The bank crisis of 2008 revealed an urgent need to apply more restrictions on the banking sector. Many has also raised the question whether a reform of the current financial system would be in place. Most recently, in March 2015, Iceland’s prime minister commissioned a report, written by Frosti Sigurjonsson, on the subject of a new monetary system for Iceland.
It is hardly surprising that Iceland is a keen contributor to the topic, as the country has experienced many periods of extreme financial pressure over the last 50 years, including inflation, hyper-inflation, devaluations, an asset bubble, collapse of its banking sector which ultimately brought the country to bankruptcy in 2008.
Sigurjonsson explains how the fractional banking system is not just a contributing factor in creating boom and bust cycles, but also responsible for amplifying them severely. The explanation is simple: when economic outlook is positive, banks will maximise their profits by increasing their lending, which increases the money supply. In bad times they will slow down their lending, leading the money supply to slow down or contract. The fact is, he explains, that as long as commercial banks are able to create money by giving loans, the Central Bank is not in control of the country’s money supply.
The solution to this problem could be a so called Sovereign Money system, which doesn’t allow commercial banks to create money. All lending effectively goes through the Central Bank, while the commercial bank will act as an intermediary. A similar system was proposed by a group of economists already back in 1939, that was supported by 235 economists from 157 universities, but did not receive any following from policy makers.
I strongly recommend reading Sigurjonsson’s full article, which is in pdf format.