The Role of an Austro-Hedge Fund

0:00I don't know what kind of level of knowledge people have on Austrian economics, but one of the things that's very helpful for me and the thing that really has hooked me into Austrian economics is its methodological approach is entirely different to the mainstream and I think this is very helpful to people. Austrian economics is characterized by a priori logical reasoning and the mainstream approach, The approach of monetarists, Keynesians, anyone else is based on empirical research. And this can be good and it can be bad, but with a priori reasoning, logical deductive reasoning, if you have a truthful proposition, anything you can deduce from it will always and can only ever be correct.

0:49And so it must be the goal of all economics, the goal of all economists, and the goal of all people who want to pick up on economists' ideas and put them into practice is to find what a correct proposition is and then deduce thereafter. And when I've looked at applying Austrian economics, because I've intuitively or instinctively felt at home with Austrian economics, I've sought to find out where the gems, the golden nuggets of correct thinking are and then apply it to the real world situation. And one of those that I think, one of those nuggets that the Austrians have is a correct definition of the money supply which unlike Greenspan who says the money supply is impossible to quantify, the Austrians say it is.

1:41And if you have a correct definition of the money supply, you can then look and observe and compare your money supply vis-a-vis that of another currency, another country or central bank's money supply. And from there, you can start to look at successfully determining exchange rate differentials. And this is really something, if it can be achieved, it's very powerful. So, I think in mainstream exchange rate determination there are three basic errors that occur and I'd like to show how the Austrians correct each of those three errors and then we'll give you some practical examples of how we forecast exchange rate determinations and we'll be using the euro dollar as an example.

2:35The first error I call, well, it is establishing a correct definition of money supply. Frank Shostak is the leading Austrian economist who has, I think, put the definitive version of the Austrian theory of the money supply in the quarterly journal of Austrian economics. Dr. Shostak opens by saying, according to mainstream economics, the validity of various Most definitions of money can be ascertained by means of a statistical test. What determines whether money, M1, M2 and the other M's are valid definitions is how well they correlate with national income. Most economists hold that since the early 1980s, correlations between various definitions of money and national income have broken down.

3:22The reason for this breakdown it is held is that financial deregulation has made the demand for money unstable. In short, the nature of financial markets has changed, consequently past definitions of money no longer hold. He then goes on to say, observe that for the mainstream, the definition of money is established through an arbitrary mixing of various liquid assets and then correlating this mixture with another dubious set of statistics labelled national income. In other words, any mixture of liquid assets will be classified as money as long as this mixture passes the correlation test. Now if any mixture of liquidity is accepted, why not include retail good inventories, after all these inventories might be as liquid as stocks or bonds, yet no one will consider these inventories as part of the money supply.

4:08And this is something that Rothbard pointed out in an article in 1978 that Frank's got hold of there which is really if you're just looking at correlating an arbitrary band of statistics with National Income. Virtually you can include anything. You can include inventories in my factories, for example. You can include the stock of the meat and the fish that I sell because it's readily exchangeable into money very rapidly as soon as you sell the thing. Why not include those figures in National Income Statistics? The mainstream won't have any problem with that. Milton Friedman wouldn't have any theoretical problem with doing what would seem such an unscientific and illogical way of determining what the money supply is.

5:06Shostak then, he looks at what the actual origin of money is. He goes back to barter and reasons as follows. In a barter economy, if you have a double coincidence at once, everyone's happy, you can exchange your goods with the other person. If you want to conduct any exchange with someone who doesn't have the goods that you want, then you've got a problem. Money comes into being as a commodity because it's the most marketable and the most exchangeable final product. It's the final commodity for which all goods trade.

5:53That's the Austrian definition of money. And I think really, Frank, what the essence of money is, is the final commodity in exchange. And if we use that definition of money, of Money, we can then go on to define what the supply of it is in a given economy. I'll suggest to you that we need to have an accurate definition of the money supply in order to predict its movements because currency movements are simply movements of the exchange rates of different national monies. To be able to count the supply of a particular people's monies or people's final commodity in exchange, you need to distinguish between a claim transaction and a credit transaction And this is something that Ludwig von Mises introduced in his 1912 book, The Theory of Money and Credit, the distinction between a claim transaction and a credit transaction.

6:55And this is where it falls, lives or dies, the Austrian theory of the money supply, is how you distinguish between claim and credit transaction. A claim transaction is when you, as the holder of money, your final commodity for exchange, When you say you deposit in a bank, you still have your rights over it if you put it into a current account or into any account that you have instant access to. A credit transaction is one where you actually forego the ownership. You may not know you're foregoing the ownership of that money. You think, well, I've put some money on a 90-day deposit account, you know, it's my money and it sits in my conceptual valuation of what my assets and liabilities are.

7:43but in effect you have legally given away the ownership to the bank and the bank can then pyramid its it can do an inverse pyramid of fractional reserve banking and lend out your money. If you want your money back you've got a timed restriction on it. Presumably you can pay a penalty in most of these things to get your money back but it's a credit transaction and where? All the definitions of money supply over and above M1, that's M2, M3, MZM, all the various other definitions come into play. They don't use this distinction of claim transaction and credit transaction. And they have created a double and sometimes a triple or quadruple accounting of the actual real essence of money.

8:34And this is where they go wrong. This is where they can't really effectively use the money supply to do what they set out to do which is to control the economy religiously and be able to be predicting things and be able to be 100% accurate because they don't successfully distinguish between the claim and credit transaction. but if you're doing this correctly and there are a few practitioners in Austrian economics one of them is Frank Shostak who's here who does it and one of them is Michael Ryan in Australia as well then you can actually come up with information that you can use which we call the actual Austrian money supply which you can then deploy in your efforts to do exchange rate Determination. But the full definition of money in the Austrian tradition now, according to Shostak in the quarterly journal of Austrian economics, is cash plus demand deposits with commercial banks and thrift institutions, plus government deposits with banks and the central bank. Now that differs slightly

9:48from M1 because M1 excludes, as I understand it, central bank and Governance Owned Deposits in the Central Bank. So the, I mean Frank you're over there, correct me if I'm, am I right in saying that? Yes, that's good, excellent, thank you. But that, once we have the Austrian money supply, we can then go, we can then, you know, use it for correct exchange rate determination. Error two is that the Austrians have corrected is actually, I mean, it's a very, very odd one. When I was an undergraduate at London School of Economics, the first thing you learn is that everything about economics is, prices are always determined by demand and supply.

10:36And this is correct. Then the mainstream then go on and they actually miss out the supply curve in its entirety in exchange rate determination. They just look at the demand side of the equation. Demand is here and supply is like way over there. It's completely missing. I'll read you out an example from the textbook that I had to use as an undergraduate. It was done by Richard Lipsy, who's professor emeritus and fellow at the Canadian Institute of Advanced Research, Simon Fraser University, Vancouver, Canada. fantastic title and he says the following the exchange rate is just a price albeit a very important one as with other prices will approach the explanation of exchange rates from the perspective of demand and supply that all sounds very good at the moment because one currency is traded for another in the foreign exchange market it follows that a demand for foreign exchange dollars implies a supply of pounds while the supply of foreign exchange dollars implies a demand for pounds

11:40They then go on in the traditional fashion to explain that a demand for exports from the UK as people need pounds to pay for the goods will have an effect on the exchange rate and how dividend income from foreign holdings will be repatriated in sterling and so on and so forth. They then go on to point out the traditional things and that's all very well and good as well and we use it in our forecasting, we collect data on these. But when they come to supply, this is what they say. The sources of supply of pounds in the foreign exchange market are merely the opposite sides of the demand for dollars. The critical error is they completely fail to talk about the physical supply of the commodity in question.

12:29The physical supply is just missing. What they're talking about is a ratio. And it's a subtle difference. But if I can try and explain, if you If you think of two very simple commodities, money after all is just a commodity in itself, it's the final thing for which we exchange. But if we take two simple things like two apples, if you take two apples or two countries' productions of apples, they're fairly homogeneous products. If one country, for example, England produces, English apples are called Copse's apples, French apples are called Granny Smith's apples, the mainstream would look at the demand for each of the other country's apples and compare the ratio.

13:23That's what the mainstream will tell you in foreign exchange rate determination. But if you think hypothetically, let's say the French apples, the Granny Smith apples, if there was half the amount of them in supply vis-a-vis the English Cox's apples, and if the demand was, well the mainstream would say that the price for the French apples would rise in price. Yes, that's what they said, which is of course correct with the restriction of supply. But if the demand for the English apples completely fell out of the marketplace and the French apples, even with their restricted supply, the price would still go up.

14:13So you see they've completely missed the point that supply matters, physical supply of a commodity matters vis-a-vis another commodity and this is the grave error, the second error that the mainstream have just completely walked them by. I think it's because they can't define what money is. They can't successfully count it. When you can successfully count it, you can then compare it with other people's currencies. And this is what we do. And you can see in this graph here, what we have is we have a series of graphs behind this, which would show you how for example if the American central bank is printing more money vis-a-vis the European central bank you've always got to compare currency pairs and you've got to compare the rate of increase of one central bank versus the rate of increase of another central bank.

15:25So even if the US Central Bank is, as we know, and Mark Thornton's figures were, you know, perfectly illustrated the point, then massively pumping up money in America. But if Europe is doing the same, or if Europe is pumping up even faster, then you look at the differential and that's what will determine whether the exchange rate rises or falls, the differential in Supply. So here you can see, on the top, the points A, B, C, D and E. These are showing high points and low points in the Euro versus dollar exchange rate. And that, we can directly correlate that with the Austrian actual money supply with a time lag. So it's a very, very The graph down below shows you how it's a quarterly trend average, so what that is showing you is it's showing you how much the market is moving away from that ratio of difference between the respective increases of supply in the Federal Reserve vis-a-vis the European in Central Bank and what we notice is we notice that when the currency, if you take, you can

16:49see the zero line down at the bottom here, that's presuming that the currency is trading exactly on their fundamentals. The ups and downs over and above, the oscillations over and above the zero point are very, very interesting because it shows roughly when the dollar is is 5% overvalued vis-a-vis the fundamentals, it will start correcting and when it's undervalued to the tune of about 4% over its quarterly trend, it will correct back and in terms of earning money out of this, applying Austrian economics to earning money, which is what we're interested in, is you can trade around these periods with relative confidence that The currencies will correct, will take off the excess each time traders have got so excited about either the depreciation or the increasing in value of the currency.

17:55So we have here an ability to be able to, it's a medium and long term predictive model. You know, it's a type of thing where you take trades that may, you may open a trade on day one and you may close it, anything from three months or two years or two years later to reap the rewards of those trends there. So that really is really how you can apply Austrian economics. I said there were three errors, but I don't think I'm going to have enough time to do the third error, one or two minutes. Well, the third error is a timing error. Mainstream people, and even some Austrians, are fairly insistent upon, they can only understand things in terms of cause and effect, which is good, which is good, but they need to put something objective like an equation around the cause and effect.

18:57This is something that we say is impossible to do. We can't put a time lag, we can't put a predictive time lag on any of these things. For example, you know intuitively that if a Japanese bond trader buys a US Treasury bond, at some point in time, it's an absolute certainty, he's got to pay for it, otherwise the transaction doesn't go ahead, but you don't know whether it's today, you don't know whether it's in the future, you don't know whether he's going to be doing some kind of derivative around it, you don't know and you can't predict that, but what you can predict with the quarterly trend, and it's very just so, so, so powerful, is that when it does get up to near that excess, the market will trade it away, it's not sustainable And it's not sustainable because of the very reason that I could come to this country before Christmas, stay at the Waldorf Astoria Hotel in New York and it would cost me the same of staying in a two-star hotel in London.

20:04It's because the purchasing power parity theory tells us, and that's a mainstream theory, that you just can't, currencies can't diverge that much, so all this hubris about the dollar just going to, dollar is going to collapse and so on and so forth, it's not a reality, there's no, it's a fiction that the dollar is vis-a-vis, because you always need to look at it vis-a-vis other currencies and if everyone else is being as bad or worse than the Federal The Federal Reserve, then the dollar still stays as a strong currency and that's the situation that all the fundamentals are telling us.