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Rethink needed for monetary policy role

Central bankers are not famous for breaking traditions, but the ones in Iceland may be about to start a revolution. An island of 320,000 with a banking system that grew to more than seven times the size of the economy in 2007, Iceland was hit hard by the financial crisis.

Under its proposal to reform its monetary system, Iceland’s central bank would take exclusive powers to create money. It would not just set interest rates, but also control the quantity of credit: commercial banks would be allowed to lend within a maximum range, reviewed each month. Iceland’s proposal is too centralised to work in an open economy, and overly constraining credit may choke growth.

And yet, Icelanders have recognised one of the core problems facing monetary policy in developed countries: central banks cannot control money (credit) creation by commercial banks. As a result, private debt has grown exponentially over the past decades.

“Remember that credit is money,” said Benjamin Franklin. And contrary to “popular misconceptions”, it is commercial banks — not central banks — that create money and deposits, by issuing loans, as the Bank of England explains in a 2014 report.

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