Suppose that I own a share in an oil field. The oil is real wealth. The shares are paper wealth. The value of the oil is determined by supply and demand for oil. The value of the shares is determined by. . .?
[“Paper wealth” is, like “carbon copy,” an anachronistic phrase in the digital era. Bear with me.]
The hypothesis of strong efficient markets would say that oil share prices reflect precisely the value of the underlying oil, both now and expected in the future. But for those of us who don’t believe in strong market efficiency, oil price shares can diverge from the value of the underlying oil. Paper wealth can be higher or lower than real wealth.
The value of oil itself is not intrinsic to oil. Before inventors came up with the technology to convert oil into useful energy, oil was just annoying gunk. Environmentalists hope for a renewable-energy future in which oil reverts to being just annoying gunk.
Otherwise, oil is relatively easy to value. It is a tangible resource that has measurable characteristics, such as the volume of oil in a field and the energy density of the particular type of oil in the field.
To illustrate real wealth that is harder to value, consider a fictitious example devised by George J. W. Goodman, writing as ‘Adam Smith’ in Supermoney, published in 1973. [note: if you want to update this example to make it seem closer to the present, multiply every dollar amount by 10]
There are two Park Avenue doctors swabbing children’s throats. They are doing a land-office business. Together they make $100,000 a year.
…They form Pediatricians, Inc., meet the hungry underwriter, and sell stock to the public at thirty times earnings. Their after-tax net is $50,000, so their stock is worth $1,500,000. Now, when they want to pay grocery bills, they peel off some of the $1,500,000, as much as the market can stand. They have moved into the Supercurrency class. If their auditors had made a statement of their net worth before, it would have consisted of stethoscopes, fluoroscopes and a jar of lollipops. Now their net worth is $1,500,000—partly in cash, which they sold to the public, and the rest in their stock. Their old net worth—the sum of stethoscopes, fluoroscopes and lollipops—came, let us say, to $10,000. Their new net worth is $1,500,000. The difference of $1,490,000 is new money to the economy, just as if the Fed had printed it, and should be included in all the calculations of the money supply.
In this hypothetical example, no new real wealth was created. The real wealth is in the medical practice. But the real wealth is more than just the jar of lollipops and other tangible assets. The value comes from the medical qualifications of the pediatricians and the loyalty of their swanky Park Avenue clientele. But only by creating a corporation and issuing stock can the doctors monetize this wealth immediately, rather than waiting for patients to pay their bills year after year.
In a strongly efficient stock market, the shares in Pediatricians, Inc. would be worth $1.5 million. As earnings come in from the medical practice, the dividends paid by the corporation going forward are worth $1.5 million today. Another way of saying this is that if the shares are priced correctly, then the practice today has $1.5 million in real wealth.
A lot of us are used to equating “real wealth” with tangible wealth. For example, in 1969, James Tobin (later a Nobel Laureate) proposed that the ratio of the market value of a firm’s shares to the replacement cost of its tangible capital would be a useful indicator. This ratio since has become known as Tobin’s q. In the original theory, if q=1 the firm has the right amount of tangible capital. If q is less than 1, then the firm should sell off some or all of its tangible capital. If q is greater than 1, then the firm should expand by investing in more tangible capital.
Tobin’s q for Pediatricians, Inc. would be $1,500,000/$10,000, or 150, which seems ridiculously high. That is because most of the value of Pediatricians, Inc., is in intangible assets. In other words, Tobin’s q might be a decent approximation for valuing an oil field, but not a pediatric practice, where the real value cannot be found in the lollipop jar.
Most of our economy today is more like a pediatric practice than an oil field. A lot of value is intangible. In fact, much of the intangible economy is more difficult to evaluate than a pediatric practice. How much are shares of Uber and Lyft worth? Unlike the pediatric practice, their earnings history is probably not a reliable guide. How much are the various digital coins worth? It depends entirely on crowd behavior.
All wealth is socially constructed. We saw this with oil, which can be nothing but annoying gunk if the culture says so. In fact, wealth arises from patterns of specialization and trade, which do not reside in any single firm. To put this another way, the wealth of Apple or Amazon is influenced by all sorts of cultural factors, the behavior of suppliers and competitors, and government policies.
But the values of paper wealth nowadays are particularly arbitrary and subject to rapid changes in crowd behavior, because so much of that wealth represents intangible assets. Trying to value Apple on the basis of its buildings and equipment would be like trying to value Pediatricians, Inc. on the basis of its lollipop jar.
If this weren’t enough ambiguity, the government has in recent decades decided to dump unprecedented amounts of paper wealth into the economy, in the form of bonds to finance deficit spending as well as the balance sheet operations and regulatory machinations of the Rube Goldberg Fed.
My analysis is that the inflation we are now experiencing is the result of the ratio of paper wealth to real output having gotten out of hand. If this is correct, then in order to tame inflation, some of the paper wealth has to be wrung out of the system. Maybe a crash in financial markets will do that. But a less dangerous solution would be for the government to reduce its spending.