By James H. Nolt
The public media, following the lead of economics textbooks, treat steady, continuous growth as the natural consequence of a market economy. If economic crises happen, the reason must be sought in something extraordinary, perhaps the excesses of crooked evildoers or venal governments. Liberals blame corporate malfeasance while conservatives point the finger at meddling politicians. While it is always possible to find plenty of scapegoats of your preferred category for every economic downturn, few realize that the inevitable two-party polarization of capitalism is the ultimate culprit.
Last week I explained two related polarizations: creditors versus debtors and bears versus bulls. These are related but not identical categories. This week I introduce how they interact dynamically, over the business cycle. In future columns I will put more flesh on the bare bones of this outline with examples, both historical and institutional, of how these polarizations play out to generate economic crises.
We can start at any point in the business cycle. Since it is a cycle, it generally repeats, though not in any exact pattern, since the dynamic of the cycle is complex interaction of contending human agents acting deliberately, along with various random unanticipated events, including natural phenomena like epidemics, weather, and natural disasters. Business cycles are also a sort of fractal phenomena, in the sense that larger patterns over years and decades also look like smaller patterns over days or weeks, adjusting for scale.
At the start of a boom, after the economy has been in a slump, there are many unemployed people, underutilized factories and empty buildings. Some venturesome bulls decide that the economy is likely to turn around. Optimism may come from many sources: new products, inventions, peace, or just a general sense that things are not likely to get much worse. Bulls may create a self-fulfilling prophecy just by taking a chance and borrowing money to start spending on new investment projects.
We will see in future columns that new credit does not have to pre-exist somewhere, it can be created out of nothing by bullish creditors with a willingness to lend and bullish investors with a desire to spend by ordering new raw materials and productive equipment and putting more of the existing idle stock or resources and people back to work.
There may still be numerous bears who do not believe the time is yet ripe for a turnaround, so they will hold back on new investments and keep more of their capital liquid, for example, in the form of cash. Depending on the relative balance of forces between bears and bulls, the economy begins to take off or has a false start and slumps again. If a boom roars ahead, bulls are vindicated as their investments pay off and the stodgy bears are left behind. Some bears switch sides and join the rush of bulls as the boom intensifies.
As a boom gathers steam the value of many assets—stocks, real estate, commodities, etc.—is typically rising. More and more bulls want to jump in. The more you can borrow, the faster you can grow. The temptation to borrow money to invest in a rising or bull market is always a powerful incentive for ballooning debt leverage. Since so many want to borrow, collectively their excessive demand for credit may begin to bid up the price of credit, i.e., interest rates. Yet as long as investments are yielding even higher returns than the cost of borrowing, plenty of bullish debtors will jump on the bandwagon.
Inflation of prices often accelerates during the boom, since credit is typically expanding faster than the production of real goods (later columns will explain how), so with so many buyers chasing a relatively limited supply of goods, prices rise. As mentioned last week, rising prices is equivalent to saying the value of money is falling, but since most debts have a fixed face value denominated in money, the value of the entire stock of existing debt is also falling.
This is much more important than merely the increasing prices of goods. As inflation picks up, many (not all) creditors turn bearish because their main assets—cash and debts—are some of the few things falling in value. They want to restore the value of what they own.
This is why a boom must lead to a bust. It cannot go on forever. The boom is fueled by increasing credit, but inevitably the most bullish creditors expand loans faster than others and lend to riskier, more highly leveraged bulls. Other creditors are more conservative. Historically these bears often include the largest banks. Much of their own wealth in the form of existing loans is likely to depreciate if the boom goes too far.
Yet bearish creditors also have a solution to their problem. They can simply reduce their own lending and refuse to rollover (continue) some of their existing loans, particularly to creditors deemed too bullish. If credit is reduced, interest rates go even higher, since the supply of credit falls relative to the still strong demand. As credit dries up, many bulls suddenly find themselves unable to continue their borrow-and-spend habit. When spending slows down, so does the economy, and the boom peters out.
Whether a boom ends or bumps along in several successive peaks depends on the relative power of bears and bulls. If bears are too weak to prevail, they might just lose market share, if the boom continues, to those still bullishly lending. On the other hand, if the bears are powerful enough, the economy may crash. Falling prices then reward bears by increasing the real value of their loans. Some bears will also profit enormously from short positions (described last week) built up during the weeks or months before the crash.
Although most of us prefer boom to bust, among capitalists, fortunes can be made at any point in the cycle if their strategy anticipates the future well. There is a Wall Street saying, “Bulls make money, and bears make money, but pigs get slaughtered.” In other words, there may be a risk of being too greedily leveraged, and too committed to the wrong strategy at the wrong time.
However, there is no such thing as too much leverage if your timing is right. Capitalism is not a game of predictable, steady growth—it’s all about the churn. Next week I will detail bearish tactics so you can grasp why “bad times” are not bad for everybody.
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James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.
[Photo courtesy of Wikimedia Commons]