What exactly is a sovereign money system?

After almost three years, I returned to RT Boom/Bust on Tuesday.  There are many changes at RT.  Many new people, and a growing effort to put together an alternative channel that covers the world rather than just the US or just the developed world.  They are bursting at the seams, and their funding has doubled, so I was told.

Check out our H2 hedge fund letters here.

David Merkel

I get surprised by who watches RT and sees me.  My  congregation is pretty conservative in every way, but I have some friends working in intelligence come up to me and say, “Hey, saw you on RT Boom/Bust.”  And then there is my friend from Central Africa who says, “The CIA has you on their list.  Watch out!”  He’s funny, hard-working, but very earnest.

I’ve never seen anything in what I have done where there is any hint of editorial control.  Maybe it is there, but I think I would be smart enough to see it.

Anyway, the topic at hand was alternative monetary systems, and the thing that kicked it off was the Vollgelt in Switzerland, where they are trying to create a monetary system where the banks can’t lend against deposits.  Here were my notes for the show, with a little more to fill in:

  1. Mr. Merkel, what exactly is a sovereign money system?

The banks can’t lend against deposits.  Deposits are segregated, and wait for the depositor to use them.  The deposits no longer can be used by the bank but only the depositor.  There would be no need for deposit insurance, because deposits are off of the bank’s balance sheet.

  1. What is the difference between a sovereign system and the way banks handle your money now?

You would have to pay for your transactional account, because the bank can’t make money off of lending against the deposits. Banks would no longer do “maturity transformation” by lending long against short-term deposits.  Long-term lending would have to be other entities in the economy, such as insurance companies, pension funds, endowments, private individuals, foreign lenders, mortgage REITs, and banks funded by matching sources like CDs, bonds, and equity.

  1. Switzerland is poised to vote on a sovereign money system, or Vollgeld in German. How likely is this vote to pass?

Not likely for three reasons.  First, the Swiss turned down a proposal to back the Swiss Franc with 20% gold.  Not one canton voted for it.  Only 22% of the electorate voted for it.  Second, things aren’t that bad now, and the financial system isn’t that levered.  “If it ain’t broke, don’t fix it.”  Third, this is a total experiment with no real world precedents.  Many criticize economists for imagining what the world should be like and then proposing policy off their unrealistic idealized models.  This is another example of that.  We don’t know what the unintended consequences might be.

Some unintended consequences might be:

  • Transition would be difficult
  • Recession during the transition, because middle and small market lending would likely suffer
  • Pay for transactional accounts – no interest even if inflation is high.
  • Increase in savings accounts, which might be short-dated enough to be transactional
  • Gives a lot of power to the SNB, which might be halfhearted about implementation (Regulators dislike change, and risk).
  • Could be subverted if Government becomes dependent on free money, leading to inflation
  • Moves monetary policy from rate targeting to permanent quantitative monetary adjustment. Unclear how the SNB would tighten policy; maybe issue central bank bonds to reduce money supply?
  1. Could something like this rein in credit bubbles? Are we facing another credit bubble?

Yes, it could.  Most credit bubbles result from short-term lending funding long-term assets.  This would rein it in, in the short-run, but who could tell whether it might come back in another unintended way?  If some new class of lender became dominant, the threat could reappear.

We aren’t facing a credit bubble now, because the last crisis wiped away a lot of private debt, and replaced it with public debt.  Perhaps some weak nations with debts not in their own currency could be at risk, but right now, there aren’t any categories of private debt big enough and misfinanced enough to create a crisis.  That said, watch margin loans, student loans, and auto loans in the US.

  1. Are there any modern day equivalents we can compare Vollgeld to?

None that are currently being used.  There are a lot of theoretical ideas still being tossed around, like 100% reserving, lowering bank leverage, strict asset-liability matching, disallowing banks from lending to financial companies, etc.  These ideas get a lot of press after crises, but fade away afterward.  Most of them would work, but all of them lower bank profits.  Concentrated interests tend to win against general interests, except in crises.

  1. You mentioned there is a similar concept for derivatives that no one is talking about. How exactly would that work?

Derivatives are functionally equivalent to insurance contracts, but they are not regulated.  I believe they should be regulated like insurance contracts, and require that those seeking insurance have an “insurable interest” that they are trying to hedge.  Only direct hedgers could initiate derivative transactions, and financial guaranty insurers would compete to fill the need.

This would prevent the unintended consequences of having multiples of protection written on a given risk, where a weak party like AIG is incapable of making good on all of the derivative contracts that they have written, which could lead to its own systemic risk if other derivative counterparties can’t absorb the losses.

I know that is over-simplified, but I read through the papers of both sides in the debate, and I thought both overstated their cases significantly.

I know fiat money has its problems, and so does fractional reserve banking, but if you are going to propose a solution, perhaps one that fits the basics of how a well-run bank at low leverage would work would be a good place to start.

Article by David Merkel, The Aleph Blog

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David Merkel

David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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