Fractional Reserve Banking

Fractional-reserve banking is a system by which banks lend money whilst guaranteeing that depositors will be able to make withdraw their deposits on demand. However it is important to remember that when they lend money, they are in reality creating it. A fraction of deposits held by the bank cannot be lent against to create new loans and acts as a reserves. This fraction varies from nation to nation. Because the bank creates the loan as a promise to pay rather than existing money, this system has the effect of increasing the economy's money supply. When this money is spent into the economy, the newly created money will be deposited in a bank again, where it will be lent out again, increasing the money supply further. However it should be noted that although the bank creates the money for the loan, it does not create the interest that needs to be repaid with it, and thus for all debtors to meet their loan repayments of principle plus interest the money supply needs to constantly expand. Otherwise mathematically it is inevitable that some people will default.
As a result of the crash of 1929 and the subsequent Great Depression a series of reforms of the fractional reserve system were put in place in the 1930s. These included the creation of deposit insurance to protect against possible bank runs. In some cases countries have also implemented higher legal reserve requirements which impose minimum reserve requirements on banks. The Vickers report in the UK which has just been released has recommended that banks should hold up to 20% of capital reserves. Economists believe that these monetary reforms have made sudden disruptions in the banking system less frequent.

There are critics of fractional reserve banking who argue that the practice is a kind of "fraud" perpetrated against depositors/savers as they believe that it gives financial institutions too much power, artificially lowers real interest rates, inflates the money supply and contributes to volatile and unsound business cycles. Some compare it with counterfeiting, as the banks are granted the legal right to create money "out of nothing" while also being granted the right to charge interest on this ‘counterfeited’ money. Some commentators, such as Michael Rowbotham, argues that this concentrates wealth in the banking sector (which has a "cannibalizing" effect on the rest of the economy), which leads the rest of the populace to be in a state of perpetual and ever growing debt, and encourages volatile hyperinflation in the property markets and deflation in the consumer goods market. He also argues that this reduces real wages, destroys farming and agriculture and de-industrializes heavily indebted economies.

Fiat moneyBanks create new money as loans through fractional-reserve banking and as a result money is no longer backed by a tangible asset. The result is so-called ‘fiat’ money which does not represent anything other than the debt of another; the only "tangible" aspect of the system is the borrower’s promise to pay back the interest and principal on the loan. Debt and the ability of borrowers to repay their debts then becomes the underlying currency.
Money creation by the central bank

When central banks issues government bonds (usually known as ‘gilts’) they are sold to the private sector to raise funds and the government has to pay interest on this as debt. Alternatively the central bank will issue money in the form of notes and coins, but this represents an increasingly tiny fraction of the overall money supply – usually between 1 and 5%. The money to buy the bonds usually comes from the bank’s own profits or may again be created from nothing. Many economists argue that this leaves the state too vulnerable to the interests of private bankers who create the money to make profits, without any other binding social or legal obligations to the nation that are legitimately demanded from a government.

International organizations and developing nations
Some monetary reformers are highly critical of global financial institutions like the World Bank and International Monetary Fund and their policies regarding developing nations in particular, as they have in the past imposed stringent conditions and unpayable debt on weak governments that cannot repay either the loans or the interest without dramatically affecting the lives of the poorest citizens. Many governments feel compelled to concentrate on selling ‘cash crops’ or similar commodities on world markets in order to earn currency to pay their debts, sometimes at the expense of local cultures and the environment.

Most Argued Alternative money systems

Central Bank Independence
Some countries, such as New Zealand, Australia and the UK, have created a currency board, or granted independence to their central bank. The central bank is granted the power to set interest rates and conduct monetary policy independent of any direct political interference or direction from the central government. The argument is that interest rates will be less susceptible to political interference and thereby assist in combating inflation (or debasement of the currency) by allowing the central bank to more effectively restrict the growth of the money supply. However, given that these policies do not address the more fundamental issues inherent in fractional reserve banking, many suggest that only more radical monetary reform can promote positive economic or social change. Although central banks may appear to control inflation, through periodic bank rescues and other means, they may inadvertently be forced to increase the money supply (and thereby debase the currency) to save the banking system from bankruptcy or collapse during periodic bank runs, thereby inducing moral hazard in the financial system, making the system susceptible to economic bubbles.

International Monetary Reform
Theorists such as Robert Mundell and James Robertson believe that the only solution is for global monetary reform. Robert Mundell in particular advocating the revived use of gold as a stabilising factor in the international financial system. Some mainstream economists argue for monetary reforms to reduce inflation and currency risk and to facilitate the efficient and fair allocation of financial capital. However their ideas rarely receive any coverage in the mainstream media.

The provision of debt-free money directly from government
Other radical reform proposals centre on empowering governments to have a more direct control of the money supply rather than relying on private banks to issue money as debt. Reformers, such as Michael Rowbotham, Stephen Zarlenga and Ellen Hodgson Brown, support the restriction or banning of fractional-reserve banking and advocate the replacement of fractional-reserve banking with government-issued debt-free fiat currency issued directly from the Treasury rather than from the quasi-government Federal Reserve.
Alternatively the Social Credit movement argues for the issuance of repayable interest-free credit from a government-owned central bank to fund infrastructure and sustainable social projects. This Social Credit movement flourished briefly in the early 20th century, but was marginalised in the post-World War II era.

These groups see the provision of interest-free money as a way of eradicating "debt slavery" and transforming the economy away from environmentally damaging consumerism and towards sustainable economic and business practices.

Historical examples of government issued debt-free money
Before the American Revolution, the colonies used the "Colonial Scrip" system which was praised by Benjamin Franklin. He argued that one of the causes of the Revolution was the desires of English bankers to undermine this government-issued money. During the American Civil War, Abraham Lincoln used interest-free money created by the government to help the Union win. This money was, he said, "the greatest blessing the people of this republic ever had."

Micro creditThis involves banks offering small loans on simple interest, not compound interest particularly for people in poor nations who are often excluded from the formal banking sector. The Grameen Bank pioneered this technique and it remains a popular and largely successful idea that has implemented in many nations, even in the US.