Money & Markets: Governments are running a financial engineering experiment

The global economy is in shock thanks to coronavirus lockdowns, and governments are implementing innovations that could serve as potential rescue packages. Huge changes are coming, and that brings opportunity to those positioned to take advantage.

When engineers built the cathedrals of Europe, erecting their buildings to God’s glory, they didn’t exactly know whether their designs would work. Economics is in that state today. With governments building up mountains of debt, too many of these structures seem as likely to fall as the walls of Notre Dame without their ad hoc flying buttresses.

Globally, there have been startling government economic reactions to bridge the chasms opened by worldwide lockdowns.

Quantitative easing, which smoothed out the financial crisis of 2007-2009, has again been brought to bear, but that is only one of many central government ‘innovations’ that have been rolled out. The US, for example, has been handing out free money left and right, and it expanded the money supply at the beginning of the lockdown by an annualised rate of 100 per cent.

There is no consensus on the likely outcome of all this; sage opinion is split down the middle about the ramifications of governments going ‘all in’ to try an ‘Evel Knievel’ leap over the economic sinkhole created under our societies. Will it be inflation or deflation?

Old-school spectators are naturally panicked by the wall of new money rolling past, and from seeing giant inflation on the way; gold and Bitcoin have reacted accordingly. Yet new financial engineers scoff. Printing money doesn’t make inflation, they say. You can print as much as you like until it creates inflation, then drain the money away with tax to stop inflation dead in its tracks if it raises its ugly head. This new economic architecture is either hubris or genius and is likely – in any event – to need plenty of flying supports to its edifices.

Markets go their own way on these matters and, unlike economists, markets are always right. When they are wrong, they are still right. When they are wrong, it is your error for not understanding why they are right. Even when you are right and markets are wrong, it’s best to give the market the benefit of the doubt. As the saying goes, when the market is wrong, it can stay wrong much longer than you can stay solvent. 

Then there is the matter of ‘implied volatility’, which is a notion from the options market. The options market is the most sophisticated market of all, where buyers and sellers trade in the right to trade at some future moment. Options is a game the professionals play with maths, while amateurs play cocooned in their stories. It doesn’t usually end well for the amateurs. 

There is a value in options, called ‘implied volatility’, and it can be imagined as representing the gap between where the price should be and where it is. It’s a measure of the unknown unknowns, monsters the market implies are lurking out there, and the wilder the times, the bigger these bogeymen get.

The implied volatility of the current global economy is sky-high. 

Putting aside unknowns of the actual path of the virus, and the emerging response to it, what has occurred is enough to blanket the future in a dense ‘fog of war’ the likes of which have not been seen in all but the oldest people’s lifetimes.

At this juncture, you might expect me to write something dire and doom-laden and you must forgive me for my last few columns, which were necessarily Cassandra-esque. Yet volatility begets change and change can be progress.

We must focus on that – while change can be a double-edged sword, we need to be at the right end of it and be holding the weapon, rather than having it thrust at us. Most of us are very well positioned to benefit from the huge coming changes. If not us, then who?

Take heart; volatility and implied volatility do something interesting to options. It makes them more precious. A huge part of the value of an option is its volatility and so is the time between now and when it expires. As the amount of volatility diminishes and the time to the end of the option life shortens, so the value drains away.

So here we are – volatilities at enormous levels with a time horizon beyond calculation. Indeed, our options are rich.

You could wish for a less bumpy ride, but that does not look like an option at any price. The devil will take the hindmost, but engineers and technologists are in the vanguard.

As I write, Decentralised Finance – an offshoot of blockchain and cryptocurrency technology – is quickly exploding into 2021’s financial boom and bubble. For those software engineers navigating that byzantine technical challenge and minting their fortunes, all the misery and chaos of our times will be nothing but a distant detail. Recession, inflation, depression and deflation will not even impinge on their life so much as a mosquito’s high-pitched buzz.

It is a hard-to-learn lesson: no matter how tough the times, how bad the situation, how bleak the outlook, somewhere there is always a party going on. It is our responsibility to find it and knock on the door. If not us, then who?

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