By James H. Nolt
Last week I introduced the crucial difference between productive and unproductive capital. The expansion and contraction of credit is how business cycles are created. Over the course of the business cycle, emphasis shifts between productive and unproductive uses of capital. In addition to this cyclical effect, when debt grows faster than output across several business cycles, this also tends to shift more and more capital into unproductive uses, predominantly chasing raised asset values. We are in such a long-term debt bubble today.
The most visible aspect of a debt bubble is the growth of the financial sector relative to every other sector of the economy. Its business primarily involves creating credit and selling financial or “paper” assets, such as stocks, bonds, and derivatives. Expansion of credit increases both the supply of and the demand for these financial assets. Credit expansion also stimulates demand for real assets such as real estate and commodities. Throughout history, financial interests have been adept at bullishly blowing up asset bubbles by expanding credit and bearishly bursting them by contracting it. As I have said throughout this blog series, this is what polarizes real political economy.
Unfortunately, you can get a Ph.D. in either economics or finance and know none of this. Both fields are dazzled by a fantasy version of economies that imagines “perfect markets” as the quintessential means of transacting all business. Finance theory has coined its own term, the “efficient market hypothesis,” instead of using the hackneyed economic term “perfect markets,” but the two concepts are closely related and rely on similarly fantastic sets of assumptions.
The first thing missing from textbook economics and finance is private power. Ever since my first blog of this series, I have made the point that private power and strategy infuse all real business. The fantasy version in textbooks ignores everything that matters for comprehending real business and economic dynamics. Consequently, it is very difficult to think strategically or to imagine what real strategic actors actually do if all you have is a textbook education. Successful financial players learn more on the job than they do from textbooks. Even “experts” can be blindsided, as many were during the 2008 crisis, because most are experts on the fantasy version of finance rather than the real thing.
One key way to show the difference is to consider how finance and economics use the concept of risk. Risk plays a critical role in theories about how assets are priced. The textbook version of risk is measured statistically based on the past performance of an asset. If an asset has a history of highly variable prices, it is defined as more risky than an asset whose historical price tends to be more stable. The prices of financial derivatives are strongly affected by this measure of risk. Derivatives are more expensive the riskier the underlying asset.
All this becomes misleading when you introduce the possibility of private power. If a powerful actor, like a trading desk at Goldman Sachs or a rich individual investor like George Soros or Warren Buffet, wants to bet on an asset price and then move it, an asset whose price has recently been stable is a tempting target because its derivatives will be cheaper than those of a volatile asset. In other words, it costs less to take a position in a stable asset. Once the position is set, strategic manipulation of news (including news of powerful investors’ own positions, carrying with them a reputation for power and prescience) and the buying or selling pressure of the strategic investors’ long or short positions tends to create a self-fulfilling prophecy–unless powerful countervailing players jump in. Once any asset is in play, the balance of power of the contending players determines its outcome, as in any strategic contest. Price stability is not primarily a property of the asset itself, but is influenced by whatever big players might do with it.
If you can understand strategic behavior like this at the micro level, then it is easier to generalize to the macro level and see why the business cycle as a whole is produced by strategic competition. For those who are mathematically inclined, price trends are fractal phenomena. That is, their micro complexity in a short period does not average out to long-term, large-scale calm. Sometimes roiling markets appear to produce no broad unidirectional trends, but at other times, which Keynes called “culminating points,” the micro behaviors of many investors are “in phase,” to borrow a term from wave physics, and broad bull and bear positions line up across many assets. Unlike the waves that physics studies, however, the waves of financial markets are moved by the conflicting intents of powerful strategic investors. This is not just crowd behavior. Portions of the investor crowd are well organized. Wall Street lingo includes colorful phrases for such organized movements, such as “bear raid” and “bull squeeze.”
Risk is thus not an emergent phenomenon of crowd behavior. It is not analogous to a school of fish. It is more like the risk of battle in a war. There is much in both war and business that can be calculated, but there is also always an irreducible degree of uncertainty that derives from the rapidly changing behavior of others, whether it is strategic or merely emotional. Routine behavior is broadly predictable. Extraordinary behavior is not, but it is not random either. Sun Tzu explained this 2,500 years ago in The Art of War.
Economics, with its conceit that the economy is driven by consumer tastes and spending, largely ignores strategic behavior. Thus, standard textbook macroeconomics argues that aggregate demand derives from household income, which sounds sensible for routine demand, but is wrong in general. Demand derives from buying power, which is often–especially for investors–driven less by income than by strategic instinct combined with the power to borrow. Any investor who is creditworthy has flexible spending power only partially constrained by income. If assets seem to yield more than the cost of borrowing, then the temptation to borrow and buy bullishly, without regard to income or wealth constraints, is enormous. Investment decisions are inherently strategic.
Creditors also make a strategic decision on whether to continue to extend credit to high-flying bulls or to resolve that enough is enough and stop the party. All crashes begin with such strategic choices by creditors becoming bearish.
Understanding capitalist economies as fundamentally credit-driven rather than income-driven undermines the entire macroeconomic textbook view in many ways. For example, consumers are indeed free to allocate their income among a variety of possible purchases, but loans do not function in the same way. Much credit is directed toward specific uses: consumers apply for car loans, home mortgages, and student loans. Businesses apply to fund specific capital expenditures. Speculators borrow to fund specific strategies or positions. All of these typically provide extensive information to the creditor about their income, wealth, and their intended use of funds. Large creditors like big banks accumulate timely information from diverse players. The banks’ data are much better than the out-of-date summary statistics governments glean. The banks’ data are real-time and actionable. By managing their credit choices, banks also direct the economy much more precisely than governments can, but never without risk, since within business there are always rival forces contending. Next week I will discuss more about how these contending forces interact to produce macroeconomic outcomes.
James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.
[Photo courtesy of Emilio Labrador]