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The Method of An Austrian Hedge Fund

Mises Daily: Tuesday, March 15, 2005 by


The most "unpalatable" distinguishing mark that separates Austrians from the mainstream economists is the use of the a priori logical analytical method as opposed to the a posterioriempirical approach to working out the problems that economics poses to us. If you can reason from self-evident propositions and not contradict the laws of logic as you reason, anything you deduce can only be true.

Let me give you an example of an Austrian approach, In "The Mystery of the Money Supply Definition" written by Frank Shostak, in (Vol. 3 Num. 4) in The Quarterly Journal of Austrian Economics, the author opens by saying:

"According to mainstream economics, the validity of various definitions of money can be ascertained by means of a statistical test. What determines whether money M1, M2, and the other Ms 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. The 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."

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 statistic labeled 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 would consider these inventories as part of the money supply (Rothbard 1978, p. 149).

In short, the mainstream will look at what comes after the fact in trying to get a definition of the money supply and not what comes before.

Shostak looks to the past and the origins of money to give us a correct Austrian definition. When we have this definition water tight and under wraps we can then start building theories in economics that will have some predictive ability. The reasoning is concise and straightforward; before money there was barter, but barter was inefficient as you always required a double coincidence of wants to trade. If you did not have this unique set of circumstances, no trade happened. People chose to facilitate transactions where this set of circumstances did not arise, on commodities that were most marketable, such as gold and silver, products that most people wanted and these commodities became money.

Money is thus the final commodity for which all goods trade. This is the essence of money, as it has been and as far as we know, as it always will be. It is the principle of being a medium of exchange and only because of this that secondary functions come into being, such as the role of money as a store of value.

When we think of money, we must always think of it as the final commodity in exchange, we must think of it as a physical thing in itself. In the modern economy today, because we have electronic money, credit cards, e-money, and paper money all sorts of derivatives that are not just simply weights of precious metal, we should not let this cloud our thought process. The essence of money has not changed.

Now that we have a working definition of money, we can now move on to defining what the supply of it is in a given economy. I will suggest to you that we need to have an accurate definition of the supply of money in order to predict currency movements, because currency movements are simply movements in the exchange rates of different national monies. To be able to count the supply of a particular money, peoples’ final commodity in exchange, you need to distinguish between a claim transaction and a credit transaction.

Claim Transaction: this is when the owner of the money passes it to say a bank for safe keeping but never loses his ownership claim on it, for example in the case of current accounts. At any point in time, the owner can withdraw this money.

Credit Transaction: this is when the owner contracts with a bank to relinquish immediate ownership as he or she deposits the money in a savings account, which has timed withdrawal provisions. The bank in the interim period is then free to lend out this money. As Shostak says, "credit always involves a creditor’s purchase of a future good in exchange for a present good. As a result, in a credit transaction, money is transferred from a lender to a borrower."

As long as you apply this distinction, it then becomes possible to count up the money supply of any given country. The definition of money supply that Shostak settles on is "Cash+demand deposits with commercial banks and thrift institutions+governmentdeposits with banks and the central bank." He then goes on to say: "This definition shows clearly that any expansion in money supply results solely from central bank injections of cash and commercial banks’ fractional reserve banking." This is a point we will come back to later.

As all economists know, if a supply of a commodity goes up, all things being equal, the price will fall. So if one can successfully define money and thus money supply, one can then see how the price of that commodity changes vis a visother money commodities and it should become possible to predict exchange rate fluctuations. This is the Holy Grail of FX traders and a big claim by me that I will attempt to justify later, but for now let's turn to the regular theories of exchange rate determination.

The Missing Supply Curve

Richard G. Lipsey, Professor Emeritus and Fellow of the Canadian Institute of Advanced Research, Simon Fraser University, Vancouver, Canada, produced textbooks that we used as undergraduates at LSE. In one with K. Alec Crystal, they say the following; "The exchange rate is just a price, albeit a very important one. As with other prices, we will approach the explanation of exchange rates from the perspective of demand and supply . . . 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 a supply of foreign exchange (dollars) implies a demand for pounds."

They then go on in the traditional fashion to show how demand for a Pound Sterling is influenced by the demand for exports from the UK, as people need pounds to pay for the goods, how dividend income from foreign holdings will be repatriated in Sterling, how capital inflows will boost demand for Sterling, and so on and so forth.

This is all fine and good, but when they seek to define what constitutes supply, they say the following; "The sources of supply of pounds in the foreign exchange market are merely the opposite side of the demand for the dollars."

Wrong. The critical error is that they have omitted to talk about the physical supply of money; they are just talking about a ratio of exchange. What the modern mainstream method is trying to determine is the price changes between . . . apples in one geographic location, say French Granny Smith’s in France and English Coxes apples in England by noting orders placed for each ones in the other respective geographic locations, then comparing the change in the ratio of demand and saying that the result of this observation will determine the price.

This is all very well if the supply of each is the same, but the big error being the failure to understand, if there are only a handful of physical Granny Smiths in France and comparatively small demand in England and smaller demand for the coxes, there still will be a price rise, the value of Granny Smiths produced for consumption, however small in demand in this situation, will go up. Also note, this will only be but to a certain point as people will soon switch to Coxes as the Granny Smiths become too expensive as these are a close substitute. Physical supply matters as do substitutes, not just the demand for one commodity vis a visanother.

You can see how we need a correct working definition of money to be able to determine the true definition of the money supply, to be able to count the supply of it to be able to determine its price against other monies. Two errors by the mainstream have been corrected by the Austrian understanding: We need to go back to basics and put the supply curve back into the demand and supply curve framework to get accurate price determination. We need also to resurrect the Purchasing Power Parity theory of exchange rate determination as well.

Anyone in business will tell you that all commodities have a floor price and a ceiling price. For example in my industry, people, whatever the demand and or supply situation are only going to pay so much for a sirloin steak.

Let us consider a hypothetical example to illustrate the point. If Mad Cow Disease hit the US in a big way and half the available cattle for slaughter were taken out of the human food chain, there would be a severe contraction in supply. With the remaining cattle, presuming consumers still remained loyal to the US beef industry, there would be half as much beef available for consumption. Certain cuts more in demand such as fillet and sirloin would command a more than double price premium, but would the consumer take this?

Faced with over a doubling of prices, restaurants’ or Joe public who served or consumed these cuts would have to absorb the price and or pass it on. There is only so much one would be prepared to pay for an evening meal, before one would give up the thought of a juicy succulent steak and switch to another protein such as a chicken breast or salmon portion. This may seem obvious but it is worthwhile pointing this out, for money itself is a commodity as we have established. It is the final commodity in exchange for other commodities.

When the money commodity in one geographical jurisdiction becomes too expensive, it pays for people to switch out of that commodity money and move into a cheaper one. This arbitrages away the differences over time and irons out differences in one set of purchasing power parity in one country vis a visanother country. It is quite laughable to hear economic commentators say the dollar is imminently going to fall to 30 – 50 % against the Euro. If that were the case arbitrage opportunities would become so large, as Western Europe and the USA largely consume the same things, that purchasers would switch to where it is so obviously cheap.

There seems to be no consensus that the purchasing power parity theory of currencies holds, except you will get more economists saying yes it will in the long term, with a lot disputing this and very few saying it will in the short term. Our research over the last five years indicates that this process can happen, and does happen, surprisingly quickly; take a look at this graph.

By simply monitoring the deviation from the quarterly trend, we can see over the many years we have been collecting data, that broadly speaking, if a currency pair is trading 5% beyond its quarterly trend line, a relatively quick re-balancing correction generally takes place. What is more, this usually comes in three spikes, one up and two down.

The one up is the market testing the limits on the up phase, the two down is when the initial correction happens, traders can not believe it, they push back up, then the market goes back down and the market starts the correction process. Purchasing power parity matters here and can be very useful in providing indications as to which currencies at any point in time are overvalued re other ones.

The underlying trend itself, as opposed to over-extensions beyond trend, is determined by the ongoing relative balance of the two monies in question, ie., a slow upward* moving Quarterly trend is the result of one money supply expanding faster than the other over and above changes in demand.

Two potential financial products come out of this. Product 1, a strongest currency fund can be developed off the back of this understanding. For any company who trades in multiple currencies and runs cash surpluses, Product 2, a cash overlay service, applying this methodology, for the treasury departments of companies could always mean that the company remains exposed to the strongest currency only.

Suffice it to say, if you know what the real physical money supply is, you can see how the various central banks around the world, intervene via the sale and purchase of bonds in turn supporting certain interest rate policies. The interest rate then has a direct and predictable effect on the determination of the exchange rate on the demand side. This is shown in the following two graphs.

The Leading Composite Monetary Index that we have created incorporates among other things the percentage interest rate carry of one currency over another, in this example, the Euro over the Dollar. Actual Austrian Money Supply shows how a monetary disturbance is required to effect an interest rate change: a tightening of your monetary policy v that of another central bank will cause interest rates to go up in your jurisdiction vis a vis the other jurisdiction. Traders will exploit this arbitrage opportunity. Take notes on points A-E on the graph and then see how these points manifest themselves on the Euro Dollar exchange rate shown next.

Hopefully you can get the picture as to how powerful this methodology can be regarding the prediction of medium-long term general exchange rate movements.

The Moving Time Dimension

Mainstream methodologies insist on placing a time dimension on the cause and effect in any given economic situation, so if X takes place then Y will take place with a time lag of A number of months. The Austrian School holds that it is unachievable to regulate actions that are determined by human choice preferences into a fail-safe mathematical model. You can see on the two graphs that points A and B both happen within the same time frame, then point C on the second graph happens some 18 months later.

The point is that although the cause and effect of an increase in Austrian Money Supply and the associated effect on its purchasing power parity is certain, when it will happen depends on the subjective valuations of people. So we apply no mathematical tools to help us predict when the effect will be seen, we trade the position as and when it becomes apparent visually.

To conclude, there is a role for an Austrian Hedge Fund that applies our methodology to exchange rate determination and indeed to credit spreads.


Toby Baxendale is a London entrepreneur and one of the founders of the first Austrian FX fund. The author would like to thank Michael Ryan for his unique thoughts and opinions in the writitng of this article. tbaxendale@billfields.co.uk.  Listen to the MP3 audio version of this article, as presented at the recent Austrian Economics and Financial Markets conference.