By James H. Nolt
One of the introductory economics textbooks I often taught from (co-authored by former Fed chair Ben Bernanke) included short boxed features titled, “Think Like an Economist.” Instead I want to teach how to think like a capitalist. My purpose is not to train you to be a capitalist or to laud capitalist brilliance. My intent is morally neutral. You need to think like a capitalist in order to understand how the strategic conflict among capitalists creates the business cycle.
Last week’s blog introduced the idea that capitalism is a two-party system. Private exercise of power can be polarized in a variety of ways, but one division that never disappears is creditors and debtors. James Madison in his most famous essay, Federalist Papers, No. 10, identifies these two as enduring “parties” with irreconcilable interests. On a broad range of credit, monetary, and fiscal policies, creditor and debtor interests stand opposed.
Most importantly, creditors hate price inflation and debtors love it. Most debts, from home mortgages and other bank loans to bonds, are legally fixed at a certain money value. But since money itself varies in value (i.e. varies in the amount of stuff you can buy with a given quantity) the changing value of money also changes the value of debts. Inflation effectively means that debtors are paying back their loans with money that is worth less than the money they borrowed. Inflation can be thought of as rising prices or the falling value of money—and thus everything denominated in money, like debts. Deflation has the opposite effect.
Furthermore, deflation, falling prices, means falling income for the debtors selling whatever their business produces. If your income is falling but your debts are not, that is a recipe for bankruptcy. Throughout history, among the largest waves of bankruptcy occur when deflation reduces current income, but not debts, since deflation means that money and debts are rising in relative value.
The most severe deflation in world history occurred from the 1860s through the 1890s. During those decades, thousands of businesses, including all major railroads in the USA, went bankrupt. Worldwide, thousands of companies facing bankruptcy were combined together by their creditors, the big banks, creating the largest wave of corporate mergers in world history. Deflation also means companies tend to be cheap to buy for those bearish capitalists who still have capital in reserve.
Creditors versus debtors is thus one rivalry that always exists, but there are other polarities as well. Creditor and debtor are objective roles, but bears and bulls are related rival parties based on strategic intent. Understanding private strategy helps you think like a capitalist. Most people understand bulls better. Bulls profit from the rising value of whatever they own, whether stocks, bonds, factories, or real estate. A bullish economy typically means higher investment and thus higher growth and higher employment too. Bears benefit from falling prices, which allow them to buy the assets of others at a discount. Bears and bulls take “positions” (in capitalist lingo) reflecting their strategic intent. Popular media obscure the two-party nature of capitalism by anthropomorphizing “the market” (whether stocks, or whatever other market) as if the mind of the market were as singular as any individual. In fact, all asset markets are polarized between buyers and sellers. Insofar as these are acting as pure capitalists (not buying and selling for use, but as investments), most buyers are bulls and sellers are bears. So markets are never of one mind. They reflect opposing tendencies.
Throughout economic history, asset prices generally rise more slowly than they fall, creating a kind of “saw tooth” pattern of business cycles. Bulls make money gradually as asset prices rise. Bears make money quicker when asset prices fall. Everybody understands how you can profit as a bull when what you own rises in value, but far fewer people understand (and few economics textbooks explain) how bears make money.
The most common way to profit from falling prices is taking a “short” position, a.k.a., “selling short.” This is the claws of the bear. Nowadays this is most often done using financial derivatives, which I will explain in future blogs, but I start with the simplest way to sell short, used for centuries. The “short” borrows the asset whose price he expects to fall. He borrows the asset (such as a specific stock), not money, often from a broker or another capitalist who is bullish.
The short immediately sells the borrowed asset at the current price. Later, if its price falls, the short buys it back at the lower price and returns the same asset he borrowed, plus interest on the loan. The more the price falls, the more the bear profits. The only cost to the bear is the interest, which for a short time period might be very little. A successful bear can reap huge profits quickly in a falling market. On the other hand, if the short is wrong and prices continue to rise, he stands to lose a lot too, because he must buy back the asset at a higher price to “close the position” and return what he borrowed.
A short sale is also an example of a universal tactic capitalists use to increase profit: debt leverage. If you are borrowing money to buy assets, you are a bull. If you are borrowing assets to sell short you are a bear. Both bears and bulls increase their profit using debt leverage.
Consider a simple bullish example: If you can borrow money at 4 percent interest to invest in an asset that is rising at 5 percent a year, you will make more profit the more you borrow. If your leverage is 50-to-1, like some hedge funds these days, for each dollar of your own capital you borrow fifty. You make 5 percent profit, let’s assume, on the entire balance, both the borrowed capital and your own, but if you pay only 4 percent for the borrowed portion, the rate of profit you earn on your own capital is enormously magnified by the leverage. In this example, instead of earning 5 percent profit, you are earning 55 percent! (5+((5-4)x50)) It sounds like magic.
However, there is a risk. The same leverage that can make you rich also makes you vulnerable if the price moves against you. The higher the leverage, the higher the profit if the position succeeds, but the greater the losses if the numbers change. In the previous example, if either the cost of borrowing (interest rate) increases or the profit on my asset decreases, I can quickly move from big profits to big losses when I repay the debt. Thus, as Clausewitz, the great Prussian strategist of war asserts, business is like war. Greed for higher profit drives leverage up and thus also the risk that circumstances may change. When the economy is booming, bulls trample bears. When the economy crashes, bears eat bulls. This is the strategic struggle that has animated the business cycle for centuries. Stay tuned.
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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 by Medill DC]