Since the financial crisis in 2008, industrialised countries have enacted numerous reforms to get the global economy up and running again. These have not not had the desired effect though, and economic growth is already on the decline again. This comes as no surprise to Icelandic politician and entrepreneur Frosti Sigurjónsson, who claims we haven’t yet addressed the root of the problem: our monetary system. To better understand his ideas, let’s have a look at what happened in his home country, one affected very severely by the breakdown.

Once upon a time there was a small Nordic island with three banks. The banks were strong and rich. One day they decided to expand their business dealings to become even richer: They started handing out loans, lines of credit, and mortgages, and trading with other banks and business people from abroad. And as they did, they forgot about something very important: the money involved. With every loan, line of credit, and mortgage the banks gave out, they were handing out money. Suddenly so much money flooded the small Nordic island that prices rose by 18% in only six months! For as we know, too much money in circulation causes inflation.

There was another bank on the small Nordic island, the central bank  owned by the government and thus – in theory – by the people. Initially, the central bank supported the three banks by extending them credit whenever they needed it. But when the central bank saw that there was too much money circulating on the island, forcing everyone to pay so much more for typical food and drinks like skyr, Þorramatur, and Brennivín, they tried to stop the three big banks. 

But it was too late. In the meantime, the three banks had gotten themselves into trouble: Their foreign business partners did not want to trade any more, and were demanding their money back. The three banks asked the central bank to help them out like it had in the past. But by this time, the three banks had grown so much that the money they owed their trading partners was more than the central bank, the government or the people of the small Nordic island had. Like a fat man who has eaten too much Þorramatur and drunk too much Brennivín, the banks collapsed. The people’s money disappeared when the banks failed, and any remaining cash they were left holding was practically worthless. 

The island had suffered what we call a financial crisis. 

Iceland, a small island where the North Atlantic meets the Arctic Ocean, was hit tremendously hard by the 2008 financial crash and became a symbol of devastating effects of the global crisis. At the same time, it has recovered better than many other countries. As new crises loom – the IMF just released its annual report with new warnings for the global financial system – Frosti Sigurjónsson, Member of the Icelandic parliament and Chairman of the Parliament Committee for Economic Affairs and Trade, wants to put an end to the looming risk of financial breakdowns. Our financial system could be easily fixed, he explains, if we changed the way money is created.

Frosti, we have been taught that the central banks control the money supply. What went wrong in Iceland and in the world in the recent past? Did the central banks fail? 

The problem is not limited to the banks or the central bank. It is also the current monetary mechanism, the fractional-reserve system, which does not work well. 

Fractional-reserve banking means that a bank can accept deposits, give loans or make investments while holding reserves that are only a fraction of its actual deposit liabilities, where the central bank usually acts as lender of last resort.

This system has limited the central banks’ ability to control the money supply. At the same time, commercial banks have been given the power to create money. 

But doesn’t the central bank control the money supply through the interest rate? When there is too much money in circulation, it usually raises the interest rate to make creating money more expensive for the commercial banks.

Between 2003 and 2006 the Central Bank of Iceland raised the interest rate to stop the huge money expansion and warned that the economy was overheating, but this did not stop the banks from expanding their money supply. The Central Bank of Iceland is not in control of the money supply you see.

Facing with a run on the banks in 2008, the Icelandic government nationalized the banks and restructured them using public funds. All over the world banking regulations are being tightened. If the monetary system is the problem as you claim, how helpful are these measures?

It is tempting to add more rules and regulations as was done with Basel I and Basel II, but in the end we need to reform the monetary system. As long as the bulk of our money is tied into the liabilities of commercial banks, the state will have no option but to guarantee these deposits to avert crisis. When a bank is forced to sell its assets quickly to payout depositors, this causes market prices to drop and gets other banks into trouble. The implied state guarantee of banks’ liabilities encourages risky lending. Plus, it gives an unfair competitive advantage to commercial banks. They can access cheap funding in the form of state-guaranteed deposits, while investment banks have to borrow funds at markets rates. 

In the report you wrote for the Prime Minister of Iceland, “A better monetary system for Iceland”, you claim that the sovereign money system is a promising alternative to the existing fractional-reserve system. What would this alternative monetary system look like?

In a sovereign money system, private banks do not create money. All money, whether it is physical or electronic, is solely created by the central bank. Instead of relying on the interest rate to influence money creation, the central bank can directly control the money supply: New money is transferred to the government and released into circulation in the economy via government expenses or the reduction of public debt. 

How did this happen?

When commercial banks extend credit, give out loans and mortgages, they create money. The Central Bank of Iceland must provide the banks with reserves so as not to lose control of interest rates. For decades, commercial banks have been expanding the money supply much faster than what was needed for economic growth. Between 1994 and 2008, the commercial banks in Iceland expanded the money supply nineteen fold, and the central bank was forced to provide new reserves to accommodate the banks. This system was a contributing factor to the various monetary problems in Iceland, including the banking crisis of 2008.