By James H. Nolt
“The facts speak for themselves” is a commonplace saying, but it is not true. Economic and business data can be read all sorts of different ways. How you think greatly influences the sense you make of numbers.
Economists typically think mechanically. That is, they make mathematical models of the economy and feed data through them. The conclusions they can draw from the data are no better than the quality of the models. Unfortunately, most of the models economists routinely use are so full of empirical and logical errors that they produce more nonsense than sense. They obscure more than they reveal.
Political economy must examine data strategically. In other words, data provides a source of puzzles that hint at both the strategic action and routine processes that produced them. Economists’ models can only capture routine action, what Sun Tzu in The Art of War calls “ordinary force.” Strategic analysis looks especially for “extraordinary force,” reconstructing the often covert strategic action that produces surprising or puzzling data. The data itself may be like the tip of an iceberg. It indicates that there is much more there, but you need well-trained imagination to visualize that which you cannot see or measure.
Anticipating the future especially requires strategic thinking. Economists claim they can forecast the future, but all they do is project past trends. Nothing extraordinary can ever register in their models, so of course they almost always miss major turns in the economy and then claim nobody could foresee such things. Certainly nobody who relies on mechanical models can do so.
Strategic thinking is never precise but offers the best insights you can get about the future. (For more detail see chapter four of my book, “International Political Economy: The Business of War and Peace”.) The strategic method requires identifying the power and interests of key players so you can anticipate their likely actions.
This is never easy. Anticipating the future may be easier in war than in business or the economy, because in war, much of the time, you know who your enemy is and roughly where they are and what his strengths are. Private power is more complex because allies and adversaries can change quickly; the “terrain” of combat (assets in play), especially in financial operations, is fluid; and new players may jump in unanticipated and unannounced. Despite these complications, accounting for extraordinary action is vital to have any chance of anticipating the future.
The strategic analysis of political economy is not as daunting as it might seem in the abstract because, as I have said from the beginning of this blog, capitalism is a two-party system. Opposing bear and bull parties always exist. The only difficulty is specifying them and assessing the balance of power between them. Unlike formal economic models, the data available might be only anecdotal or partial, but that is often enough to yield significant clues about which way the economy will turn and approximately when.
Public declarations are seldom of much use. Sun Tzu said, “All warfare is based on deception.” It is no different for political or business strategy. Strategies that are known are easier to counter. Powerful people do not broadcast their intent. Therefore to understand how others will act, it is often necessary to think deductively about their interests, based on what you can discover about the assets they own and how their portfolio is changing, in other words, what are they buying and what are they selling. Publicly observable action may give clues to underlying strategies.
For example, during a boom those borrowing to buy rising assets are clearly bulls. They will profit as long as the yield on the assets is greater than the cost of borrowing. Anything that raises their cost of capital or lowers the yield on their assets threatens to turn leveraged gains into leveraged losses.
When leveraged position goes “underwater,” i.e., the cost of borrowing exceeds the yield of the assets, then bulls are very likely to sell assets quickly to avoid heavy losses. Asset prices do not necessarily have to fall in order to cause a leveraged position to suffer losses. If the yield is too low, it cannot cover the cost of borrowed funds. Selling like this is called “unwinding” a position.
On the other hand, bears will hold cash or short positions to be ready to buy assets at a discount after an expected price fall. If an economy is booming but some players are holding onto what seems like excessively liquid positions, chances are that they are betting that prices will soon turn down. If bears are also creditors, they may raise interest rates or even deny credit, which helps insure that prices do fall. When credit is curtailed, buying power declines and prices must fall.
Continuing price increases impose losses on a bear positions; perhaps very heavy losses if their have vulnerable derivative-based positions. Even if bears are merely liquid, holding cash, bills or liquid bonds like U.S. Treasuries, inflation erodes their wealth because the flip side of rising prices is the falling value of money, and of all financial assets denominated in money, including bonds and bills. Creditors and bears (not all bears are creditors and not all creditors are bears, e.g., if they are financing bullish borrowers without collateral) must fight inflation or lose.
Economic textbooks rarely mention bears and therefore do not describe who might benefit from the falling asset prices typical of an economic downturn. Slumps are bad; growth is good. This one-sided view blinds economists to the strategic possibilities of countervailing bears and bulls. This is why they believe that sustained growth is possible if only “markets” are set free. In fact, sustained growth must be interrupted periodically as bearish interests coalesce and exercise their power to deny credit and end the boom, profiting in the process by buying up the discounted assets of overextended bulls.
Just in case you are still skeptical that bears in bulls exist in almost equal measure, may I remind you again that in the world today there are close to one quadrillion dollars in outstanding derivatives contracts. Every one of these contracts is two-sided: a bull betting the price of the underlying will rise and a bear betting it will fall. Every derivatives contact necessarily involves a loser paying a winner, just like any bet.
Owning derivatives contracts is not the only way to establish a bear or bull position, as we shall explore in forthcoming blogs. Even industrial assets can be positioned either way. But the enormous volume of the derivatives business today makes the bear-bull polarizing obvious and inescapable to anyone who has even the simplest understanding of what derivatives are.
One further characteristic of derivative contracts that ought to concern the general public is this: the value of derivatives increase as economic volatility increases. In other words, the more chaotic things become, the most valuable derivatives are. Their owners actually profit from instability.
James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.
[Photo courtesy of Vladimir Agafonkin]