STL #1: Economic Equity

My Thoughts On: May 6th, 2003

Ever wonder where money gets its value? In my See the Light columns, I hope to open your eyes to important issues, but try not to go over your head. In this first issue, we talk about something we all have to deal with but don't usually take time to really understand, the "Almighty Dollar".

Nothing is really more important to modern everyday life than the institution of money. It affects what we do, what careers we seek, what places we live. Having money can mean prosperity for the average American, not having it, well, just plain sucks. Most violent crimes need no motivation further than greed for money to be explained. On the other hand, some of the pinnacles of American achievement have been made on just this, the strive for financial wealth. Just look at the invention of the automobile, or the aircraft, or the telephone... all inventions made by people striving to profit off their respective discoveries.

In the See the Light series, your humble curator, Phoebus Apollo, is going to take you through a tour of some complex topics and help shed some light on a few things you may have never thought through. And who knows, along the way we might just uncover a part of the New American Myth.

Adam Smith, Scottish Economist and Philosopher back in the days prior to the American Revolution, influenced modern economics by presenting a large volume of work, "An Inquiry into the Nature and Causes of the Wealth of Nations". By investigating the "Wealth of Nations" he came to basic principles of where wealth comes from, what its value means to it's holders, and how a society might become more wealthy. Later on, Adam Smith became considered the father of what we now call "Capitalism" for his ideas.

Money can most broadly be considered any good used as a base unit for determining the value of a thing. In barter societies, usually goods were traded much like currency. For instance, a cow might've equaled four sheep, which were likewise equal to 10 turkeys. If you had a pelt of fur that equals one turkey, it might be considered fair to trade 40 pelts for a cow.

As it became harder to value things by so many different systems, banking systems arose to unify currency by minting precious metals into coins. The weight of these metals usually related to a set value, so the pre-weighted coins each had fixed values, depending on the scarcity of the metal and the labor it took to produce it. It was rather easy to take rare metals, like gold, and apply a standard to them since production was always organized and consistent - unlike cows, sheep and turkey, gold was more reliable to produce.

The value of metals in bullion (smelted into bars, ingots or plates) balanced the value of the metal's coinage (its value in the marketplace). Obviously, the market would never allow gold to be worth less than the bullion - if so, you could smelt the gold coins and make more back in currency, which you could then smelt, to make even more. Likewise, the markets wouldn't allow gold to be much more in value - minters would coin so much that the demand for bullion would increase, thus increasing the value of bullion to come to par with the value of coin. It soon became obvious that having a common coined currency would lubricate trade, and eased trade makes all tradable goods more valuable (an idea we'll touch on a little later).

The balance of metal to coin plays a very important role in stabilizing currency. Without it, a currency may inflate or deflate easier, since the bullion values regulated how much money was minted, and thus controlled inflation/deflation. Between 1880 and 1914 the U.S. had the "classic" gold standard system, a system where gold and money were exchangeable by law, inflation was at 0.1%. Now inflation rates skyrocket. Why?

Many modern governments have centralized banking and have gotten rid of the gold standard, replaced by government-issued paper "fiat" money. In this situation, governments print out as much money as they care to, and inflation or deflations occur if money is printed out in too high a volume or too low a volume. As Fredrich von Hayek pointed out, history has shown that governments always abuse the power to print money and print too much, causing inflation. Printing out paper money and banning the gold standard allows a government to do something else as well - it takes the gold reserves it had to save to match exchange rates, and confiscates it. Essentially, a government that centralizes its banking and takes away the gold standard can eat the nation's weight in gold. While the gold standard created sometimes uncertain but stable currencies, government monopolized currency created certain but totally unstable currencies. The value of money being set on a material thing (or "specie" as it'd be called) is more stable than a central bank's arbitrary authority in printing paper "fiat" money. Governments having this ability have always been known to produce too much and for the wrong reasons. It's fair to say that governments are not fit bodies to judge the proper value of currency.

Now for the last few paragraphs we've talked a lot about "value". What is value, really? To answer this question, is to delve into the basic principles of trade.

Value is, literally, what you make of it. You may value something for many different reasons. Whatever the value, you cannot extract that value until you put that thing into use - you put it into service or apply it to something. There are many ways a thing can be useful - for instance, if you have a beautiful painting, you may put it in "use" by merely admiring it - even though you are not physically using it, you are mentally using it, and value is (as we said) what you make of it. Food, on the other hand, may be put into use simply by eating it, but whether you like the food might affect how you value it (either way, you didn't determine how much you really valued it till you used it, by eating it, and found out). You may use a shelf by putting books on it and you could use books by reading them, and you likely won't hold much value in a shelf or a book if you don't use them at some point. Use doesn't have to be physical. How you use things is entirely up to you. If you feel like putting shelves on a pile of books and admiring the food while eating the painting, then that's perfectly fine - albeit a little weird, you are still putting these things into your service, to do with as you please. Whether something is valuable because it's useful to you is entirely up to you and what your values are.

However, when we talk about money, we talk about a different kind of value - the potential value of exchange. Why is exchange valuable? Because in exchange, and only in exchange, can you create new value (in usefulness) that wasn't there before. Above we showed how value lies how useful something can be to you - and how you use a thing is entirely up to you. It's only through trade that we can take two things and actually create usefulness from where there was none. For instance, let's say you have two people. The first person has a cow, but doesn't know how to milk it. This person doesn't find the cow to be very useful - he doesn't know what to do with it. Its value to him is slim. However, this person really loves fine oil paintings - if he had more fine oil paintings, he'd hang them up on his walls and admire them every day. Likewise, let's say you have a farmer, who always needs a good cow, but doesn't need his grandfather's antique landscape painting of the farm in it's early days. He doesn't value the painting much since he doesn't personally find a use for it - it's hard to admire a painting when you got to milk cows all day, even when it's an antique heirloom. The value of each of these things, the cow and the painting, are both low, as it stands for now.

Now, let's say the two meet and trade. To the first person, his cow meant next to nothing, but having a fine landscape painting to add to his collection makes him ecstatic. He will grow to use this painting all the time, by doing with it what he will, in this case, admiring it as he goes through his gallery. And to the farmer, who doesn't really care for art, the cow means much more to him in milk and meat than any admiration for the artistic impressions of oil painting. The two people have the two things they originally had; they just switched to gain usefulness. The value of the two things, the cow and the painting, have both increased when they both were once low. This means that more value exists between the two of them, new value was created merely by trading where there once was next to no value. The difference between what the value was prior and what it is now is the "potential" value of trade realized.

The value of use (the "real" value), and the value of exchange (the "potential" value), combine to define what value really is to individuals. But, as we can tell, when you go to buy something, its price does not always reflect its usefulness to you. As we brought up before, a money market is where a currency is declared to set a system of determining the value of things by the quantity of currency. Yet, you could go into a store, and buy something like a chair, which may be very useful to you since you may need one - but to the next person who thinks about buying it, it may not be very useful at all. What if they have all the chairs they need? In this case, the chair's real value to each of these people are obscured by its price, since the price is fixed for both people, in spite of its usefulness changing from person to person. This, however, is not necessarily a bad thing.

There are three kinds of exchanges. The first kind is like the example we used above, two people trade and find more value than they had before, and thus there was a net gain for both parties. Another kind of trade might be if two people trade but one person doesn't find his thing to be as useful as what he had before, while the other person finds his good to be very useful. In this case, one party benefits and the other loses. The third kind of trade is the worst however, when two people trade but realize after the trade that they in fact valued what they before more, which would be a net loss of value. The overall wealth of the nation then is determined by net gains, partial gain/losses, and net losses all combined. If there are too many people trading away valuable things and not getting enough value in return, then the nation becomes poorer. If people trade in ways that benefit each other, then the nation becomes wealthier.

The goal of trade is to attempt to create the largest net gain for all parties. However, the seller of a good knows only how much that good is worth to them - they don't necessarily know the exact value something may be to a buyer. Placing a fixed price in currency allows the seller to declare how much the thing is worth to them and helps ensure that the third kind of exchange - net loss - doesn't occur (in the least, if the transaction occurs, the buyer will gain - any losses will be partial). This is the economic purpose of having fixed prices, stating a standard so all parties don't end up losing from the transaction. A smart buyer then, will approve of buying only what benefits them, and the seller will only sell for what benefits them, and thus, both parties should routinely benefit in such a system.

However, how does the seller know what kind of price to affix to a good? How valuable is it to the seller? Well, Adam Smith touches on this, by bringing in the idea that the amount of labor invested into a good is the true value of it - and thus, the "natural" price of something should reflect how much time an individual invested into making it. But we know that this is not the case for market prices - some goods take only a few moments to make but are expensive (like fine clothes), others (like agriculture) take a long time to develop but are relatively inexpensive.

Smith's idea here isn't that the price of things you'll find in stores are their "real" price, but that the true value of a currency, like the dollar, lies in how much labor you command in spending it (how much actual work goes into providing you the service or product you are buying). This should at least in part command the base going rate of goods. Labor is the only other real method to create wealth - by laboring someone can create something that is more value to himself or others from where there was otherwise nothing. The difference in the value of raw materials (for instance, leather) and the value of a newly created thing (for instance, shoes made from the leather) is the inherent value of labor, and this value is behind everything since we invest labor to create/maintain/supply everything in the market. Everything in the market will have this much value backing it, in the very least, hence creating a "true" value equal to the amount of labor someone has invested to create/maintain/supply it.

Other factors that move prices away from labor, said Smith, were things like the demand of a good (if it is in high demand, that may drive it's price up), it's scarcity (if it's hard to find, that may drive it's price up), the general expenses involved in it's production (if a manufacturer needs to pay a high rent, that'll drive up the price), and the amount of profit the seller may need to acquire from it (or the basic degree of net gain from the transaction the seller may need for it to be worthwhile). If everything was traded without the profit considered, then businesses would never be able to invest back into production and expand, and people would spend a lot of their time and energy in engaging in trade that isn't worth their time. Wasting away doing something unimportant is usually not how people like to do business. Profit can sometimes be said to be the basic value of your own time and energy making a trade happen, and if this is true, profits will typically center around the value that best compensates the seller for their time and energy in making the trade happen.

If the real value of goods lay in labor, then the potential (exchange) value of currency is in the amount of labor you can command with it combined with the amount of benefit you get from trading it. Now, markets aren't static, but if this principle is true then even the most dynamic economy will migrate towards a stable price system (so long as the currency is not hyper-inflated or hyper-deflated), and that will create a long-term stability in prices to reflect what's the best value for everyone. Prices should then only change as the real-life conditions of profit, expense, demand, supply and most importantly, labor command them to. As things are easier to merit trading, cheaper to make, demanded less, in higher supply, and more importantly easier for people to provide - the market prices will reliably fall.

More importantly, a price fall or a price increase will reflect in some way the total value of a good (it's "real" and "potential" values). In this situation, the economy is fair, and I call that state Economic Equity. As things become inequitable, if for instance, someone demands too much or too little, the market changes to tell people. The same goes for inflation or deflation. Or even bartering, trading cows for paintings. I voluntarily trade, and if you voluntarily trade, assuming we use good judgment of our own values, we both will benefit. Pending outside interference, these are the laws that govern the value of your cash. An equitable market, in some ways, is the only market where people really value the time and labor they put into it.

So, thus far, we've established a lot of points about money and where it's value comes from.

1. Money that is tied to a "specie" (or physical commodity - like gold) is more balanced and stable than government paper fiat money (like what we currently have)

It's true that inflation occurred less when the dollar was tied to gold through the "gold standard" of exchange. This kept money from being overminted/underminted. When the U.S. government got rid of the gold standard, it did so to confiscate federal reserves of gold and have a monopoly over the printing of money. Since the early 1970's (when the last vestiges of the gold standard fell), rising prices and increased inflation of the dollar are very evident. Prior to that an unorthodox gold standard let some inflation slip by, some say the unwillingness to practice a traditional gold standard contributed to the Great Depression.

Just look at how much food, clothing and other common commodities were worth in 1970, and compare that to now. Ever go to a movie theater? Hear people in line complaining about how the movies used to be far cheaper then as opposed to today? That's part of the evidence of an inflating dollar. The Federal Reserve is in charge of controlling how much money is printed, and thus, inflation and deflation. However, it blames the problems of "business cycles" - the "booms" and recessions - on every factor but itself. I'll discuss at a later time how this boom/bust "business cycle" is another part of the New American Myth.

2. Value comes through use (in any form) and is dependent on the individual

Another important thing to remember is that we value things for different reasons. I love video games and the internet, but someone else may love biking and the wilderness. I value my computer more than a bike, but the opposite might be true for someone else. It's the computer's usefulness that is the only real expression of how valuable it is to me - if I can't put the computer in use, I might as well not have it. This kind of "use" doesn't have to be physical - I can "use" my painting by merely admiring it, for instance, or a book by reading it.

3. Only through labor and exchange can total wealth increase

If what we value is what makes us wealthy, then by trading we can create wealth from where it wasn't before. If I had a bike and my friend had a computer, we could trade, and both value what we have more - the collective value of both items going up means that new value exists where it didn't before. Only through trade can we take what we now have and create value from what was otherwise not there.

Likewise, if we invest time and energy into making something, we can create something more valuable than the parts of what was before. The wealth created by labor is part of what is meant when we talk about the "real" value of money being based on labor.

In a sense, labor provides the real investment, and trade provides the real return.

4. Property has two values, the "real" value (it's usefulness) and it's "potential" value (the possible value that can be created through trade)

Money, a unit made entirely for exchange and trade, is a unit of potential wealth. Paper fiat money has no "real" value, while money in a system of convertibility (such as the gold standard) has a "real" value based on it's worth in bullion. As we said before, having money that only has "exchange" value and no "real" value is very unwise.

5. The real value of market prices is labor, while modifying factors like expenses, profit, scarcity, demand, and other things create a common market price (in a free market) that tends to reflect the best possible dollar-for-product exchange rate

Pending outside interference (like by a government), self-interested individuals who trade are guided by an invisible hand (as Smith calls it), and will likely only engage in trade that creates net gain (which makes the nation more wealthy - or valued) as opposed to net loss or partial loss. This is why our market works successfully today.

6. Economic Equity, the condition of a fair market, is the only situation where your money has it's fullest value

What is a fair market? When we each are free to decide for ourselves what our values are - so we can fairly decide what is really a net gain for us and what isn't, thus, the optimal condition for people who want to trade at net gains instead of losses. When we trade regularly to find ourselves at net loss after net loss in a fair market - that can sometimes be a sign that the market is no longer truly valued by the people. For instance, when automobiles were created, the market for horse-drawn carriages underwent massive losses until it virtually disappeared. It was because people freely decided they didn't value carriages as much anymore. It's pretty easy to see how that was a fair judgment in light of the benefits of cars and mass transit for people in general.

But in nations like the Socialist Soviet Union, we saw markets experience net losses in basic needs like agriculture, clothing and housing. Does that mean people no longer truly valued these things?

No, of course not. Some systems, like Socialism, interfere with trade in even basic necessities like food and water to such a degree that people have the "net loss" of starvation and thirst. This creates unfairness in the market, or Inequity. The trend of Inequitable markets typically start with people who don't know why they value the things they do, be it money, corporations, gold, or even cows.

Please come back and join me next time when I try to tackle shed a little light on another important issue, perhaps exposing important pieces of the New American Myth. I'll try not to be as long-winded as I was this time! To find out more about me or get contact info for feedback, just check out my writer's profile.