared to other European nations. The real irony in all of this is that Switzerland is one of the world’s most stable economies. As the chart (taken from the FT) indicates, Latin American and Asian nations have taken a big hit in the wake of a credit crunch in recent years – as have the US and UK. But of all the places to justify experimenting with a Vollgeld programme, Switzerland would not be high on the list.