Iceland and Pink Floyd ponder the nature of money

Money, it's a gas/ Grab that cash with both hands and make a stash.

Roger Waters provided as good a definition of money as there is on Pink Floyd's rock classic Dark Side Of The Moon. Still, it is worth digging deeper as the post-crisis debate about the structure of the financial system heats up again, this time from one of the biggest victims of the crash: Iceland.

A report commissioned by the Icelandic prime minister has recommended abandoning the current banking system and moving to "sovereign money".

It seems unlikely that the residents of Reykjavik are about to embark on the biggest monetary experiment since President Richard Nixon abandoned the last vestiges of the gold standard. But the report is part of a resurgence of debate about money and banking after the 2008 Lehman failure.

The discussion is a fascinating one, and vital to the future not only of banking but also of saving and investment. In many ways, though, it is merely a return to a debate that rumbled on throughout the 19th century.

At its heart is a question about the nature of "money". Those who think money is defined by government fiat as something used to buy stuff - "new car, caviar, four-star daydream" in Pink Floyd's case - want to protect the transaction system from the ravages of bank failures.

The Icelandic proposal would create "transaction accounts" for payments, with accounts fully backed by central-bank money. Alternatives such as "narrow banking" require 100 per cent reserves for current accounts; Britain is making a halfhearted step towards this with the ringfencing of retail banking. In the 1840s this approach was pushed hard in the UK by economists of the currency school, who succeeded in requiring issuers of banknotes to hold gold reserves backing them in full.

Another use of money is as a store of value (it is also a unit of account). This role is split out by the Icelandic proposal, with savings outside transaction accounts no longer available for payments, locked in to specific maturities ranging from 45 days up.

The aim of all the reform ideas is to remove the need for government support for failing banks, protecting a utility-like payments system.

There are two big problems with the idea. Savers want an impossible trinity of safety, liquidity and return, and the system will always find ways to try to satisfy that desire.

The current system of fractional reserve banking satisfies the desire, most of the time. Banks promise that depositors can access their money, an illusion that works so long as most do not try. Each new bank loan creates a matching deposit, with a mismatch of maturities - a mismatch that only becomes a problem if there is a bank run. Meanwhile, short-term deposits are transformed into long-term loans which can, in principle, be much more useful for the economy.

Human nature being what it is, savers are gulled into believing that bank deposits are a totally safe place to stash their cash. This is one reason governments end up providing bailouts.

So, the first problem with any system that makes clear to depositors the risks they are taking is that they may well choose not to take those risks. Fractional reserve banking creates big difficulties when it goes wrong; the trade-off is that when it goes right, it offers long-term financing more cheaply than depositors would otherwise be willing to provide.

The second problem is that finance constantly finds new ways to sidestep government rules and satisfy investors' desires. In the 19th century, restrictions on credit led to bills of exchange circulating very like money.

In the 2000s, money market funds came to look like banks. In 2007 they were caught out the same way when it turned out their overnight promises were, in some cases, backed by long-term structured subprime credits. As with banks, the US government had to step in with a rescue.

Runaway credit always creates problems. But it is savers, not governments, who decide what they are willing to accept as a store of value. Reforming banking may help in the short run, but history suggests investors and savers will always get carried away, and governments and regulators usually miss the signs of trouble until it is too late.

For now, investors should be wary. Reforms may not go as far as some want, but government support is being cut back. Cypriots have already found that deposits are really a form of credit, vulnerable to losses. If the reformers have their way, savers elsewhere will rediscover credit risk too.

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