By James H. Nolt
So far in these blogs we have covered some basic financial instruments: bills, bonds, and derivatives. Now let’s consider how they are used to implement business strategies and why these interacting strategies create a business cycle.
Bulls profit from leverage. The more prices rise, and thus the more bulls are drawn into rising markets, the more tempted the most aggressive bulls become to leverage their gains using other people’s money, or what is called debt leverage. Adding new credit in a booming market tends to continue the boom and drive prices even higher, creating a self-fulfilling prophecy of ever-higher prices drawing in more and more investors extending their gains with ever rising leverage. Asset prices then bubble upward to dizzying heights.
Bullish opportunity, however, creates vulnerability. All that debt makes sense as long as the cost of it (the interest rate) is less than the profit earned from employing the capital. If investors are using their capital to buy assets rising in price, then as long as those prices are rising faster than the interest rate, bulls are “in the money.” (If the assets earn some profit stream, that must be factored in as well.)
Two things can go wrong. Credit can become more expensive or asset prices rise more slowly or both. In my blog, “Big Bearish Banks,” we saw why banks and other creditors may start to rein in credit (regardless of what government regulators do). Insofar as creditors are major owners of debts dominated in fixed money terms, like most bonds and mortgages, they do not like the real value of these financial assets to go down, which occurs if the currency that debts are denominated in is falling in value because of the overall inflation in general prices.
Booms tend eventually to cause price inflation, but exactly what prices inflate the fastest matters a lot for economic dynamics. Unfortunately, economists teach us to talk about THE inflation rate, as if there is only one. Of course, “the” inflation rate is a very imperfect index based on the weighted average of a typical basket of consumption goods for the average consumer. This is known as the Consumer Price Index or CPI.
There are enormous problems constructing such indices over time because the sort of products that are consumed vary over the decades. For example, all sorts of electronic gadgets that are a major slice of the consumer budget today did not even exist a few decades ago. Whereas many items purchased throughout history, for example, horses and their equipment, are no longer important consumer items. Therefore comparing prices over time is a highly approximate business at best. However, economists are well aware of these issues and, in fact, discuss them even in introductory textbooks.
A bigger problem is much more neglected. In my second blog I told you we would learn to “think like a capitalist.” Most capitalists are rich. The CPI has no application and no relevance to them. It matters not one whit to anyone who is rich what the costs of bread or shoes are. What matters for them is whether the prices of their assets, whatever specific things they own, are rising. Furthermore, if they are ‘shorts’ (or if they are betting that some prices will fall) then they may also be interested in realizing profits on their short positions. Therefore capitalists are concerned only with the prices of assets when assessing where to deploy their capital, plus the prices of whatever that capitalist might manufacture or own shares in the manufacture of.
In normal times, the portfolios of capitalists are complex and diverse. Bears are selling, bulls are buying, and most capitalists are a mix of both across various assets. However there are particularly decisive moments in the business cycle, which Keynes calls “culminating points,” when bears and bulls polarize more distinctly and the economy is thus poised to change direction depending on the balance of forces between contending bears and bulls. These are like decisive battles in war. They may portend boom or bust.
When such polarization occurs, capitalists who are most broadly bearish are not bearish in absolutely everything, not the least because the rising prices of most things (inflation) means the falling value of money. Money, on average, buys less stuff when inflation occurs. Since the value of most debts is fixed in money terms, then creditors, such as the big bearish banks discussed two weeks ago, will want to reverse the price increases of other things to raise the value of the debts they own. Bears are “bullish” on the value of money and debts they own. Bears typically want what is colloquially called “tight money,” but which is actually tight credit. Tight credit raises the value of money and debts and tends to undermine the value of most other things since bulls can no longer borrow to buy as much as they did during the boom.
Economists, at least since Keynes, teach that it is up to the government to regulate the value of money through monetary policy. Governments do have some means of influence, but for now I will put those aside because it is important to understand that even in a laissez faire economy without any government action, bears and bulls loosely “regulate” each other through their strategic interaction. Broadly speaking, governments never fully regulate the credit supply. Advancing or denying credit is a private power beyond the control of governments.
Bullish investors and the bullish creditors who facilitate their profitable leverage eventually run up against resistance from other creditors, bears, who do not like the effects on prices (and thus, inversely, the real value of debts) that excessive expansion is having. These bears, especially when they coordinate their timing or are simply very big (historical examples include the Bank of England, J. P. Morgan, or the Rothschild family banks), can create a self-fulfilling prophecy at the moment—the culminating point when they choose to deny credit to the most highly-leveraged and vulnerable bulls. Credit expansion abruptly reverses as firms contract their capital and “unwind their positions.” Some are bankrupted. The resulting crash causes prices to deflate and thus restores the real value of debts. The bears drink champagne.
Every real boom and bust has a dynamic like this. As always, economists miss such dynamic details because they are absorbed in dull gray averages (like CPI) and thus lose any sense of real business dynamics. Next week we will start to illustrate this by examining the anatomy of real crises.
James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.
[Photo courtesy of Stéfan]