Money, markets and prices all contribute to a more efficient economy, to maximize the creation of wealth.
Most financial assets inherently represent some positive amount of wealth, implying that the economic demand for them is greater than zero, with their supply being less than infinite.
These same financial assets often need to be exchanged, implying that their inherent wealth is to be transferred. As this wealth is being transferred in one direction (from seller to buyer), an equal amount of wealth is simultaneously transferred in the opposite direction (from buyer to seller), in the form of money. Equal and opposite wealth flow.
Where money is anything that many believe can be conveniently and safely used to store and transfer wealth with each other, today and in the future. But in our case, usually dollars.
How much wealth a dollar stores is solely determined by what we collectively believe it stores, it is a faith-based system. On any given day we all tend to agree on the amount of wealth stored per dollar, but it should be no surprise to anyone that this amount gradually decreases over time, otherwise known as inflation.
Like all other financial assets, the value of a dollar is influenced by the economic forces of supply and demand, the details of which will be explained in a later blog.
The purpose of money is to facilitate the exchange of wealth, it has proven to be vastly superior to bartering. An efficient economy requires the usage of money, preferably one that is non-volatile in the short-term, that the amount of wealth it stores changes relatively slowly and predictably. This ability to facilitate efficient trade the primary demand for dollar, whereas the supply of dollars is controlled by the Federal Reserve.
The exchange of a financial asset for money requires that both parties agree as to how much wealth is stored in the financial asset (i.e. how much it is “worth”), and how much wealth is stored in a dollar. This process can be simplified by assuming that the wealth stored in a dollar is a constant, but as will be demonstrated, this can lead to poor economic decisions.
How much a financial asset is worth depends on the supply and demand for it, at that time, and sometimes, at that place. This is the purpose of markets, to find the balance between economic supply and demand for a financial asset, to determine how much it is “worth”, or how much wealth many believe it represents.
Another faith-based system.
An efficient economy requires markets to determine the value of financial assets accurately and transparently. Inaccurate valuations are market distortions, and will result in economic inefficiencies, and a reduction in the creation of wealth.
Given that financial assets have an agreed upon value, that they represent some amount of wealth, and that dollars are also worth some mutually agreed upon amount of wealth, it makes sense that dividing the wealth of the financial asset by the wealth of a dollar results in some number of dollars, also known as the “price” of the financial asset. The price will have units of dollars.
While prices are useful, ultimately it is not the price of a financial asset that is important, but how much wealth many believe it represents. Which means that the value of the dollar must always be considered when valuing financial assets.
That is not to say that prices are not important. Prices are more than convenient; they make markets possible. They work perfectly well for relative comparisons. Just not so well in the absolute.
If this sounds uselessly abstract, consider the following:
Assume that in the year 2000 you purchased a home for $100. Also assume that the annual rate of inflation is fixed at 3%, which means that about every 20 years the dollar loses half of its value, half of its wealth storage capacity. Twenty years later in the year 2020, ignoring all other factors, the exact same house stores the same amount of wealth, so you sell it for $200.
Did you make a profit? Yes, $100 to be exact, as measured in dollars. And you will almost certainly be subjected to a tax on this dollar profit.
But did you make wealth?
When you purchased the house in the year 2000, you transferred $100 from your bank account to the seller’s bank account, representing some fixed amount of wealth.
Thanks to inflation and the static state of the house, when you sold the house for $200, the exact same amount of wealth was transferred from the new buyer back to you.
So while you made a profit (as measured in dollars), you did not gain wealth. An important difference. The $200 sitting in your bank account stores the same amount of wealth that your $100 did twenty years ago.
Except that after paying taxes on your “dollar profit” you now have less wealth than what you started with, registering a net “wealth loss”.
The dollar “profit” is an illusion of wealth gain, prices in dollar can be misleading.
Money’s purpose and power is to conveniently store and transfer wealth, to enable efficient markets, to facilitate the exchange of financial assets.
Markets are where financial assets are exchanged, and in the process of establishing the balance between supply and demand, markets determine the value of such assets, how much wealth all agree they represent. Which is then indirectly reflected in the monetary price.
Money, markets and prices all contribute to a more efficient economy, whose ultimate goal is to maximize the creation of excess wealth.
It is wealth, not money, that should always be the focus. It is excess wealth we want to create, not excess money. Don’t confuse the two.