“Paper money eventually returns to its intrinsic value – zero.” - Voltaire
In this blog post I will cover the concepts of financial value and valuation from a unique perspective. This post is not designed for you to become a valuation expert in any specific good or service. Instead, it presents material to make you think about money and value from a higher level of abstraction. It's important to understand the abstract concepts of money and value because they form the foundation for how we determine what goods and services are worth now and what they might be worth in the future. If you know what something is worth today and what it will be worth tomorrow, you can make better decisions and position yourself correctly for the future.
Some of the concepts might be a bit difficult to wrap your head around at first, but if you are able to grasp this content, it will substantially increase your financial literacy and understanding of economics and finance. I encourage you to read my financial series blogs in order as they are presented in a logical sequence.
Money and Financial Valuations are Fabrications
The first and most important thing to understand about financial valuations is that they are made up. This has to be the case because the money that we use to assign valuations to goods and services is made up. Money is created by governments and banks (and more recently by groups of programmers as in the case of bitcoin) out of thin air.
The reason why we think money is real and has real value is because we make it real by using it as our primary valuation and exchange mechanism. If enough people believe that money has value and use it as if it has value, it becomes valuable. If all the individuals in the U.S. decided to no longer accept the US Dollar (USD) as payment for goods and services, the USD would no longer have any value for U.S. residents. In this way, money is a self-fulfilling prophecy.
The Two Types of Money
Historically, there have been two types of money/currency: 1) commodity money 2) fiat money
Commodity money can be anything that has “inherent value.” I put inherent value in quotes because nothing really has inherent financial value. Commodity money includes things like sea shells, gold, silver, copper, salt, tea, cigarettes, cocoa beans, etc. Developed countries and most developing countries no longer utilize commodity money as their primary currencies because of its inefficiencies. These inefficiencies include things like storage costs, volatility, lack of divisibility, bandwagon effects, value erosion, counterfeiting and many others.
Fiat money is what most developed and developing countries use as currency. Fiat money doesn't need to be grown, harvested or mined. It is simply written into existence by banks. The process is simple. You go to a bank and ask for a loan for $50,000. After the bank determines your credit-worthiness and approves the loan, they simply input $50,000 into your account and you now have access to that money. The money wasn't printed, it wasn't transferred from someone else's account to yours, it was simply created in digital form from nothing. Examples of fiat money include the US Dollar, Euro, British Pound, Japanese Yen, Chinese Yuan, etc.
Where Does Value Come From?
Now that we have that bit out of the way, let's talk about the origins of value. We will use apples as an example of a good that we want to value. If you happen upon an apple tree that is in bloom, you can pick an apple off of the tree and eat it. In this scenario, the financial value of the apple is zero. If you live in an area where apple trees are abundant, you can continue to consume the apples from the trees indefinitely at zero financial cost. The takeaway point from this example is that goods and services have zero inherent financial value under conditions of abundance.
Imagine another scenario, where you need to travel a considerable distance to pick apples from the apple trees. In this case, the cost of the apples becomes linked to the cost of retrieving the apples. If you walk, you incur the cost of energy expended during walking and time spent commuting. Even though the cost of the actual apples is till zero, you now incur associated costs in the form of labor and time required to obtain the apples. You also might want to pick extra apples and store them at home so you don't have to commute as often to retrieve the apples. Storage of the apples adds an additional indirect cost to the apples. The takeaway point from this example is that goods and services have associated costs related to production, retrieval and ownership/storage.
In our third scenario we will now include private property, part of which includes a temporary, artificial monopoly on land and the items on that land. Imagine that an individual erects a fence around the abundant apple trees from which you used to harvest your apples. This individual claims that s/he owns these trees and the property on which they grow and that you now have to pay them $1.00 for every apple that you want. This individual has created scarcity by restricting your access to the abundant apple trees and is extracting resources (money) from you for use/consumption of their supposed property. This is essentially the cornerstone of the capitalist system. The takeaway point from this example is that capitalism creates financial value/costs by creating and/or maintaining artificial or real scarcity.
It is important to understand that financial value can only exist when scarcity and demand for a product/service exists. For example, air, which is the most important thing for aerobic organisms (like humans) is extremely abundant and therefore has a financial value of zero. Think about it, when is the last time you paid for air? On the other hand, gold, which is relatively scarce and costly to extract from the earth, sells for about $1200 per troy ounce as of this writing. Both air and gold are in high demand, but because air is abundant, it is not assigned a financial value. This is a huge flaw/limit to viewing the world from a purely economic standpoint.
To summarize, goods and services have zero inherent financial value. Financial value is assigned based on relative scarcity and demand for a good or service. A good or service derives part of its value/cost from the costs associated with its production, retrieval and/or ownership/storage.
A Beach House in Antarctica
How much would you pay for a beach house in Antarctica? If you are a rational person, the answer is probably zero. How could that be? Similar houses in Southhampton sell for tens of millions of dollars. The answer is obvious. The value of a thing is related to its location and function within a particular environment at a particular time. When you buy a beach house, you're buying more than just the structure and the land that it sits on. You are buying into the community where that thing exists. This element adds a lot of complexity to financial valuations because it is difficult to value things like access to a private beach, proximity to rich and influential people, access to clean air and drinking water (remember that air supposedly has zero financial value).
The standard solution to this valuation nightmare under our current economic framework is to let the market dictate the price. One way this is done is by using comparatives or other prices as anchoring points. For example, if there are four similar houses around your house that have sold for $1M, then your house must also be worth around $1M. However, if someone is willing to pay $1.5M for your house, then that becomes your house's valuation. Simply put, something is worth only what someone else is willing to pay for it. What someone else is willing to pay for it is usually based on what similar items have sold for in the past.
But what if the good or service you are trying to sell has no comparison. It is the first of its kind or maybe it is one of a kind, like a painting by Salvador Dali. In this case, markets perform something called price discovery through a private or public auction. The good or service is auctioned off and the price for the item is discovered through bids that are placed by interested individuals.
Price discovery doesn't have to reflect anything real. A painting might sell for $150 Million dollars. Compare this figure to a high school teacher's salary, which might be $50,000. Did the painter really create value equivalent to 3,000 educational years of high school? ($150,000,000 / $50,000 per year = 3,000 years). That has to be one hell of a work of art! Again, here we see a horrible flaw in our current economic/financial framework.
Despite its flaws and limitations, capitalism has offered the best and most efficient solution to date for efficient pricing of goods and services. However, digitization and abundance have and will continue to erode financial values and the mechanisms that make capitalism work. As this happens, we will have to modify our current economic and financial models to better represent our reality. Eventually, money will evolve itself out of existence.
I know that this blog may have created more questions than it answers, but I hope that it has sparked your interest in thinking about money and value. I would love to hear your comments and answer any questions, so please feel free to comment below.