Bull Magic

By James H. Nolt

Last week we took a look at bears to consider how investors can profit from falling asset prices. Bears are harder for the public to grasp than bulls, who benefit from rising prices and a booming economy. Thus they seem more congenial to the public interest than bears. There is a bronze statue of a charging bull on Wall Street in front of the New York Stock Exchange, but no monument to the bears.

Yet there are indeed problems with bulls as well. Bulls are the quintessential debtors. No bull movement occurs without massive new credit creation. Credit is the life blood of capitalism. However, if credit creation continues indefinitely, the result is a growing mountain of debt that must eventually become unsustainable. The old adage, “The higher they rise, the farther they fall,” applies well to many bulls.

Why haven’t you heard much from economists about bullish debt mountains? Yes, some economists do complain about public debt, but few economists (except for a few unorthodox critics like my friend, Steve Keen) worry much about even larger private debts. They often say private debts matter little for net demand because supposedly debt merely transfers purchasing power from one hand to another.

This is not true. New private credit is a net addition to aggregate demand. Economists miss this because of their odd theories about money, banking, and credit. It will take a couple of columns to explain what is wrong with these, but I will start this week so you can begin to appreciate the fact that the magic power of bulls is rooted in credit expansion.

Well into the 20th century, many people assumed “real” money was related to something scarce, like gold or silver: either it was such specie or paper tokens backed by bullion held somewhere. Actually, for centuries banks and merchants issued paper notes and bills as means of payment without any deep concern about how well-backed with bullion these paper tokens were. Capitalism from its inception depended on liberal issuance of credit in the form of paper tokens backed by little more than the good name of the private issuer.

Literally anybody can create money. Contrary to what you have been told, it is entirely legal for you to create money. Try it. Get a piece of fine paper. Write on it, “I [your name] promise to pay $100 in legal tender notes or coins on demand to any bearer of this note.” Sign and date it. If you want to buy a friend’s used textbook, present your note and ask them to accept it as payment. If your credit is trustworthy, it may be acceptable. If your credit is widely acceptable, she may even be able to use your note herself to pay someone else for a used bicycle, and so on.

As your note continues to circulate, you have expanded the money supply. Even better, as long as it circulates and does not return to you for redemption, you have purchased something valuable without diminishing your own wealth or money one iota. You have created new credit out of nothing. You have added to aggregate demand without producing anything new, other than a promise.

How can you produce something from nothing? Doesn’t this violate some fundamental law of thermodynamics or something like that?

Well, in fact, the mathematics underlying early “pure” economics from the 1870s was indeed based on the closed thermodynamic systems of physicists that maintained the principle of conservation of energy. These early economists (even many today) ignored money creation, let alone credit, to try to avoid the complications of an open-ended credit creation.

When money was introduced, it was treated as a fixed stock of some mysterious substance. Credit, more broadly, was ignored entirely. John Maynard Keynes and some others during the Great Depression tried to reintroduce money and credit as a more flexible quantity. Though by then, the false idea proliferated that money is not merely one form of circulating credit, but rather a unique means of payment, the quantity of which governments could and did control.

If governments claim to control the “money supply” (though never the broader credit supply), then surely it must be illegal to create money.

Actually, it isn’t. As we saw above, anybody can do it. Bankers and merchants, especially, have been doing it for centuries, if not millennia. Such debt issuers do not create money because they have legal entitlement to do so, but merely because people trust them to be creditworthy. What is illegal is not creating money under your own signature, but rather impersonating other people’s notes.

As long as your credit is trusted, you are in business, and you can conserve your capital by paying with credit instead of diminishing your cash reserves. Doing business without credit is a grossly inefficient waste of scarce capital. Bulls know this better than anyone. The surest way to leverage profits is to use as much credit as you can get away with. Credit magnifies your profits—and your risks.

Debt leverage is extremely powerful, and thus tempting to anyone who believes they can earn profits higher than the cost of borrowing. If I can borrow at 4 percent and earn 5 percent in whatever line of business, then the more I borrow, the richer I become.

This is bull magic. Its only real constraint is the fear that some bear will discover you have issued more credit than your business warrants if conditions change—for example, if your cost of credit rises or your ability to earn profits falls. If that bear is your creditor, watch out!

The bearish tactics I outlined last week exploit the vulnerabilities of bulls. Just as the balance of nature is maintained, with fluctuations, by predator-prey relationships, the business cycle is regulated, if somewhat anarchically, by the expansion and contraction of credit, by the increase and decrease of prices, in a never-ending irregular cycle of boom and bust.

Much of what we have outlined in these first five columns might seem rather abstract to those of you with limited business experience or knowledge of business history. However, starting next week I will put more meat on the bones. We will investigate the major forms of circulating credit, including notes, bills, stocks and bonds, how they are used to implement bear and bull strategies, and how the resulting strategic dance necessarily creates business cycles rather than the imagined stable equilibria of economists. We will then apply these tools to exposing contemporary economic and business secrets.

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James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.