The monetary system is surprisingly simple yet is shrouded in the mystery of 'financial instruments' to make it seem inaccessible.
All money is created by debt in a method akin to double entry book keeping. When a loan is taken out the bank opens a 'loan' account for that person, debits it with a sum of money (the total loan value) and pays the money into the person's current account allowing them to spend the money. Interest is debited from the loan account each month and credited to the bank as payment, creating further money to enter circulation.
Cash is created in the same way with notes being printed and entering circulation backed by a debit in an account which is in turn backed by government securities. Whether money is created virtually as a figure in an account or as cash, it is balanced by a debit to an account. The Bank of England prints notes and puts an equivalent debit to its cash account, when high street banks need cash they debit their cash account and credit the BoE, the BoE credits its cash account (i.e. reducing the negative balance) and hands the cash to the high street bank. Cash is simply another form of credit which is created through, and backed, by debt.
**What should happen**
1. The power of injecting new money into the economy should be transfered from commercial banks to the Bank of England, with commercial banks banks taking on a credit broker role for customers wanting new loans.
2. Government borrowing should be transferred to the Bank of England.
3. Electronic money should be made legal tender making its creation by anyone other than govt akin to counterfeiting.
4. The Bank of England should control the amount of money it lends to commercial banks to contract or expand the economy.
Government borrowing should be replaced by Primary Credit - credit that forms the money supply. Primary Credit is a simply loan account created by the central bank that attracts no interest and requires no repayment (one account is debited and another credited - the credited account is the money that enters the economy). This is akin to the process by which cash is created. This Primary Credit required no interest repayment by government, which currently pays around £30 billion on the government borrowing (at 2007). Primary Credit can provide a stable constant in the monetary system.
Primary Credit would eventually provide the total money for the economy to function. Retail banks stop creating their own loans based on customer deposits (the Fractional Reserve system) and starts to act as a credit broker only, by borrowing money from the Bank of England and brokering it to businesses and people.
The level of current retail bank loans are gradually wound down as they are repaid or could be transfered to the Bank of England in one block. Either way the money supply stays constant (but could be increased or decreased at the government's request).
Electronic money becomes legal tender. Any bank lending money that it has not brokered from the Bank of England or doesn't already own would be guilty of counterfeiting.
The amount of money in the system is then easily controlled through the amount of Primary Credit. If the government increases the Primary Credit the money supply increases; if it repays the Primary Debt from a higher level of taxation than spending, the money supply decreases.
The government holds the strings on credit - banks have to borrow from the Bank of England rather than through interbank lending... any credit crunch would be the fault of the gov't and within the gift of the gov't to resolve.
I have put this on my new wiki (these are great for setting out one's thoughts).
Much of this is adapted from Huber and Roberson's book: Creating New Money