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That Towel Won’t Work

October 31st, 2006

How a galactic hitchhiker can use a towel:

“Wrap it round your head to ward off noxious fumes or avoid the gaze of the Ravenous Bugblatter Beast of Trall (a mind-bogglingly stupid animal, it assumes that if you can’t see it, it can’t see you–daft as a brush, but very very ravenous).”

–Douglas Adams, The Hitchhiker’s Guide to the Galaxy

The whole of Adam’s book is a satire, and a pretty good one, on a range of human foibles played out by a variety of alien species and on a galactic scale. By nature we would prefer it if more of our antagonists hewed to the Bugblatter Beast’s flawed logic. Don’t see them, and they’ll let you alone. The problem with relying on covering our eyes–metaphorically–to get us through the day is that it precludes even the option of judicious inaction as a possible response to danger. I mean, beating a very quiet, very cautious retreat is the recommended course of action when encountering a grizzly bear in the wild; covering your eyes would make both the “quiet” and the “retreat” parts of your response highly problematic.

In real life, ignorance is not bliss. Even the Hitchhiker’s Guide assumes that prior to encountering the Bugblatter Beast, the towel was in fact not wrapped around your head.

Economic happenstance is another sometime-adversary that refuses to ignore you just because you can’t see it. I like simple examples, because they avoid the diversions that complexity causes. All the better if the simple example is a real story.

In a parallel life I play the lute (think of a guitar, but with a round body and more strings). The path that led me to play music of the 16th and 17th century on copies of an archaic instrument is something I won’t try to explain here. Lutenists need lutes, so as few practicing lutenists as there are, there is an even smaller cadre of luthiers who build them. These people are not renaissance-festival types who don their Henry VIII/Anne Boleyn costumes any chance they get, but are like any number of highly skilled artisans, whether they work with wood, metal, food., etc.

They are the epitome of the boutique industry. So far is their remove from what most of us call “business” that their efforts seem to be entirely a non-economic event (that there is actually no such thing is a subject for another journal entry). The profession is often called a “labor of love,” but for most of them, this love still has to pay rent and put food on the table.

One of these people is building an instrument for me. His are amongst the best (I have played them…they are so good it feels like the player hardly needs to show up), and obviously everyone who plays agrees, since his prices are top-dollar and his waiting list 6 years long. (Are they worth it? As someone once said of Porsches, if you have to ask, you won’t understand.)

The financial equation for a luthier is as simple is it gets. The complexity is all in the craft. As to numbers…figure 20% on materials cost and something for the space, although many work out of their homes. The rest is a question of building & selling enough instruments to make a living.

Well, when I spoke to him recently asking the perennial question “Is it done yet?”, he mentioned that the weakness of the dollar against his currency was reducing his gross income 40%. Being a man of his word, he did not look to me to fix his problem, but this was clearly a real problem for his livelihood. I doubt if he checks the currency board periodically; most likely, he makes his bank deposits from checks denominated in the customer’s currency and the bank converts for him. No doubt he watched the early movement with some bemusement, but chalked it up to ordinary fluctuations. But that months-long slide to a 40% discount would cause a sensation closer to panic.

His assumption, probably unspoken, when he set his prices, was that his currency would track the dollar in a sufficiently narrow range to both give him revenues to support the business in the long term and not create damaging variability in the short. That assumption was reasonable in light of his experience. Unfortunately, it is those assumptions that set us up for real trouble.

I am not trying to underline the astonishing naiveté of the craftsman. Anyone who is highly trained in one area will be comparatively unaware of the imminence of opportunity or difficulty in other areas. This is as true of financial and economic professionals as it is of luthiers. Only consider the dramatic example of Long Term Capital’s downfall in 1998, where the juxtaposition of financial genius in one area with demonstrably unwise assumptions (not to be equated with stupidity or crass ignorance, however) in another came uncomfortably close to bringing down the world’s banking system.

When important economic issues are not addressed, the resultant condition is a business engaged in unwitting speculation. My luthier was speculating in currency markets; that it was unintentional and not related to his business only makes it more wrenching. Some people do well speculating, but that is contingent on 1) they mean to and 2) they have the resources. When your business is building the best lutes in the world, you probably have insufficient resources to speculate in currencies, too. In fact, Porsche AG took a similar view with their cars; they hedged currencies on the tacit argument that their business is cars, why accept the complication of currency risk?

The more common view is that hedging a currency (or whatever ever hedgeable significant economic factor) introduces speculation–if you look at the Bugblatter Beast, he will eat you. This view is also common among professionals; it is not just the populist take on economics.

Speculation is a given in human action. We make commitments, set in motion processes which are not easily stopped, and from which the costs cannot be recouped until the end of the production cycle. In the midst of this process, the calculations that made sense at the outset can be embarrassed by changes to key elements. Some are beyond our control. Some can be partly controlled. Studying markets as they relate to the individual firm and where possible, taking positions, is about narrowing our exposure to external risk. It never ceases to amaze me that this action is slapped with the label “speculative.” Wrong! We already were speculating as soon as we committed to production, what we are trying to do is speculate less.

This does not require us to be expert economists, at least in the academic sense. The calculation on which the mitigation of external risks is based begin with the firm, not with the global economy. The individual firm, or firms, is our basic unit for constructing a risk mitigation strategy. This can include, but does not always require nor is it limited to, taking hedge positions in traded markets.

How does someone who is by definition a part-timer compete in broadly traded markets? I mean, won’t an craftsman who takes positions on a currency exchange get his head handed to him by the more experienced? To the first question: he doesn’t compete, so, in answer to the second, no. Someone whose agenda is to remove some externally-driven price or cost risk from their plans is not trying to beat the market when it comes to gains or losses. They are only seeking to insure the prices that work for their business. It works.

What do you do when you have already been hit by volatility? There are no quick fixes, unfortunately. That is why there is such a premium for preparation. Still, it is inevitable that more than once in a career we will find ourselves dealing with the aftermath of unintended and avoidable speculation. Those feeling the pressure on their cash reserves tend to chafe against this deliberative approach, but in this situation a rush to action is almost guaranteed to make things worse.

It is a difficult juxtaposition that in crisis, deliberation and patience are needed where events seem to demand frenetic activity, and that in quieter periods, a certain urgency to meet the unexpected, even unknown, is best. It challenges our instincts, and many people go with instinct, which another reason the rewards from this approach are considerable: so few others do it.