basic theories of economics in retrospect

[The following is reprinted from a now-defunct blog. It was originally published on the internet in 2006.]

You know what I was thinking about last time I was in London? I was standing in the Underground next to the tracks and I was thinking about the electrified rails and the speeding trains and the depth of the trench the tracks are in and I was thinking that standing next to the tracks in the Underground is as dangerous, in its way, as standing in front of a loaded gun or standing near the edge of a 100 foot tall building. I think about that sometimes with cars too, like when I'm standing on a corner waiting for the light to change cars go by doing 40 mph-- they go by within a foot or two and I don't even think about it. Life's full of that kind of shit. The trick is not to look down, or you'll freeze up-- but you don't want to ignore it altogether. That can be just as dangerous.

Here's one I've been thinking about a lot lately:

So, like, most of us live in a capitalist economy and -- I think most people know this -- capital is stuff. Specifically, capital is stuff you use to make other stuff. So, like, iron ore is capital; trucks you use to move ore from the mine to the factory are capital; machines you use to turn ore into steel are capital; steel you process into sheet metal is capital; sheet metal is capital; a hydraulic press you use to stamp sheet metal into spoons is capital; replacement parts for the press are capital. The spoons might be considered capital if they're going to be, like, put into a kitchen set prior to being released on the market; or you can think of them as capital in a home economy. Food cooked at home has market value even if it isn't ever released into the stream of commerce, because it is competitive with goods and services that do run in the stream of commerce. Basically, capital is assets.

Alright. Now, the value of any business is equal to the total value of all its capital, minus its debts. Shares in a company or firm represent a portion of the net value of the business. The interesting thing is this:

Imagine a firm owns 100 widgets and has no debt. It offers 100 shares of stock for sale. In real terms, each share of stock is worth one widget. In practical terms each share of stock is worth the market price of the widgets the company owns. So if the company's widgets sit around for a while they'll get old and they may sell for less than the price of new widgets. When that happens the cash value of the stock drops-- but each share is still worth a widget. For most intents and purposes this is six of one half dozen of the other. Most countries have laws about how a company can be liquidated that require them to give you cash rather than widgets. But it's worth keeping in mind that there's a difference between what a company is and what it's worth.

Which brings me to the thing I've been thinking about lately.

When a firm offers stock (or shares or whatever) for sale, the trading price is usually higher than the real value of the firm based on anticipated increases in the value of the company due to profits and subsequent re-investment of same. Right? So if you've got a company that uses widgets to make doohickeys and the doohickeys are selling at a good profit then the company will use its profits to buy more widgets. After a year the company has twice as many widgets as it used to; now they've got 200 widgets. But each share of stock is still worth 1/100 of the company (2 widgets), so each share has basically doubled in value. When the company offers the initial 100 shares for sale, investors will look at the company's profits and speculate that the shares will be worth more than 1 widget each in the future-- so they'll pay more for the shares in order to outbid other investors and reap the returns at a future date.

But how much do they bid up? Ten percent? Twenty? Ha! Noooo. They bid up by whole number multiples of the value of the company. Big numbers. You can get an idea (certainly not a precise idea, but some idea) of the discrepancy between value and price by looking at the price/earnings ratio, which is the current price per share divided by the earnings per share for the trailing twelve months (the last year). So, like, if Starbucks has a P/E ratio of 52.59, that means that the current price of the stock is 52.29 times the company's gross earnings (after depreciation, tax, interest and dividends paid to holders of preferred shares) for the last 12 months. That doesn't necessarily mean anything -- maybe the capital the company has on-hand returns relatively small earnings on investment and if you liquidated the whole shebang tomorrow you'd get your money back and then some. But really, you gotta figure there's some pretty fuckin' wild speculation going on when you see a P/E ratio like that.

Of course the actual value of a company like Starbucks is basically impossible to calculate for various reasons -- but if you're wondering why someone would even consider paying that much more than a company is earning (or worth or whatever) it's useful to get back to our widget company. If they make enough profit in a year to double their capital base -- and all other conditions remain constant -- it follows that the annual doubling could continue indefinitely. At that rate your initial investment of $1 is worth $64 in something like 6 years. That never actually happens in the real world (or rarely, at any rate), but it's easy to see why someone would be willing to invest well beyond the current value of a firm, and it makes the idea of a 52.59/1 P/E ratio for Starbucks seem slightly less irrational.

Now, where things start to get interesting -- and by "interesting" I of course mean possibly Very Very Bad -- is when you start figuring in money.

Because -- and here again, I'm sure most of you know this -- money isn't capital. Money is a medium for transferring debt. An IOU for one cow is money. The slip of paper is worth a cow; a cow is worth so many chickens and so many pigs and so on and you can trade the piece of paper for that many chickens or pigs or some combination thereof. It's easy to get fucked up and start thinking of the piece of paper as having intrinsic value but it's only worth what it represents. So its trade value in relation to other things is directly connected to the trade value of the capital backing the money relative to other capital. That's Thing One.

Thing Two is, IOUs have to come from someplace; the piece of paper comes from a specific person or farm or whatever. So for practical purposes, the IOU isn't just worth "a cow." It's worth a specific cow; it's worth Bessie. An IOU for Bessie is still money but if a screw falls out the ranch gate or something and Bessie gets loose and goes wandering and gets hit by a train, the value of your money relative to chickens and pigs and whatnot is drastically reduced. Likewise if Bessie gets old or steps on a nail and gets lockjaw or whatever. The holder of the IOU can try to defer those risks onto the person who issued the IOU by stipulating that the issuer has to provide a cow in good physical health and so on, but really those guarantees are a legal fiction; if the cow gets hit by a train it gets hit by a fuck'n train, and Farmer Bob isn't just going to pull a new cow out of his ass. So the value of money doesn't just change in relationship to the machinations of some invisible hand; it changes in response to specific circumstances, i.e., Farmer Bob and Bessie.

Things One and Two describe the shape of a problem that people have been having with money for centuries, which is that it's not actually a safe medium for investment. Which confuses people because it seems like it should be: if I buy a cow, the cow can be stolen or killed. I have to watch it all the time and make sure it's being taken care of. So my investment is always at risk. On the other hand, if I have a slip of paper worth a cow, I can just stick the slip of paper in my pocket and forget about it. But the thing is, someone still has to take care of the cow or the paper isn't worth shit.

(And I'll just take a moment here to note that the kind of money I talk about above is a very specific kind of commodity currency that is obviously very different from fiat, or fiduciary, currencies in many respects; however, for our purposes here today, the differences are not so great. Fiduciary currency is still tied to real-world variables, even if those variables are much more complicated than the value of the figurative cow.)

People have spent a lot of time trying to get on top of this particular problem with mixed results. And by "mixed" I mean "various kinds of bad." Because whatever Farmer Bob might promise you -- however hard he might try to keep an eye on Bessie -- the fact is that screws just fall out all the time. The world is an imperfect place. And nowhere is this more apparent than in the history of monetary and fiscal policy.

But wait -- how does all this relate to capitalism and the London Underground?

I'm glad you asked.

Back in dinosaur times, governments based the value of their currency on gold. So the IOU was for a certain amount of gold. That stabilized the value of currency relative to most commodities but it also prevented deficit spending which meant that it was possible for a government to just run out of money. After that happened a couple of times and the global economy collapsed causing untold human misery and death, most governments got rid of the gold standard and went over to what I call the Um System. The way the Um System works is that a wizened gnome in a bomb shelter somewhere controls the value of money by controlling how much of it is available. He or she does this, basically, by setting the interest rate that the government charges banks for money it lends them: low interest rates mean that banks can get more money from the government and offer it to the public in the form of credit. High interest rates mean that banks can't get as much money and they have to cut back on lending in order to meet their reserve requirements. The gnome has a lot of very complex indicators that guide his or her behavior around all this and some even more complex ways of making the money available (buying debt, etc) but all most people see of the whole business is kind of the economic equivalent of Groundhog Day. The Chair of the Federal Reserve comes out of his or her hole, sniffs the air, looks around with squinty eyes and says, "Um... today, the Federal interest rate will go..."

If the rates go down, it's party time. Otherwise you've got six more weeks of Top Ramen.

Okay, so, remember what I was saying before about the real value of a company compared to the price of its stock? The upshot of that is that the total trading value of all the stocks on, for example, the New York Stock Exchange vastly exceeds the real value of the companies that are being traded. So, like, it's possible for the value of the stock on the exchange to just drop. And it can drop for a good long while: the bottom is way the fuck down there. And one of the interesting things about that state of affairs is that it actually makes it sort of difficult or impossible to safely invest in capital that's attached to successful businesses because any successful business is publicly traded-- and therefore totally inflated. So you can either buy some iron ore and a truck to ship it in or you can buy some stock in Starbucks and hope you don't get zapped -- the road between those two points is weirdly devoid of intersections. But the fact is that a really stunning volume of money is tied up in an economy that is, for most intents and purposes, a mass hallucination.

But then you reckon into all this the fact that money isn't really worth anything either and that its value as a medium of exchange is based on, for example, foreign exchange rates that can be negatively impacted by Federal deficit spending, and -- well. You know...

Looking over the edge of a very tall building. Having a loaded gun pointed at you. That kind of thing.