WEBVTT NOTE The Role of an Austro-Hedge Fund 1 00:00:00.000 --> 00:00:03.740 I don't know what kind of level of knowledge people have on Austrian economics, but one 2 00:00:03.740 --> 00:00:06.960 of the things that's very helpful for me and the thing that really has hooked me into Austrian 3 00:00:06.960 --> 00:00:13.040 economics is its methodological approach is entirely different to the mainstream and I 4 00:00:13.040 --> 00:00:17.040 think this is very helpful to people. 5 00:00:17.040 --> 00:00:23.240 Austrian economics is characterized by a priori logical reasoning and the mainstream approach, 6 00:00:23.240 --> 00:00:33.240 The approach of monetarists, Keynesians, anyone else is based on empirical research. 7 00:00:33.240 --> 00:00:41.240 And this can be good and it can be bad, but with a priori reasoning, logical deductive reasoning, 8 00:00:41.240 --> 00:00:49.240 if you have a truthful proposition, anything you can deduce from it will always and can only ever be correct. 9 00:00:49.240 --> 00:01:04.720 And 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. 10 00:01:06.880 --> 00:01:15.640 And when I've looked at applying Austrian economics, because I've intuitively or instinctively felt at home with Austrian economics, 11 00:01:15.640 --> 00:01:22.960 I've sought to find out where the gems, the golden nuggets of correct thinking are 12 00:01:22.960 --> 00:01:25.480 and then apply it to the real world situation. 13 00:01:25.480 --> 00:01:35.000 And one of those that I think, one of those nuggets that the Austrians have is a correct definition of the money supply 14 00:01:35.000 --> 00:01:41.760 which unlike Greenspan who says the money supply is impossible to quantify, the Austrians say it is. 15 00:01:41.760 --> 00:01:48.640 And if you have a correct definition of the money supply, you can then look and observe 16 00:01:48.640 --> 00:01:54.720 and compare your money supply vis-a-vis that of another currency, another country or central 17 00:01:54.720 --> 00:01:56.520 bank's money supply. 18 00:01:56.520 --> 00:02:03.360 And from there, you can start to look at successfully determining exchange rate differentials. 19 00:02:03.360 --> 00:02:08.720 And this is really something, if it can be achieved, it's very powerful. 20 00:02:08.720 --> 00:02:20.600 So, I think in mainstream exchange rate determination there are three basic errors that occur and 21 00:02:20.600 --> 00:02:24.840 I'd like to show how the Austrians correct each of those three errors and then we'll 22 00:02:24.840 --> 00:02:30.200 give you some practical examples of how we forecast exchange rate determinations and 23 00:02:30.200 --> 00:02:35.200 we'll be using the euro dollar as an example. 24 00:02:35.200 --> 00:02:42.500 The first error I call, well, it is establishing a correct definition of money supply. Frank 25 00:02:42.500 --> 00:02:49.760 Shostak is the leading Austrian economist who has, I think, put the definitive version 26 00:02:49.760 --> 00:02:54.040 of the Austrian theory of the money supply in the quarterly journal of Austrian economics. 27 00:02:54.040 --> 00:03:00.240 Dr. Shostak opens by saying, according to mainstream economics, the validity of various 28 00:03:00.240 --> 00:03:05.520 Most definitions of money can be ascertained by means of a statistical test. 29 00:03:05.520 --> 00:03:10.280 What determines whether money, M1, M2 and the other M's are valid definitions is how 30 00:03:10.280 --> 00:03:13.880 well they correlate with national income. 31 00:03:13.880 --> 00:03:19.080 Most economists hold that since the early 1980s, correlations between various definitions 32 00:03:19.080 --> 00:03:22.860 of money and national income have broken down. 33 00:03:22.860 --> 00:03:26.760 The reason for this breakdown it is held is that financial deregulation has made the demand 34 00:03:26.760 --> 00:03:28.580 for money unstable. 35 00:03:28.580 --> 00:03:33.380 In short, the nature of financial markets has changed, consequently past definitions 36 00:03:33.380 --> 00:03:35.980 of money no longer hold. 37 00:03:35.980 --> 00:03:40.580 He then goes on to say, observe that for the mainstream, the definition of money is established 38 00:03:40.580 --> 00:03:45.680 through an arbitrary mixing of various liquid assets and then correlating this mixture with 39 00:03:45.680 --> 00:03:49.740 another dubious set of statistics labelled national income. 40 00:03:49.740 --> 00:03:54.420 In other words, any mixture of liquid assets will be classified as money as long as this 41 00:03:54.420 --> 00:03:56.580 mixture passes the correlation test. 42 00:03:56.580 --> 00:04:08.580 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. 43 00:04:08.580 --> 00:04:25.580 And 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 44 00:04:25.580 --> 00:04:36.580 with National Income. Virtually you can include anything. You can include inventories in my factories, for example. 45 00:04:36.580 --> 00:04:46.580 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. 46 00:04:46.580 --> 00:04:53.580 Why not include those figures in National Income Statistics? The mainstream won't have any problem with that. 47 00:04:53.580 --> 00:04:58.580 Milton Friedman wouldn't have any theoretical problem with doing 48 00:04:58.580 --> 00:05:06.580 what would seem such an unscientific and illogical way of determining what the money supply is. 49 00:05:06.580 --> 00:05:15.580 Shostak then, he looks at what the actual origin of money is. 50 00:05:15.580 --> 00:05:21.580 He goes back to barter and reasons as follows. 51 00:05:21.580 --> 00:05:30.580 In a barter economy, if you have a double coincidence at once, everyone's happy, you can exchange your goods with the other person. 52 00:05:30.580 --> 00:05:38.580 If you want to conduct any exchange with someone who doesn't have the goods that you want, then you've got a problem. 53 00:05:38.580 --> 00:05:48.580 Money comes into being as a commodity because it's the most marketable and the most exchangeable final product. 54 00:05:48.580 --> 00:05:53.580 It's the final commodity for which all goods trade. 55 00:05:53.580 --> 00:06:00.580 That's the Austrian definition of money. 56 00:06:00.580 --> 00:06:06.580 And I think really, Frank, what the essence of money is, 57 00:06:06.580 --> 00:06:11.580 is the final commodity in exchange. 58 00:06:11.580 --> 00:06:16.580 And if we use that definition of money, 59 00:06:16.580 --> 00:06:22.820 of Money, we can then go on to define what the supply of it is in a given economy. 60 00:06:22.820 --> 00:06:27.220 I'll suggest to you that we need to have an accurate definition of the money supply in 61 00:06:27.220 --> 00:06:32.660 order to predict its movements because currency movements are simply movements of the exchange 62 00:06:32.660 --> 00:06:34.940 rates of different national monies. 63 00:06:34.940 --> 00:06:40.940 To be able to count the supply of a particular people's monies or people's final commodity 64 00:06:40.940 --> 00:06:45.940 in exchange, you need to distinguish between a claim transaction and a credit transaction 65 00:06:45.940 --> 00:06:52.540 And this is something that Ludwig von Mises introduced in his 1912 book, The Theory of Money and Credit, 66 00:06:52.540 --> 00:06:55.740 the distinction between a claim transaction and a credit transaction. 67 00:06:55.740 --> 00:07:03.640 And this is where it falls, lives or dies, the Austrian theory of the money supply, 68 00:07:03.640 --> 00:07:07.340 is how you distinguish between claim and credit transaction. 69 00:07:07.340 --> 00:07:15.340 A claim transaction is when you, as the holder of money, your final commodity for exchange, 70 00:07:15.340 --> 00:07:26.340 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. 71 00:07:26.340 --> 00:07:32.340 A credit transaction is one where you actually forego the ownership. You may not know you're foregoing the ownership of that money. 72 00:07:32.340 --> 00:07:43.340 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. 73 00:07:43.340 --> 00:07:47.580 but in effect you have legally given away the ownership to the bank 74 00:07:47.580 --> 00:07:52.180 and the bank can then pyramid its 75 00:07:52.180 --> 00:07:58.680 it can do an inverse pyramid of fractional reserve banking and lend out 76 00:07:58.680 --> 00:08:01.660 your money. If you want your money back 77 00:08:01.660 --> 00:08:06.940 you've got a timed restriction on it. Presumably you can pay a penalty 78 00:08:06.940 --> 00:08:09.460 in most of these things to get your money back 79 00:08:09.460 --> 00:08:12.460 but it's a credit transaction and where? 80 00:08:12.460 --> 00:08:15.660 All the definitions of money supply over and above M1, 81 00:08:15.660 --> 00:08:20.060 that's M2, M3, MZM, all the various other definitions 82 00:08:20.060 --> 00:08:21.700 come into play. 83 00:08:21.700 --> 00:08:24.260 They don't use this distinction of claim transaction 84 00:08:24.260 --> 00:08:25.300 and credit transaction. 85 00:08:25.300 --> 00:08:30.220 And they have created a double and sometimes a triple 86 00:08:30.220 --> 00:08:34.940 or quadruple accounting of the actual real essence of money. 87 00:08:34.940 --> 00:08:37.580 And this is where they go wrong. 88 00:08:37.580 --> 00:09:01.580 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. 89 00:09:01.580 --> 00:09:07.240 but if you're doing this correctly and there are a few practitioners in Austrian 90 00:09:07.240 --> 00:09:10.860 economics one of them is Frank Shostak who's here who does it and one of them 91 00:09:10.860 --> 00:09:18.260 is Michael Ryan in Australia as well then you can actually come up with 92 00:09:18.260 --> 00:09:22.580 information that you can use which we call the actual Austrian money 93 00:09:22.580 --> 00:09:28.140 supply which you can then deploy in your efforts to do exchange rate 94 00:09:28.140 --> 00:09:34.100 Determination. But the full definition of money in the Austrian tradition now, 95 00:09:34.100 --> 00:09:39.900 according to Shostak in the quarterly journal of Austrian economics, is cash 96 00:09:39.900 --> 00:09:44.380 plus demand deposits with commercial banks and thrift institutions, plus 97 00:09:44.380 --> 00:09:48.900 government deposits with banks and the central bank. Now that differs slightly 98 00:09:48.900 --> 00:09:55.340 from M1 because M1 excludes, as I understand it, central bank 99 00:09:55.340 --> 00:09:58.340 and Governance Owned Deposits in the Central Bank. 100 00:09:58.340 --> 00:10:04.340 So the, I mean Frank you're over there, correct me if I'm, am I right in saying that? 101 00:10:04.340 --> 00:10:07.340 Yes, that's good, excellent, thank you. 102 00:10:07.340 --> 00:10:18.340 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. 103 00:10:18.340 --> 00:10:25.780 Error two is that the Austrians have corrected is actually, I mean, it's a very, very odd one. 104 00:10:25.780 --> 00:10:36.700 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. 105 00:10:36.940 --> 00:10:38.460 And this is correct. 106 00:10:38.980 --> 00:10:48.020 Then the mainstream then go on and they actually miss out the supply curve in its entirety in exchange rate determination. 107 00:10:48.020 --> 00:10:55.020 They just look at the demand side of the equation. Demand is here and supply is like way over there. It's completely missing. 108 00:10:55.020 --> 00:11:02.020 I'll read you out an example from the textbook that I had to use as an undergraduate. 109 00:11:02.020 --> 00:11:11.020 It was done by Richard Lipsy, who's professor emeritus and fellow at the Canadian Institute of Advanced Research, Simon Fraser University, Vancouver, Canada. 110 00:11:11.020 --> 00:11:15.420 fantastic title and he says the following 111 00:11:15.420 --> 00:11:19.500 the exchange rate is just a price albeit a very important one 112 00:11:19.500 --> 00:11:23.020 as with other prices will approach the explanation of exchange rates from the 113 00:11:23.020 --> 00:11:24.980 perspective of demand and supply 114 00:11:24.980 --> 00:11:28.420 that all sounds very good at the moment because one currency is traded for 115 00:11:28.420 --> 00:11:30.620 another in the foreign exchange market 116 00:11:30.620 --> 00:11:34.500 it follows that a demand for foreign exchange dollars implies a supply of 117 00:11:34.500 --> 00:11:35.740 pounds 118 00:11:35.740 --> 00:11:40.540 while the supply of foreign exchange dollars implies a demand for pounds 119 00:11:40.540 --> 00:11:58.540 They 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. 120 00:11:58.540 --> 00:12:09.540 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. 121 00:12:09.540 --> 00:12:14.100 But when they come to supply, this is what they say. 122 00:12:14.100 --> 00:12:17.540 The sources of supply of pounds in the foreign exchange market 123 00:12:17.540 --> 00:12:21.700 are merely the opposite sides of the demand for dollars. 124 00:12:21.700 --> 00:12:24.460 The critical error is they completely 125 00:12:24.460 --> 00:12:28.460 fail to talk about the physical supply of the commodity 126 00:12:28.460 --> 00:12:29.460 in question. 127 00:12:29.460 --> 00:12:31.660 The physical supply is just missing. 128 00:12:31.660 --> 00:12:33.980 What they're talking about is a ratio. 129 00:12:33.980 --> 00:12:35.900 And it's a subtle difference. 130 00:12:35.900 --> 00:12:38.780 But if I can try and explain, if you 131 00:12:38.780 --> 00:12:47.780 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. 132 00:12:47.780 --> 00:13:01.780 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. 133 00:13:01.780 --> 00:13:10.540 If one country, for example, England produces, English apples are called Copse's apples, French apples are called Granny Smith's apples, 134 00:13:12.540 --> 00:13:22.420 the mainstream would look at the demand for each of the other country's apples and compare the ratio. 135 00:13:23.100 --> 00:13:27.220 That's what the mainstream will tell you in foreign exchange rate determination. 136 00:13:27.220 --> 00:13:55.220 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. 137 00:13:55.220 --> 00:14:00.220 Yes, that's what they said, which is of course correct with the restriction of supply. 138 00:14:00.220 --> 00:14:13.220 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. 139 00:14:13.220 --> 00:14:33.220 So 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. 140 00:14:33.220 --> 00:14:36.460 I think it's because they can't define what money is. 141 00:14:36.460 --> 00:14:39.620 They can't successfully count it. 142 00:14:39.620 --> 00:14:41.780 When you can successfully count it, 143 00:14:41.780 --> 00:14:48.940 you can then compare it with other people's currencies. 144 00:14:48.940 --> 00:14:51.900 And this is what we do. 145 00:14:51.900 --> 00:14:55.500 And you can see in this graph here, 146 00:14:55.500 --> 00:15:00.220 what we have is we have a series of graphs behind this, 147 00:15:00.220 --> 00:15:14.020 which would show you how for example if the American central bank is printing more money vis-a-vis the European central bank 148 00:15:14.020 --> 00:15:23.220 you've always got to compare currency pairs and you've got to compare the rate of increase of one central bank 149 00:15:23.220 --> 00:15:25.220 versus the rate of increase of another central bank. 150 00:15:25.220 --> 00:15:33.100 So even if the US Central Bank is, as we know, and Mark Thornton's figures were, you know, 151 00:15:33.100 --> 00:15:40.060 perfectly illustrated the point, then massively pumping up money in America. But if Europe 152 00:15:40.060 --> 00:15:46.700 is doing the same, or if Europe is pumping up even faster, then you look at the differential 153 00:15:46.700 --> 00:15:52.460 and that's what will determine whether the exchange rate rises or falls, the differential 154 00:15:52.460 --> 00:16:01.260 in Supply. So here you can see, on the top, the points A, B, C, D and E. These are showing 155 00:16:01.260 --> 00:16:08.900 high points and low points in the Euro versus dollar exchange rate. And that, we can directly 156 00:16:08.900 --> 00:16:16.700 correlate that with the Austrian actual money supply with a time lag. So it's a very, very 157 00:16:16.700 --> 00:16:28.140 The graph down below shows you how it's a quarterly trend average, so what that is showing 158 00:16:28.140 --> 00:16:34.060 you is it's showing you how much the market is moving away from that ratio of difference 159 00:16:34.060 --> 00:16:41.660 between the respective increases of supply in the Federal Reserve vis-a-vis the European 160 00:16:41.660 --> 00:16:49.860 in Central Bank and what we notice is we notice that when the currency, if you take, you can 161 00:16:49.860 --> 00:16:55.620 see the zero line down at the bottom here, that's presuming that the currency is trading 162 00:16:55.620 --> 00:17:01.940 exactly on their fundamentals. The ups and downs over and above, the oscillations over 163 00:17:01.940 --> 00:17:08.500 and above the zero point are very, very interesting because it shows roughly when the dollar is 164 00:17:08.500 --> 00:17:17.500 is 5% overvalued vis-a-vis the fundamentals, it will start correcting and when it's undervalued 165 00:17:17.500 --> 00:17:25.300 to the tune of about 4% over its quarterly trend, it will correct back and in terms of 166 00:17:25.300 --> 00:17:28.820 earning money out of this, applying Austrian economics to earning money, which is what 167 00:17:28.820 --> 00:17:37.500 we're interested in, is you can trade around these periods with relative confidence that 168 00:17:37.500 --> 00:17:46.980 The currencies will correct, will take off the excess each time traders have got so excited 169 00:17:46.980 --> 00:17:55.860 about either the depreciation or the increasing in value of the currency. 170 00:17:55.860 --> 00:18:03.060 So we have here an ability to be able to, it's a medium and long term predictive model. 171 00:18:03.060 --> 00:18:19.060 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. 172 00:18:19.060 --> 00:18:27.060 So that really is really how you can apply Austrian economics. 173 00:18:27.060 --> 00:18:36.060 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. 174 00:18:36.060 --> 00:18:40.060 Well, the third error is a timing error. 175 00:18:40.060 --> 00:18:50.060 Mainstream people, and even some Austrians, are fairly insistent upon, they can only understand things in terms of cause and effect, which is good, 176 00:18:50.060 --> 00:18:57.460 which is good, but they need to put something objective like an equation around the cause and effect. 177 00:18:57.460 --> 00:19:01.460 This is something that we say is impossible to do. 178 00:19:01.460 --> 00:19:07.660 We can't put a time lag, we can't put a predictive time lag on any of these things. 179 00:19:07.660 --> 00:19:16.060 For example, you know intuitively that if a Japanese bond trader buys a US Treasury bond, 180 00:19:16.060 --> 00:19:20.300 at some point in time, it's an absolute certainty, he's got to pay for it, 181 00:19:20.300 --> 00:19:24.180 otherwise the transaction doesn't go ahead, but you don't know whether it's today, 182 00:19:24.180 --> 00:19:26.940 you don't know whether it's in the future, you don't know whether he's going to be 183 00:19:26.940 --> 00:19:30.460 doing some kind of derivative around it, 184 00:19:30.460 --> 00:19:34.460 you don't know and you can't predict that, but what you can predict 185 00:19:34.460 --> 00:19:38.180 with the quarterly trend, and it's very 186 00:19:38.180 --> 00:19:41.620 just so, so, so powerful, is that when it does get up 187 00:19:41.620 --> 00:19:45.180 to near that excess, the market will trade it away, it's not sustainable 188 00:19:45.180 --> 00:19:56.820 And it's not sustainable because of the very reason that I could come to this country before Christmas, 189 00:19:56.820 --> 00:20:04.820 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. 190 00:20:04.820 --> 00:20:11.020 It's because the purchasing power parity theory tells us, and that's a mainstream theory, 191 00:20:11.020 --> 00:20:19.820 that you just can't, currencies can't diverge that much, so all this hubris about the dollar 192 00:20:19.820 --> 00:20:25.700 just going to, dollar is going to collapse and so on and so forth, it's not a reality, 193 00:20:25.700 --> 00:20:33.020 there's no, it's a fiction that the dollar is vis-a-vis, because you always need to look 194 00:20:33.020 --> 00:20:38.220 at it vis-a-vis other currencies and if everyone else is being as bad or worse than the Federal 195 00:20:38.220 --> 00:20:45.220 The Federal Reserve, then the dollar still stays as a strong currency and that's the situation that all the fundamentals are telling us.