Frosti Sigurjonsson, a member of Iceland’s Parliament, has presented a proposal for a “better” monetary system for that nation to adopt. The proposal is the product of a study commissioned by Prime Minister Sigmundur Daviö Gunnlaugsson. There are, of course, many issues involved in any idea for a different kind of monetary system, but let's focus on the biggest, most general aspects of the Icelandic proposal.

Make no mistake: this proposal truly is something new under the Sun. It would change the way monetary policy is established and implemented, creating a system much different from any that has ever existed.

The proposal has two major goals: (1) eliminate the possibility of ‘collateral damage’ to the economy that might result from risk that banks undertake; and (2) allow for Iceland’s supply of money to be increased without debt being incurred in the process.

The first of those goals would be accomplished by separating the checking function of banks from the functions that involve risk. Banks incur risk in two ways: (1) when they lend money and (2) when they invest money to (hopefully) increase revenue and protect against possible losses (i.e., ‘hedging’).

In the Icelandic proposal, banks would offer their customers two kinds of accounts. What we now call a ‘checking account’ would become a “Transaction Account.” Money in that account would be subject to a fee. If desired, people and businesses could also put money into interest-bearing “Investment Accounts.”

Banks would offer different investment accounts, from ones used to fund riskier business that would pay higher rates of interest to accounts funding less risky investing and lending that would pay less interest. Transaction and Investment Accounts would be the only two types of accounts banks would offer their customers.

Currently, banks can use money in all of their customers’ accounts to lend and invest (though the total amount of that money that banks can put at risk is subject to certain restrictions). In the Icelandic proposal, banks would not have access to money in Transaction Accounts, except to transfer money as necessary when the account holders made transactions using their accounts. The money in those accounts would be held at the central bank at all times, insuring against bankers’ being tempted to tap into it.

Banks would only be allowed to lend and invest money in Investment Accounts. If a person or business borrowed money from a bank, that money would be taken from the pool of money the bank had available to lend and put in the borrower’s Transaction Account (whatever bank that account might be with).

The upshot is that if a bank became insolvent because too many of its loans and investments ended up losing money, the money in its Transaction Accounts would not be tied up in the business of the bank. Money in Transaction Accounts would still be available to the Account holders, even if a bank failed completely. It would simply be transferred by the central bank to a different bank of the customer’s choosing. Money in Investment Accounts would be at risk, and could be lost completely.

That brings us to the second goal of the Icelandic proposal, adding to the supply of money for the economy without creating additional debt. In current monetary systems, money is added directly to a nation’s money supply when money is created by its Treasury to give to the central bank for it to buy government bonds. (Yes, that really is how it works.) So, the government adds to the supply of money by incurring debt.

Government can do that on purpose when it engages in ‘deficit spending’ to ‘stimulate’ the economy (which is classic Keynesian policy). Government can also add to the supply of money by incurring debt even though the intent is not to stimulate the economy, but simply because spending dictated in the budget exceeds the revenue the national government collects in taxes.

Either way, money is created ‘out of thin air’ by increasing the national debt (or—cough, cough—reducing the government’s surplus) and enters the economy through government spending. The central bank decides for itself how much of the government’s bonds that it purchases will be paid for using money it has on hand and how much money it will call on the Treasury to create, so the final word on how much money will be created rests with it.

Being allowed to call on the Treasury to create money for it to buy the national government’s bonds is how central banks are able to guarantee that all bonds the national government issues will be purchased. That is what being the ‘lender of last resort’ to the national government really means in contemporary terms.

In the Icelandic proposal, Mr. Sigurjonsson states very clearly and explicitly that depending on using debt to get money into the economy has always been connected to economic instability. Allowing money to enter the economy without debt is accomplished in the proposal for the express purpose of breaking that connection. Money would be added to the economy by simply creating it and handing it to the national government, without debt being involved in the process.

There would be an “independent monetary committee” in the central bank, which would decide if and when and how much money to create. If the committee determined that the economy needed more money, it could simply create money and hand it to the national government to spend (though the proposal does cite other options for government to use to get that ‘new money’ into the economy).

Whatever the further details of this proposal, it does represent the possibility for the first really new monetary system for an individual nation with a central bank since the Bank of England was established in 1684, creating the central-bank model.

Author's note: The document containing the Icelandic proposal is titled "MONETARY REFORM: A Better Monetary System for Iceland." In it, Sigurjonsson cites "Modernising Money," by Andrew Jackson and Ben Dyson, who refer to their prescription for the monetary system as the Sovereign Money Proposal. Sigurjonsson’s document is embedded in its entirety in this article.