Value, Wealth, Money

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Perhaps the most famous, and over used, economic equation is “money is the root of all evil.” Many on the left will be quick to agree and use it as a way to shun any profit making activity. Those on the right may be quick to fire back with another over used maxim: “greed is good.” Between those two extremes, we have bland corporate claims of creating shareholder wealth and offering customer value. These terms, “value,” “wealth,” or “money” may be used interchangeably but they can mean different things. I would like to propose a way of using them that might make economic discussions clearer, and even answer the question if money really is the root of all evil.

Value: Any immediate increase in well-being. If you enjoy this post, over and above the expense of your time invested, then I have created value. No direct exchange has taken place, and certainly no money has changed hands, but value (I hope) has been created. All of us, in however tiny an amount, are better off. If several readers enjoy it then the total value created is even higher. Sadly is possible to destroy value; should you have receive less benefit from this post than your time invested then I have (and I apologize) destroyed value.

Wealth: A store of actual or potential future well-being. Wealth provides a flow of benefits now and into the future. A house is wealth in that it provides a flow of benefits (shelter) over time. It is the benefits, or well-being, provided that counts as wealth not any money price placed on it.

Any wealth creation begins with value creation. It starts with a search for a way to bring or add value by generating new or changing existing goods, services, or experiences. Google started as a value creating enterprise. Its value creation effort was to make search more effective. If I can provide something for 50 cents that you value at one dollar then I have created wealth. You have one dollar’s worth of value and 50 cents, I have 50 cents that I previously did not. Without this creation you would either have nothing (but kept your dollar) or what you wanted (but without your dollar).

Supporters of capitalism generally assume (or at least point to) the above model. In the simplified example we are both better off. While I receive 50 of your cents, you receive something that you value at one dollar, you still have 50 cents to enjoy elsewhere. We might argue how the benefits of such a transaction be distributed; I could charge 95 cents for the thing you value at one dollar and still create wealth, the distribution is the only difference, we are both still better off. The critics of capitalism, perhaps more realistically, assume (and point to) the money creation example discussed below.

Money: A notional and abstract measure for the accounting of wealth, or a useful medium for exchange. Money creation does not involve value creation; at best it involves wealth distribution, but may actually involve value destruction. Much of the recent financial meltdown was due to attempts to create money absent the creation of value or wealth. Rising asset prices do not create wealth: your house provides the exact same benefits it did when it was half the price. The notional money price offers no benefit while you remain in residence. Many of the exotic financial instruments created little or no value; they did offer the chance to shift wealth from one set of hands to the other. At its base attempts to create money are not attempts to create anything, they are attempts to capture value and re-distribute wealth.

So to return to the opening cliché: It may not be money, or even excess desire for it, but rather attempts to create money that are the root of all evil. Many of these attempts could probably be better described with their more common names: fraud, deceit, rent-seeking, or crookedness.

Notes:

I will expand upon the price versus wealth idea because it may not be obvious. When you purchase a house, it provides you with a flow of benefits (e.g., shelter). That flow of benefits represents wealth (continued well-being). Regardless of the money price that flow of benefits does not change. If the price doubles the house does not double in size or sprout granite counter tops. When you come to sell you may receive more money than you paid, but will likely have to spend more to receive the same continued benefits from another house (e.g., same number of rooms, equally good neighborhood, etc.) Even trading down does not increase your wealth, it merely changes the distribution of that wealth (less living space but more cash). You may be lucky and move from a high cost location to a lower cost one. This good fortune (for you) does not represent a creation of wealth but a transfer from the new owner to you. The new owners have the same benefits as you did when your purchased at half the price but have paid more for it. No wealth has being created, just transferred. This is the classic money creation outcome. It seems great for you but it is a zero sum game, not everyone can win. I wonder how many retirees who gleefully pocket such windfalls realize that it essentially comes from their children (assuming the children could afford to purchase their childhood home).

The most famous economic equation is more likely Black–Scholes, the pricing model for options that helped start the derivatives revolution. The award for most infamous probably should go to David Li’s Gaussian copula function used to model various debt instruments such as CDOs.
[editor’s note: In times of crisis all correlations go to 1]

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4 Responses to “Value, Wealth, Money”

  1. Linkage is Good for You: We’re Back! Edition Says:

    […] Default User – “Faking It“, “Emotion Versus Logic“, “Value, Wealth, Money” […]

  2. David Foster Says:

    I think you’re basically correct about house-price increases being basically a form of wealth transfer between generations…the same thing works in reverse, of course, when house prices *decrease*. (This is not true in those cases where the price increase is due to something that really *does* increase the value of the house, such as the creation of a nice park 1 mile away in one direction and a nice shopping center 1 mile away in the other direction, but increases of this type are not usually what drives housing market changes)

    This is less true in the case of stocks, because they are very affected by changes in the estimated wealth-producing value of the companies in question…but to the extent that increases are due entirely to higher P/E ratios, they are similar to what you’ve described for housing. As fund manager John Hussman puts it, abnormally high returns today are simply borrowing from tomorrow’s returns.

  3. Default User Says:

    @David Foster
    As you pointed out, a price change for a property could be a mixture of changes in attributes (e.g., improved surroundings) or changes in monetary conditions (e.g., interest rates). Another potential price mover is population flows that do not really fit into either of the above (although I would tend to see it as more “money” creation – with the transfer away from the newcomer).

    The problem in pricing stocks is the “estimated” in “estimated future cash flows.” Wild price swings could be a rational response to small changes in expectations because investors discount those expectations into an infinite future (if you like to work with perfect models of markets).

  4. Robert W Says:

    Great post. I hate to nitpick, but I do want to point out that many of the options, derivatives, and other complicated financial instruments are capable of producing value(though they often are used in ways that don’t.)
    Allowing producers or consumers of goods such as natural resources to “lock in” a price ahead of time can help them to significantly reduce uncertainty. This can allow them to make decisions more rationally and lead to greater productivity. A farmer, for example, can determine in advance what the maximum price will be for him to purchase seed/feed/fertilizer, and at the same time he be sure of recieving a price minimum for the crops he will produce.
    [DU: I agree on the usefulness of, even the need for, financial instruments to manage or transfer risk. Indeed, such hedging could not take place without a speculator (someone willing to take on that risk). Also I recognize that its is speculators who provide much of the liquidity of financial markets: without speculators, if you wanted to sell an amount of corn/US Dollars/oil you would need to find someone that wanted to purchase exactly that amount. Anyone that has ever purchased foreign currency before vacation has relied on a speculator (the speculator did not need the dollars you were selling for their own vacation) to effect the transaction. Newer financial instruments were more abstract and more complex than the simple futures contract of old; they may have lacked the tangible underlying asset that underpinned earlier future/swap/forwards. I think some of the newer financial instruments may have actually added to total risk rather than distribute existing risk (e.g., the ability to sell unlimited “insurance” on the same bonds). That said, I would not consider myself a financial Luddite, I am just cautious of claims for financial alchemy.]

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