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Report from the Mises Circle

Austrian Economics and the Financial Markets


May 22nd 2010

In New York University Club on May 22nd 2010 a full house of hundreds gathered to hear
thirteen economists, writers, and investors speak about Austrian Economics and Financial
Markets. The event was put together by the Ludwig von Mises Institute. As many are
already aware, the Austrian school predicted the current financial crises, and has been
gaining increased traction as other schools of thought have failed to provide a credible
explanation.

The root cause of the crises, according to Austrian Business Cycle Theory or ABCT, is
the creation of credit. Most regular people today unfamiliar with economics seem to
understand that the housing bubble was caused by improper expansion of credit. This
credit boom according to ABCT is enabled by the central banks and the laws and
regulations that permit and encourage fractional reserve banking that encourage credit
creation. Booms and busts are inevitable, given laws and regulations and banking
practice. In real historical cases, including the early 2000s as reviewed below, the Fed
and Regulators deliberately pushed the expansion of credit and lowering of lending
standards and rise of asset prices.

Presentations and Lectures can be view here.


http://www.mises.org/media.aspx?action=category&ID=232

Current Situation
Feds Deliberate Culpability
Scary and all too Real Statistics
Illuminating Stories of Historical Examples
Key Points relating to Business Cycle
Suggestions for the Future
Marc Faber Advice
Value Investing

Current Situation
The study of money, above all other fields in economics, is one in which complexity is
used to disguise truth or to evade truth, not to reveal it. John Kenneth Galbraith Money:
Whence it came, where it went - 1975, p15 For more eye opening quotes
http://www.fame.org/NotableQuotes.asp
As it turns out things are far worse with the system that even I feared. As Gordon
Browns Chief Secretary of the Treasury told the incoming Chief Secretary Theres no
money - good Luck! Losses are real, and tough choices are ahead in the coming election
cycles.

Not only are there plenty of disturbing statistics, but it turns out that the Federal Reserve
knew it was creating an asset bubble and wanted to keep prices up and money pouring in
to risky investments.

Feds Deliberate Culpability


Frederick Sheehan in his talk pointed out the Feds deliberate actions:

The March 2004 FOMC (Fed Open Market Committee transcript) says they want to
boost asset prices. They explicitly said they were trying to keep market interest rates low
and below market rates.

Here are some quotes


http://www.safehaven.com/article/16780/the-2004-fed-transcripts-a-methodical-
diabolical-destruction-of-americas-wealth

Federal Reserve Governor Donald Kohn stated the FOMC's mission at the March,
2004 meeting: "Policy accommodation - and the expectation that it will persist - is
distorting asset prices. Most of the distortion is deliberate and a desirable effect of
the stance of policy. We have attempted to lower interest rates below long-term
equilibrium rates and to boost asset prices...."

Kohn went on: "It's hard to escape the suspicion that at least around the margin
some prices and price relationships have gone beyond an economically justified
response to easy policy. House prices fall into this category [note: the Fed was
deliberately overpricing houses], as do risk spreads in some markets and perhaps
even the level of long-term rates themselves, which many in the market perceive
as particularly depressed by the carry trade...."

[There were in the market] speculators [i.e. the banks and investment banks] who
were asking for more assets [e.g. residential and commercial mortgages] to buy
with the money they had borrowed.

To see the transcript


http://www.federalreserve.gov/monetarypolicy/files/FOMC20040316meeting.pdf

Donald Kohn in 2009 said they want to prevent flight to safety and they want people to
put money into risky assets (thereby keeping up asset prices.)

It should also be remembered that the regulators of the mortgage market deliberately
encouraged the increases in lending. This is all well documented here in this 29 page
report Anatomy of a Train Wreck. There was lots of regulation it was just in the wrong
direction.
http://www.independent.org/pdf/policy_reports/2008-10-03-trainwreck.pdf
The big question is, where did the money come from? ABCT tells us that it comes from
the central banks encouraging credit creation out of thin air. We now know that Fed
policy was in fact deliberately designed to increase credit and keep up asset prices and
keep down interest rates.

The implications are very important. They are the prime regulator with the ability to
issues money. Now in 2010 the new laws are probably going to make the Fed even more
important as a regulator. How can we expect the regulator who failed to not fail again?

As was noted at the end of the day, economics journals are edited by former Fed people.
Austrian school isn't paid by Fed or other central banks but many other economists are.

Scary and all too Real Statistics


Here are some impressive statistics from Marc Faber
http://media.mises.org/mp3/misescircle-ny10/MisesCircle_NewYork_2010_Faber.ppt

Debt to GDP is 379% today. This is double 1929.

Problems have accelerated after 1980.


Unfunded liabilities and debt are 800% of the GNP. If correct, interest on 800%
of the GNP equals a huge chunk of the economy at a low interest rate.
800% * 3% interest = 24% of the economy goes to paying debt service
800% * 5% interest = 40% of the economy goes to paying debt service
800% * 10% interest = 80% of the economy goes to paying debt service

This is obviously unsustainable. If 40% of the economy goes to the government


programs and 24-40% goes to the debt, that leaves 33-20% of the economy left
over. If interest rates rise then all of the economy goes to the government and
dept repayment.
Something has to give. Tax payers, bond holders, and recipients of government
programs can all expect to be very disappointed.
Homeowners in the US went from owning 80% of their house to 40%

Europe debt is about 370% of GDP. [probably Fabers stat, may not be.]

Car, oil, and semiconductors sales to third world have increased above sales to
industrial countries. If you include Eastern Europe 60% of Chinese exports are to
developing or emerging markets. (This is hopeful in a way world isnt tied to
the west anymore.)

US overconsumption = capital depletion with Chinese forced savings and capital


investment and probably Mal investment for China

1979 to 1987 the peso lost 95% of its value against the dollar.
If you kept your money in stocks in nominal terms there was huge growth. In
terms of dollars there is no growth in Mexican stocks.
Mexican stocks in $
1979 = $70
1983 = $15
1986 = $220
1987 = $70

Other speakers points

We have a severe retail slump. Have to go back to before 1960- 61 or earlier.


Towns are suing banks to get them to admit ownership of foreclosed properties.
(Does this imply too that taxes not being paid?)

Ratings agencies in the US were cartelized in early 70s.

For a funny look at Europes debt problems watch this video


http://www.youtube.com/watch?v=brb8u0WV9ZA&feature=player_embedded

Illuminating Stories of Historical Examples


A good way to understand the effects of the business cycle and inflation are with a couple
stories from history.

Joseph Salerno told us that Ludwig von Mises had a story about a copper dealer during
the time of inflation after WWI. He would make lots of money buying a 1000 tons of
copper and reselling it. Then he would take part of his profits and spend it on houses and
vacations because he was making so much money. Then he would plow this capital and
the other part of his profits into buying more copper. But every time he would buy less
and less copper because price of copper had gone up. Eventually all his money bought
only a little copper. He thought he was getting wealthier but actually all of his capital was
being consumed.

During the business cycle overconsumption occurs combined with mal-investment. There
is capital consumption. This is not a case of overinvestment.

Lawrence Parks had another story about Thomas Jefferson. The founding fathers didn't
like paper money. Thomas Jefferson's father-in-law passed away. Jefferson helped handle
the estate. The land was sold to people but there was not enough money to buy the land
outright for cash. The new owners promised to pay off the mortgage to Thomas Jefferson.
Jefferson borrowed 11,000 pounds from English Merchants to pay the heirs. However
during the Revolution Jefferson was paid back in paper money, not in gold or silver.
Since the paper money was not worth very much he could not use it to pay back the
English lenders. This led to an intense dislike of paper money. Jefferson saw it as a form
of fraud.

The story is told here in Principle and Interest: Thomas Jefferson and the Problem of
Debt
http://www.amazon.com/exec/obidos/ASIN/0813920930/booksinfo-20/ref=nosim/
Doug French tells the story here as well
http://mises.org/daily/3209
Key Points
This is a list of interesting points made at the conference.

We are "in a system where everything is short-term and ephemeral" - Christopher Whalen

With Efficient Market Theory


It is assumed that outcomes that are being forecast do not differ systematically
from the market equilibrium results. That is, it assumes that people do not make
systematic errors when predicting the future, and deviations from perfect
foresight are only random.
Unfortunately people do make systematic errors.

Efficient market theory is wrong because people with better assumptions do better ( the
entrepreneur.) - Doug French

Sheehan - William Martin in a speech talked about how fear of inflation leads to
spending.

Inflation allows strong to exploit weak.

Inflation is deceit in contracts.

Those who want security look to government. (The government which is creating the
inflation.)

Business cycle is how people efficiently deal with credit creation. It is an effect, not the
cause of the problem.

When interest rates go down, spending goes up by recipients of credit.

Prices go up.
With a lower real rate of interest which comes from high savings, there are less price
increases.
Unfortunately when interest rates are artificially decreased through central bank policy
there is no way to know what real rates and real prices should be and will be.

With inflation we can expect per unit price increases, there is lack of the normal decrease
in prices from increased economic productivity and a stable money supply. (More dollars
are chasing goods, instead of more goods chasing a stable supply of money.)

But we have no way of knowing if price increase has to do with the money supply or if
price increases stem for increased demand or supply issues not related money supply.
Inflation distorts the chain of production.

One might want to look for the P/E ratios issues. Look for profit margin decreases.

With inflation -- people always need to worry about money, this keeps the finance
industry busy. Without inflation people can just hold money and be secure.

Apparently Ben Bernanke had some problems explaining to the Senate what the Fed is
doing with swap lines.

If we tax trade then the economy and taxes suffer.

Chinese aren't getting rich at our expense, they give us goods in exchange for dollars.

Someone has to be in charge of the government as it changes every four or eight years.
The Fed is continuity.

bail out was shocking to average Americans, changed the game. - Bob Murphy.
Americans feel like bail out violated old notions of fairness.

Bearing asset management


Japanese are working for us

Hedge funds were not at the center of the crisis. It was regulated politically connected
banks. -Kevin Duffy

Corruption of language

There is a market for credit default derivatives. What does that tell us?

Heres one way to look at the Fed


Wave maker is supposed to regulate the waves in a wave pool for but if we didn't have
the wave maker we wouldn't have waves.
The Fed is supposed to regulate the business cycle, but if we didnt have central banks
and fractional reserve we wouldnt have business cycles.

Salerno --
We have a severe retail slump. Have to go back to before 1960- 61 or earlier.

Austrian business cycle theory - boom = forced savings directed to factories.

So what about the increase in consumption.

Here is a powerpoint teaching ABCT


http://www.auburn.edu/~garriro/ppsus.htm
Wealth goes up -- paper profits. Wealth is spent on consumption. People don't save.

Overconsumption occurs combined with Mal-investment. There is capital consumption.


This is not a case of overinvestment.

How does a firm track the costs of replacing capital?

-- --

Public ownership of government leads to Fiat money inflation.


State -- institutionalized (monopoly on) violation of property rights.
Fiat money -- public/collective
Corruption = property rights violation.
People like policies because they're livelihood and investments are dependent on it.
People develop a stake in Fiat money system (my note about finance and financial firms
becoming a big part of economy in the Fiat world.)
Eventually enough fiat money or corruption leads to public impoverishment.
Intervention piles on intervention leading to socialism. Market blamed for government
policy. Private property blamed for effects of state violation of property rights.
Redistribution too powerful.

-- --

Lew Rockwell
"Government is the imposition of the values of those in charge."

Hobbes saw Leviathan as the answer to social disorder.


Lew Rockwell mentions that problems of English Civil war were a fight over the state.

DiLorenzo has some great stuff on Hamilton. Constitutions point was to pay off state's
debts.

Suggestions for the Future


Marc Faber Advice
http://media.mises.org/mp3/misescircle-ny10/MisesCircle_NewYork_2010_Faber.ppt

US dollar goes up = stocks goes down = global liquidity goes down

What is a safe asset?


Commodities = gold = volatile = no cash flow
Fed plans on low interest rates and inflation so people will spend money on something,
anything.
US overconsumption = capital depletion with Chinese forced savings and capital
investment and probably Mal investment for China.

Huge outlays on oil in 2008

Car, oil, and semiconductors sales to third world have increased above sales to industrial
countries.

50% of assets should be in developing countries (emerging markets) producers of


commodities

Strong inverse correlation between growth rate in international holdings and? US dollar
weakness?

Overseas custody of assets is very important to maintain. It is good to have bank accounts
set up in some other country preferably a reputable non-Western one.

If you include Eastern Europe 60% of Chinese exports are to developing/merging


markets.

Invest in energy for Asia and energy capital equipment.

Australian and New Zealand commodities producers.

1979 to 1987 the peso lost 95% of its value against the dollar.
If you kept your money in stocks in nominal terms there was huge growth. In terms of
dollars there is no growth in Mexican stocks.
Mexican stocks in $
1979 = $70
1983 = $15
1986 = $220
1987 = $70

10 years of negative returns in stocks in US


20 year lows in many Asian stocks.

There are higher stock yields / higher dividend yields (? or just earnings) buying and
holding stocks then there are buying and holding bonds.

Own agricultural land.


Own some gold = 10 % of wealth.
Asian healthcare should be good.
Agricultural commodities.
Gas, exploration is depressed
Water.

Capital consumption also = building unprofitable capital goods.

Investors in bonds lose capital.

Presentation is here
http://media.mises.org/mp3/misescircle-ny10/MisesCircle_NewYork_2010_Faber.ppt

Value Investing
Joseph Colandro
http://media.mises.org/mp3/misescircle-
ny10/MisesCircle_NewYork_2010_Calandro.pptx

He has a book on applied value investing, as well as QJAE Quarterly Journal of Austrian
Economics Article(s).
Here is an excellent one on efficient market theory EMT and investing
http://mises.org/journals/qjae/pdf/qjae7_3_3.pdf

Value of Business + Market Prices


What is the relationship between the two.

Buy assets below liquidation, liquidation at a good price depends on potential profits
from the assets. (For example buying a building you cant rent out is a bad idea
however buying a building with annual cash flow close to its sale price is a great idea.)
Circle of competence. Work within your circle of competence.

Stock Price charts vs. EPS chart

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