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Wenzel And The Austrians Only Half Right On Fed

Robert Wenzel lit the Fed up like a Christmas tree at a Fed luncheon he was invited to this past Wednesday. It may have been the most criticism of the Fed spoken within the walls of the Fed ever. However, some problems with Wenzel's critique/analysis:

1. While it is true that economics lacks the precise constants of the physical sciences, behaviors in the aggregate are predictable within margins of error that are acceptably narrow for the purposes of modeling and constructing formulas. All price setting activity, including hitting the interest rate targets through open market operations are based on a sufficiently precise relationship between price and quantity demanded.

2. The staggering increases in price level and money supply are relatively meaningless without also considering increases in wage levels. It is the relative prices that are of importance, not the general prices. Many of the relative price changes between wages and basic necessities are compelling enough, thus alleviating the need to harp on the general prices which is a ploy amounting to little more than propaganda.

3. The Austrian Business Cycle Theory connects the two variables of credit and output, but misses the full story. It attempts to pin the blame on malinvestment while overlooking the real drag of debt overhangs. Of course the money supply slows or contracts when loans default and consumer/business incomes are incapable of taking on any new debt. The slow down in money supply is the symptom of burdensome debt service that has the effect of reducing real incomes, thus real demand.

4. The US banking system was a disaster prior to the Fed. There were13 major bank panics between 1833 (end of the Second Bank) and 1913 (start of the Fed), each one worse than the one before, some being known as "The Great Depression" until the next one would supplant it to take the title. There were real supply shocks as businesses lost their entire operating budgets and payroll accounts when the banks holding their deposits imploded. The Fed although far from perfect, and introducing an entire set of new problems, improved much of this.

5. The faulty premises on which subprime mortgage underwriting was built were fairly obvious, namely that housing would appreciate rapidly forever.

Wenzel does make some good points as well, particularly in criticism of ardent Keynesianism :

1. The thought that real demand can be increased via an increase in the nominal money supply is a violation of Keynesian economics' very own IS/LM model. While there is some potential merit to the idea in light of its ability to lighten burdensome debt service, it impacts individuals who were never a party to the debt instruments this policy seeks to amend in real terms, and effectively externalizes costs, thus creating market failure. Far better would be to allow defaults, write-downs, and modifications between debtor and debtee. Banks that are brought to insolvency can be transferred to new management through FDIC and the receiver bank's reserve requirements can be adjusted accordingly.

2. Wenzel's most provocative, yet astute statement is when he challenges the very notion of stable prices. "What is wrong with having falling prices across the economy, like we now have in the computer sector, the flat screen television sector and the cell phone sector? Why, I ask, do you want stable prices?" The reason we can't have falling prices is because falling prices are incompatible with a fractional reserve banking system. Falling prices would make long-term leveraged finance (think the entire commercial and residential mortgage market) unfeasible as the cost of the debt service would increase in real terms in the later years, thus increasing the chance of default, thus putting downward pressure on leveraged assets, thus creating a deflationary feedback loop. Debt based banking systems need a bit of predictable inflation in order to keep loan losses to a minimum.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.