By James H. Nolt
One of the first things I teach my students is that no state of the economy is good for everybody or bad for everybody. There is always somebody making money when others are suffering. This is not the common view. Public media usually “instruct” you whether to feel happy or sad at any particular news. Economics textbooks pretend that it is obvious what a good economy is and that everybody wants the same “public goods.” In fact, the only thing a credit-driven economy guarantees is that there are no right answers for everybody; no one size fits all.
Certainly it is more reassuring to imagine that “we are all in this together” or “everybody is in the same boat,” but it is not true. The wisest of the American Founders understood this. James Madison helped design a federal system with checks and balances to prevent any one party from dominating every branch of government at every level. Partisan bickering is a good thing, Madison argues, because he knows capitalism must generate opposing parties (e.g. “creditors and debtors,” “internationalists and nationalists”). Worse than gridlock and bickering is an uncompromising rule by one party to the detriment of the other.
If bulls rule too long, the consequence is inflation, asset bubbles, and mountains of debt. We shall explore this more in future columns. If bears rule unchallenged, the result is a sluggish economy at best, quite possibly an economic crash. They are each the antidote to the excesses of the other.
Also, keep in mind that much of the time investors are bearish in some assets and bullish in others. During ordinary times there is no clear strategic direction. Some assets, such as Lehman Brothers stock or Greek government bonds, may come under bearish attack even while the prices of other assets are still booming bullishly. However, when a general economic crisis hits it is because there are powerful bears making strong bets that broad classes of assets will decline, dragging down the entire economy. During such time, the bears are rampaging.
If enough powerful bears expect asset prices are ripe for a plunge, there are several ways they can invest in anticipation of that result and even help bring it about, creating a self-fulfilling prophecy.
Broadly speaking, there are four bearish tactics: short position, credit rationing, price war, and liquidity. All of these will figure in the various case studies and future scenarios that we will consider in future blog columns, so make sure you understand each, why it is bearish and why it is potentially powerful and profitable.
I described a short sale already in the second column, “Think Like a Capitalist.” A short sale is the oldest form of short position, but in recent decades it has become more common to short an asset using financial derivatives, such as put options or short futures. This is a little complicated, so I save it for future columns. Meanwhile, just remember a short is betting that some asset price will fall and can profit a lot if it does.
Credit rationing is hugely important, yet barely mentioned in most economics and finance texts. Anyone lending money always has the power to say no to any particular loan. Thus lending is not a market like the markets for rice or rubber. It is a relationship of power between the creditor and the potential borrower. The power to advance or deny credit is the single most important cause of the business cycle. When credit is denied broadly, when it becomes scarce, that is sometimes called a capital strike. Not only workers go on strike. Capital can strike too, and may have the incentive to do so when bulls are over-leveraged with debt. Credit rationing will feature in almost any argument I make.
A price war is a bearish tactic designed to coerce competitors. A company or cartel may cut prices and increase output, flooding a market with cheap goods. The object is to either bankrupt competitors or force them to restrict output to allow the aggressors to raise prices again and restore cartel regulation. A price war is bearish because it forces down the prices of both the products and shares of stock of the companies involved. Everybody is losing money (unless perhaps the aggressors established a short position before starting the war), but the point of the war is to achieve a strategic effect: either destroying competitors by bankruptcy or forcing them to accept your ultimatum about cutting their output to form a cartel and thus raise prices above what they were before the onset of the war. A cartel raises prices by restricting output of all producers. The threat of a price war helps enforce a cartel. In international trade, a price war is called dumping.
Liquidity means holding cash or other assets easily convertible to cash in order to retain the maximum flexibility. It is bearish because if you expect the price of most assets to fall, it is better to hold cash than hold other assets. Of course cash too is an asset, so you could say that bears are bullish on cash because they think it will hold its relative value better than most other assets.
Alternatively, think of bulls as bullish in illiquid assets, like real estate, factories, and other investments that might be harder to sell without a loss in an economic downturn—whereas bears are bullish on liquidity. There is a strategic reason for this: they are building up their reserves for the day when asset prices crash and then they will be the ones with cash on hand to buy up the assets of distressed or bankrupted bulls at fire sale prices.
Instinctively people who know about bears generally tend not to emulate their methods because bears profit from loss, but they are a necessary part of capitalism’s two party system. Just as forest fires are a necessary part of a healthy natural forest cycle, throughout history it has been bears who are much more effective (than government regulation anyway) in limiting the excesses of bulls run amuck.
Next week we will take a closer look at the bulls to see why the bullish nirvana of continuous, uninterrupted growth creates problems, such as debt and inflation, that may grow to insurmountable proportions when bullish ambition is unconstrained. The surest antidote to bullish greed is bearish greed. This is what keeps the business cycle from flying off in extreme directions.
James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.
[Photo courtesy of Geralt Altmann]