Getting the Sign Wrong

I’m going to show my age here, but that’s OK.

In my very first consulting assignment with a professional trader, I came in to rescue a project that had been started by an academic who was pursuing a PhD in Computer Science.  Unfortunately, that meant there was already a computer and a partially-completed bunch of software that didn’t quite run on that computer.

The software was written in APL (favorite of the theoretical computer science set at the time), and the computer was IBM’s earliest attempt at creating a PC.  It was the model 5100, for those who want to place this story in the context of useless technological history.

The punch line of this story is that I wrote the rest of the program exactly as specified, but when it produced the results for the commodity trader who hired me, it was telling him to buy when he should be selling, and vice-versa.

Luckily for both of us, my client had his pencil-and-paper trading system that worked, and he didn’t lose any money trading with the new system.

I told him that his specification of trading rules had to be incomplete or incorrect, but there was a simple solution.  I asked to watch him do his pencil-and-paper calculations for the next few nights.

The answer came a couple of days later when the “current” silver contract rolled over to the next month.  It turns out that in the inflationary environment of the time, rolling from one month to the next nearly always took the nightly settlement price higher for all the commodities he traded.

My client’s method of trading involved taking the nightly price changes of the commodity and various lengths of moving averages, and multiplying them together to get a weighted directional factor.  The numbers typically varied between positive and negative 100,000.  If one element in the chain of multiplied factors had the wrong sign, that would change the sign for the entire series.

In his paper-and-pencil technique, he adjusted for the shift from one contract to the next by using the “new” contract’s change in price from the prior day rather than taking the difference between the “old” contract and the “new”.  On the run in question, the price of silver had gone down the day of the switchover, but the price for the forward contract was still higher because of inflation.  That threw the whole series off.

That’s basically the problem with the inflation fighters (I mean you, Trichet and Ryan) dealing with today’s soft economy.  They’ve got the sign wrong.  Naturally, they will want to address the issue with exactly the wrong tools.  To be fair, they’re not alone.  Austerity is the medicine of choice through all the western economies, and the sluggishness we now experience is exacerbated by the policies they adopted.

So now the market and the talking heads are very worried about a new recession, like we had in the 80’s…. the dreaded “double dip”.  As in the 80’s, we have effectively limited our options even though the policies counteracting the first wave of the recession only reversed the negative growth aspect of recession without reversing the unemployment picture.

They should probably change the sign and learn a lesson.

In 1981, Volker wasn’t about to lower rates and unleash a new round of inflation even though rate cuts might deal with the incipient second slowdown. The resulting second wave of the famous W-shaped recession that plagued Reagan’s first term was deeper and longer than the first.

Today we are in a deflationary environment, but the fiscal tool of stimulus spending is politically off the table to address the slowing economy.

If anything, the coming austerity at Federal, state and local levels of government is guaranteed to make the employment and aggregate demand picture worse. That’s not ideology — it’s arithmetic.

As to the recent self-inflicted “crisis” over raising the debt limit to meet the obligations already in place, I’m glad they avoided putting us into a full-blown depression.

Yes, I said depression.  You simply can’t remove aggregate demand of 10% of GDP (lowering government spending to the 15% of GDP that is currently coming in as tax revenue) without creating a self-reinforcing spiral of business failure and bankruptcies.

So how can I be so sanguine, and suggest that we may not have a double dip recession coming right now?

Simple… the yield curve is telling me something different.

It’s telling me that in a few years, maybe as many as five to seven of them, we will have short interest rates at 5% or higher.  It’s telling me that inflation will come back into the system somehow, and that it will finally help our consumers and governments pay off their debt with cheaper dollars.

As Ken Rogoff, a college acquaintance and author of “This Time Is Different” said in late 2008, inflation is probably the best medicine for debt ills that plague us.  He didn’t specify the kind of inflation we really need, so I will — what we needed, and still need, is wage inflation He reiterated this week that we are still trying to treat the meltdown (“Great Contraction”) with the wrong medicine.

One of the things we learn studying the long march of economic history with the framework of Kondratyev’s cycle is that we cannot necessarily see what will fuel the growth of the next upswing, but we do know that secular deflationary phases (last quarter of the K-wave) are followed by new growth phases with mild inflation.

Some call this the Kondratyev Spring following its associated Winter.

Key to solving our current US and international fiscal problems is generating that new growth and mild inflation. In every other K-wave, the driver for that growth was investment and innovation, which came from manufacturers, resource extractors or even government.

So what innovations are about to drive the next growth phase?

If I had to guess, I would say our next phase of growth will come from a combination of developments growing from our relatively new understanding of the DNA molecule, and from our recent exponential growth of networked computing capacity.  Maybe it will be from a new engineered algae that produces cheap diesel fuel, or vaccines that mitigate the effects of cancer, diabetes and a plethora of expensive degenerative diseases.  Maybe it will be a shift in how we address logistic issues of feeding, housing, teaching and entertaining the billions of us sharing this tiny rock in space.

Call me an irresponsible optimist.

Of course I could be wrong.

Next I’ll post on the idea that Ben Bernanke and the Fed (and now the ECB) are breaking the predictive power of yield curves by interfering with the biggest market in the world.  It’s pretty impressive when you think about it, that they may have actually disrupted the ebb and flow of rates and credit so the yield curves might now speak with forked tongues.

hh

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2 Responses to Getting the Sign Wrong

  1. Bruce B says:

    HH, if the government creates inflation to pay off debt with a cheaper currency, would you not consider that a default? Maybe a “soft” default?
    .
    Glad you mentioned that GDP would drop by 10% if government spending met revenues. There do not appear to be any pain free solutions. We can’t keep spending like this, but GDP can’t absorb a 10% hit. Have you ever noticed that it’s the “smartest” among us that got us in to this chaos?

    • hhill51 says:

      I can’t get behind that unless I can also get compensation (as a bond holder) from the Goldman commodities trading operation. After all, they led the charge to $140 oil in 2008. Not anything that makes sense in a major, worldwide, drastic decline in economic activity.
      .
      The point I’m making is that inflation is right up there with GDP or trade balance as a “top line” economic variable that has a thousand fathers. It also can’t be measured accurately by anyone, so how much of a “default” would you attribute to it?
      .
      Bottom line, inflation expectation is built into riskless rates in any credit market, so bondholders are already compensated for it.

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