The increasing securitization of everything under the sun within a framework of a fiat money economy raises many interesting questions with respect to the nature of wealth. The value of a company is measured by its “capitalization”, whose value is achieved by positing that the aggregate value of its shares is simply determined by the price of the most recent sale of one of its shares. Certainly, prices are determined on the margin, but does the wealth of a company increase when its share price goes from $20 to $25 without any increase in profit, or future expectation of such? Let’s look at the housing stock of a country. Within the last few years, many homes have sold for twice the price of what they fetched, say, 5 years ago. OK, so does that mean we can extrapolate these marginal prices to infer that the value of our housing stock has doubled, and hence we as a nation are wealthier? Looking only at the housing stock that existed 5 years ago, has its utility increased? How does wealth relate to prices?
According to the Fed, these price increases are evidence of the robustness and health of the American economy. We are now supposedly wealthier. But isn't this like referring to increasing “No Child Left Behind” test scores to answer the question of the day: “Is our children learning?” A given house has a fixed utility. Its utility does not go up simply by having occupied it for the last 5 years. If its price has gone up dramatically, is one dramatically wealthier?
Wealth, it seems to me, is related to the production of goods (and services) that people want to have (essentially manufacturing) and is not determined by prices, although price movements may be indicative of changes in wealth. If that were so, what would the relationship be? If increasing the supply of goods that people want to buy, whether through importation or domestic production, means more wealth, where would price fit into this picture of wealth measurement? Let’s go back to housing.
To some degree, increasing the manufacture of houses would increase wealth, but this would, ceteris paribus, have a depressing effect on house prices. So I reason that falling prices is a good measure of wealth creation (such as the prices of electronics and computer hardware). In the 19th century, there was a slow decrease in the price level over the entire century (excepting the Civil War era – think of Lincoln’s greenbacks, which were later declared unconstitutional). It would seem to make sense that with a steady amount of money, individual ingenuity (human action) is going to tweak the production process every year to make it more efficient (less resources for a given output) to produce a given good, which will tend to lower the price. The price reduction for this good will free up capital to produce other, or better goods – all within a framework of falling prices.
In a 100% reserve gold-based monetary system, the amount of money is relatively fixed over a medium range period of time, so as increasing innovation tweaks the production process, this increased efficiency – savings of inputs for a given output – is reflected in the price. The price reflects the decreased inputs by, well, decreasing. Decreasing prices simply means that your dollar (or whatever monetary numeraire is in use) buys more. The more your dollar buys, the wealthier you are! Sort of makes sense, doesn't it, or do you prefer your dollar buying less? Over time you can buy 3 loaves of bread for a buck instead of 2. But wait you say, that means that the price of bread has decreased from 50 to 33 and that's deflation. You want price stability. OK, that can be fixed by just taking away one of your loaves of bread – either through strong-armed robbery or via a more gentile thievery – inflation. The result is the same, now you still have only two loaves of bread for your dollar – no more deflation! Happy? By increasing the amount of money into the system, the sovereign benefits from efficiencies that have been earned by increased productivity – not the economic actors who have earned it. One can anticipate the objection here that there isn't really any inflation, because prices have been "stabilized". But inflation is just theft by another name and the theft of the increased production (resulting in a stable remainder) is theft all the same.
Now consider your exuberant neighbor coming up to you and exclaiming that he just got a $1.2M offer on his house (a 1200 sq. ft. cottage). Well, dare and double dare. Tell him you can top that, your grandfather back in Weimar Germany got more than that for a loaf of bread! Exuberance becomes consternation. (Yes, if he sold now before others prices reset, he would be better off, but that begs the question of whether we as a nation are wealthier overall because of this price increase.)
Why the confusion? Because we have no guiding star by which to navigate within a fiat money economy. With a relatively fixed-base monetary system, the economy can be pictured as a pie of a given fixed size. The diagram to the right reflects a simple economy meeting needs of shelter, food, and medicine – represented by the different colors. The size of the sector represents the monetary value of the inputs needed to meet the needs of society in that area. As efficiencies set in, a given sector becomes smaller – requires less resource input to satisfy our need, and other products comes into being to take up the empty space, so to speak. We now can allocate those freed up resources, say, to a cosmetics industry. Also, within a given sector, as more units are added without the sector growing overall (more output but the same overall input – increased efficiency within the industry), the sub-slices will get smaller. A sub-slice fulfills the need of a given person, for example, a housing unit. The pie is a fixed size, so the size of the "slice" is related to price, and since the size of the pie doesn't change, the relative sizes of the slice over time readily signals changes in price. Each dollar, which represents a set percentage of the overall monetary base, and hence is also of a fixed size, can be exchanged for more goods as efficiencies work themselves into the economy – the slices become smaller. With this sort of system, we can know whether our wealth is increasing or decreasing by observing prices – lower prices means more wealth. What happens inside the pie when it begins to change size is beyond the scope of this article, but suffice it to say, that the entity that benefits is the entity that is adding the monetary base matter to the pie that causes it to grow.
So, to go back to the question raised in the beginning of this article as to the relationship between prices and wealth, I do not believe that one can put a number on the wealth of an economy, nor would it have any meaning if one did. Prices exist only within a framework of trade. However, trade operates at the margins of each trader's diminishing marginal utility, and these are constantly in flux and prices are merely signaling devices wherein these values of diminishing marginal utilities find expression. So the relationship between prices and wealth is similar to the one between speed and acceleration. It is not the value of speed that is in any way related to acceleration, but only the changes in speed that are relevant in contemplating acceleration. So it is with prices. Price level in no way relates to wealth. The relationship is one associated with the change in prices. Changes (decreases) to the general price level of a fixed set of goods (within our fixed-based monetary system) relates to positive values of wealth creation. So when the Fed talks about asset prices and economic robustness and all, it isn't so much wrong as it is just plain meaningless. I view much of the pronouncements of the Fed as nothing more than the blather that goes on between the dealer and his mark in a game of three-card monte. Its purpose isn't to communicate, rather it's to distract one's attention from the action at hand.
Now people might still argue that if a person buys, say, a house and then 10 years later its price is 5% less, he is poorer. They still believe that lower prices means less wealth. Rubbish! People are still going to be consumers of housing (shelter) and if its relative price has fallen – society is richer. Look at the extreme case where 90% of a workers salary goes to provide shelter compared to just 50%, or 40%, or 20% of his total salary. Is he wealthier for having paid more, or less, for a given good?
But this is static analysis, that $0.05x of capital has been freed up because housing costs less, can go to produce, or improve, other things – tweaking that goods’ production efficiency and lowering its price. Keep in mind we are assuming that his income is the same (no COLAs or inflation), so he can now actually buy MORE with his $0.3x of annual income because prices have fallen overall. He is better off? (As the efficiencies accumulate, so will capital, and wages are positively correlated to capital/labor ratios, so on the whole, relative labor rates would increase.) Falling prices are indicative of increasing wealth!
Does that mean that rising prices mean decreasing wealth? In a relative sense, yes! Relative to a stable price regime, people are less wealthy than they would have been. Prices can rise by 2 means:
- Decreasing productivity. The relative cost of the inputs FOR WHAT PEOPLE WANT TO BUY increases due to scarcity. For example, people don’t want to buy war or its implements, so a war economy means decreasing wealth as it siphons off resources from what people want to buy. No guns AND butter – imagine that! (Yes, an economy can have both guns and butter – at the cost of leisure, which cost may be voluntarily paid, if the society were attacked, for example. But this is usually not true for wars of imperial aggrandizement.)
- Inflation. Historically inflation was caused (within a regime of precious metal coins) by the sovereign shaving some of the metal off the rim of the coin (that’s why coins have ridges on the end). So as the agent of inflation skims off wealth they became richer – effortlessly. Historically these people use that (stolen) wealth nefariously to attempt to increase it some more through aggressive war. Indeed, inflation has historically been the chief means of financing wars, because a people oftentimes will not tolerate the levels of direct taxation that aggressive wars require.
If decreasing prices signifies increasing wealth and rising prices are indicative of a society organizing itself in such a way that results in less than optimal wealth creation, or indeed wealth destruction, why is it that the prevailing perception that rising asset price levels and ever-increasing levels of debt are indicative of increasing wealth? If the reason is, as I have alluded to above, the lack of a guiding star. Why aren't our schools helping us to look up at the stars towards a true Polaris?
What role has public education and a centralized educational bureaucracy played in all of this consternation? Why do I say that? Do I believe that a private school is going to simply be automatically better than a public school? NO! But in a private educational regime without a centralized grant-giving educational bureaucracy, different schools of thought are equally free to express their own theories of wealth creation (or any other topic). Wealth is produced by worshipping the moon and she enjoys sacrifices of otters and rabbits. OK, could be. How would I know? I was born naked and ignorant. Somebody else may have some other silly idea like eating less wheat this year so next year we don’t have to work from dawn to dusk. Rather, we could spend an hour a day on improving the plow (maybe metal works better than wood?). An hour a day tinkering around like that means less production, but then we can live off of what we had saved before. Maybe the metal plow will mean that we can plow the fields quicker – same output for less input. Then we can spend the time we saved drinking moonshine and getting drunk. Are we better off? You bet. More leisure. Maybe somebody else will use that spare time (additional resource) for more tinkering around and creating a whole positive feedback loop of productivity increases.
Sounds silly. Well, who knows. Some people will slaughter rabbits and otters; some will mess around with the plow. Nobody knows – but the truth will out! In the public education system, and within the centralized educational bureaucracy, diversity of ideas is suppressed. (Note! I am not attacking them for what they teach or support. Who am I to say that these professional educators know less than I?) It is what is not taught that is the problem. Both schools of thought – fiddling with plows and slaughtering rabbits – must find their expression. But monopoly education, like Marxism, hews to a party line approach and the true dialectic of competing ideas is never allowed to materialize. It is the very process of public education that diminishes and debases society’s knowledge. It is not a personal thing. The point is not whether public school teachers are good or bad, or are paid way too little – or way too much. It’s a systemic thing.
Referring to our public education system as monopoly education is really misleading because the competition of ideas will still exist, just at a different level. Japanese, German, or Chinese citizens may be taught other schools of thought (either in another monopoly regime or within a diverse private regime – it doesn’t matter which, there will still be competition – globally). Some society will hit upon the plow-tinkering theory and succeed, while the moon worshippers won’t, or vice versa. Over time, a society may hew to an entirely different school of thought, but without the competition of ideas, it won’t know what is optimal. So it goes, the ebb and flow of civilizations. This process is inevitable, but the periodicity of it is highly dependent, it seems to me, on the relative freedom of its educational and intellectual environment.
June 21, 2006
