> If that's the case, how do they keep fulfilling those promises?
By having the government magically conjure new money into existence, and getting everybody to believe that that counts as "fulfilling the promise". And then having to wave their hands and obfuscate when the economy melts down.
> If you believe any lending when you don't have the full money on hand to account for all the loans is wrong, then you need to apply the same level of scrutiny to borrowing.
What counts as "the same level of scrutiny"? The analogue from the borrower's side would be borrowing money without any intention of paying it back, not borrowing money period. If the borrower takes the money, does something profitable with it, and pays back the loan with interest out of the profits, there's nothing wrong with that; indeed, it's why borrowing exists in the first place: because it's a positive sum transaction, benefiting both sides.
> The system works because both sides are taking on risk.
A system in which loans were always backed by real wealth would have this property; the lender takes the risk that the borrower won't pay the loan back in full, with interest, and the borrower takes the risk that his business venture won't pan out and he'll have to either find some other way to pay back the loan, with interest, or default and take the penalty for that. But both sides also have the possibility of gain to balance the risk.
But our current system forces third parties--the taxpayers--to also take on risk: the risk of having to bail everyone out when the house of cards collapses and the economy melts down. What gain do the taxpayers get in exchange?
Overall economic growth. If you believe that a system where only real assets could be used to back a loan, and loans needed to be backed 100% by real assets would result in the same or better overall situation now if started some point in the distant past, then yes, we should strive for that. Personally I believe that the current system has allowed advancement farther and faster than the alternative. Sometimes progress is best achieved not through the safest route, but through the fastest of the routes with the acceptable safety margins, given a cost/benefit analysis. That's the system we live in. We don't always agree on the metrics of the cost benefit analysis, or what constitutes a good safety margin, but even the safest path forward we have is not guaranteed (recessions and depressions can still happen, regardless).
Thank you very much! You have actually come out and said what even Nobel-Prize-winning economists are unwilling to say.
Here is the argument you are making, in a nutshell: if we limited ourselves to a "hard money" system with no fractional reserve banking, economic growth would be too slow. So in order to get faster economic growth, we allow fiat money and fractional-reserve banking; but we also have to accept the downside of that, which is occasional economic meltdowns and a general skew in the way wealth is distributed. This is a fair tradeoff because the benefits of faster economic growth outweigh the costs of economic instability and skewed wealth distribution.
Whether or not I agree with this argument is really beside the point (I don't think I do, on balance, but it's certainly not a slam dunk either way so I can understand that reasonable people could take either side). The point is that we, the taxpayers, were not sold the system we have on the basis of this argument. We were sold the system we have on the basis of "it will make sure no Great Depression ever happens again--trust us!" We have never had a real public debate on whether it really is a fair tradeoff to accept economic instability and skewed wealth distribution in exchange for faster economic growth. (I personally think that is because the parties that benefit from the existing system, mainly politicians and banks, are afraid that a real public debate would result in a majority of people rejecting the existing system and demanding a different one, one that would be harder for the existing players to game. But the only way to know for sure is to have the debate.)
> Thank you very much! You have actually come out and said what even Nobel-Prize-winning economists are unwilling to say.
I didn't think it was that controversial. I'm not aware of any economists that wouldn't endorse a system such as that (even if they disagree whether we are currently acting within the constraints as they think they should be), unless they are forced to also be politicians (such as the Fed chair).
> Here is the argument you are making...
Yes, except I don't think that's as much a facet of FRB as much as Fed lending. FRB can exist with just deposits, and FRB rules are to keep banks from getting too leveraged. FRB can happen with an entirely commercial backer to the bank, so I I think FRB is a red-herring. At this point we are just talking about central bank lending (which could happen without FRB, as well). I will concede that the importance of FRB is greatly influenced by the ability of Fed lending.
> Whether or not I agree with this argument is really beside the point (I don't think I do, on balance, but it's certainly not a slam dunk either way so I can understand that reasonable people could take either side).
Definitely. I would be willing to revise my view of it with more information. I'm far from authoritative on the subject. My knowledge comes mostly from discussions here, common sense, Planet Money, Freakonomics, and some other random sources, in roughly that order.
> We have never had a real public debate on whether it really is a fair tradeoff to accept economic instability and skewed wealth distribution in exchange for faster economic growth.
That may be framing it a bit strongly. I'm not sure that requiring real assets to back loans leads to more stability. One of the selling points of Fed lending is that it provides a lever to control (or at least influence) the economy. If you believe that enough that you think the influence matters, it's a question of what has a stronger influence or more likely, under what constraints does that influence outweigh the runaway situations (that might be exacerbated by FRB) it's meant to counteract.
> But the only way to know for sure is to have the debate.
Well, I'm all for the debate. :) I don't necessarily think the public would go one way or the other by themselves. The topic is complex enough, with enough moving parts, that I think the majority could easily be swayed by their politicians of choice and the view they espouse.
I don't doubt that our current economic system is purely hovering semi-close to a local maximum. We could probably find much better systems with the ability to perform meaningful tests. Unfortunately, meaningful tests are hard because it's hard to simulate real, encompassing behavior of people in a test. I'm also not sure that a superior system wouldn't die off purely due to the inertia of the current system. All things being equal, a better system might win, but things aren't equal, the current system has a lot of leverage to bring to bear.
True; and so can the economic instability that comes with the possibility of bank runs. Also, the argument that that possibility is worth accepting in exchange for greater economic growth can be made with FRB alone; Fed lending is not required. (Fed lending might make the argument easier to make, since it comes along with the government guaranteeing bank deposits, so that an ordinary bank run basically can't happen in our current system. Instead we just get occasional meltdowns of the entire economy; but it's easier to shift the blame for that.)
> I'm not sure that requiring real assets to back loans leads to more stability.
I certainly don't have a proof that it does--I don't think economics is anywhere near developed enough as a science to be able to produce such a proof. But there is an obvious heuristic argument: requiring real assets to back loans ensures that whatever the borrower does with the loan, it must provide enough benefit (on average--obviously there's always risk involved in individual cases, but that's true of any economic venture) to make him willing to bid away those real assets from whoever else wants to use them. In other words, it uses the price mechanism for the purpose intended: to channel real resources to their highest valued uses. But as soon as you allow loans to be made without real assets backing them, you break that mechanism, and at that point, all bets are off.
> If you believe that enough
I don't--not because the influence doesn't exist (clearly it does), but because nobody understands how the economy works well enough to make using that influence a net gain. We'd be better off if everyone admitted that nobody knows how to run the economy, and adjusted our expectations accordingly.
> Instead we just get occasional meltdowns of the entire economy
I think we have different metrics for what constitutes a meltdown. We haven't had another great depression, which is what I would consider a meltdown. We've had recessions, less than desirable economic growth over periods, but that's a far cry from a Grapes of Wrath dust bowl type situation.
> it must provide enough benefit (on average--obviously there's always risk involved in individual cases, but that's true of any economic venture) to make him willing to bid away those real assets from whoever else wants to use them.
That argument only works if you think the banks don't make their own assessment on the risk of individuals and whether they are even going to lend. If money was unlimited then that would be the case, but there's a cost to borrowing, and a cost to lending. In a well balanced system the costs of each are outweighed by the gains. As it is now, different people and different ventures get different rates because the risk is not the same. The Fed provides liquidity, which makes the market more efficient, and uses rates to simulate supply. The banks provide market pricing by assessing borrowers and additionally tweaking the interest rate up or down, further simulating supply.
> We'd be better off if everyone admitted that nobody knows how to run the economy, and adjusted our expectations accordingly.
We're driving in the fog. We have limited time to see the dangers and take action, but if we don't attempt to steer in any way, for all we know we'll just start going in circles. The clues that we're makign headway aren't always clear, but they do come occasionally. I would rather tweak the current method than abandon it entirely, as it seems to be working overall, even if not fairly (we're all gaining, just not at the same rate).
But we did have one, and it happened almost two decades after the Federal Reserve was put in place.
Also, I think the situation in 2008 qualifies as a "meltdown", even though it was not as severe as the Great Depression. It was just a meltdown in a reactor that had had some additional backup safety features put in place since the last one.
> That argument only works if you think the banks don't make their own assessment on the risk of individuals and whether they are even going to lend.
Of course banks are going to do that, but I don't see how that invalidates what I'm saying. In a banking system where there is no FRB and no fiat money, there is no way to expand the money supply at will to provide enough for everyone who wants a loan. So there will be more potential borrowers than there are real assets to lend to them. Obviously banks ultimately get to choose who they will lend to, but a key component of their decision is going to be what interest rate various borrowers are willing to pay. A rational bank will choose whichever set of borrowers will maximize its expected return, adjusted for risk, and the higher the rate a borrower is willing to pay, the more likely it is that that borrower will be in the set that maximizes the bank's expected return. See further comments below.
> As it is now, different people and different ventures get different rates because the risk is not the same.
Sure, and that would still be true in the hypothetical system I was describing; a borrower who was more risky would have to be willing to pay a higher interest rate. And a rational borrower would only be willing to do that if his expected return, adjusted for risk, was high enough to make it worth paying the higher rate. So there would be risk assessment being done on both sides. In other words, there would be a functioning price mechanism driven by supply and demand.
> The Fed provides liquidity, which makes the market more efficient, and uses rates to simulate supply. The banks provide market pricing by assessing borrowers and additionally tweaking the interest rate up or down, further simulating supply.
Yes--"simulating" supply. But why does supply have to be "simulated"? Because the usual price mechanism has been broken. In a market with a functioning price mechanism, nobody has to "simulate" anything.
> if we don't attempt to steer in any way, for all we know we'll just start going in circles
You're assuming that the entire economy has to be "steered" in a single direction. But an economy is not a monolith; it's billions of people each with their own needs and wants, trying to improve their condition through specialization and trade. Why does it have to be "steered"?
By having the government magically conjure new money into existence, and getting everybody to believe that that counts as "fulfilling the promise". And then having to wave their hands and obfuscate when the economy melts down.
> If you believe any lending when you don't have the full money on hand to account for all the loans is wrong, then you need to apply the same level of scrutiny to borrowing.
What counts as "the same level of scrutiny"? The analogue from the borrower's side would be borrowing money without any intention of paying it back, not borrowing money period. If the borrower takes the money, does something profitable with it, and pays back the loan with interest out of the profits, there's nothing wrong with that; indeed, it's why borrowing exists in the first place: because it's a positive sum transaction, benefiting both sides.
> The system works because both sides are taking on risk.
A system in which loans were always backed by real wealth would have this property; the lender takes the risk that the borrower won't pay the loan back in full, with interest, and the borrower takes the risk that his business venture won't pan out and he'll have to either find some other way to pay back the loan, with interest, or default and take the penalty for that. But both sides also have the possibility of gain to balance the risk.
But our current system forces third parties--the taxpayers--to also take on risk: the risk of having to bail everyone out when the house of cards collapses and the economy melts down. What gain do the taxpayers get in exchange?