The Value of Nothing

The stock market as a consensual hallucination

For the WSJ, T.J. Stiles writes,

The 19th-century mental architecture of finance was concrete, built directly on the physical world. A share stood for a set amount of tangible stuff, which limited stock volume and value.

Until very recently, people thought of the economy in tangible terms. In 1900, the price of gold in the United States was fixed at $20.67. The government stood ready to buy or sell gold at that price. It could only issue dollars to the extent that they were backed by gold.

Today, the government can issue as many dollars as it needs to close the Budget deficit. Anchored to nothing, the value of a dollar is a consensual hallucination.¹ We accept payment in dollars because other people accept payment in dollars. People are accustomed to receiving a particular amount of dollars each pay period, keeping a lid on inflation in spite of the ever-increasing supply of money.

In 1900, a share of stock was, like the dollar, backed by something tangible. Stiles writes,

At the time, typical shares were issued with a face value of $100 each, known as par value. This was supposed to represent an expenditure of $100 on real capital—land, physical plant, rolling stock and the like. If you founded a railroad and needed to spend $6 million to build it, you were supposed to issue 60,000 shares with a par value of $100.
Par value mattered to Americans, who thought it made shares tangible and honest. The market value was expected to fluctuate around this figure, not steadily rise. Investors looked for a return in the form of dividends, often called “interest on capital.” In other words, one share’s stock certificate stood for $100 of physical stuff, which management used to make a profit, which was distributed as a dividend.

Stiles tells the story of how this changed, right around 1900. Share prices began to rise far above par value. Investors began to enjoy the capital gains that we now think of as a normal part of the return on investing in stock.

But the idea of stock as shares in tangible capital persisted. Fifty years ago, when I was in graduate school, we were taught the theory of “Tobin’s q,” which was the ratio of the price of a stock to its cost of plant and equipment. It makes sense that when q is greater than one, firms will want to invest more. One of my grad school contemporaries, Andy Abel, became a well-known scholar investigating how this played out in practice.

Today, however, share prices have almost nothing to do with plant and equipment. That is because the so-called “factors of production” of neoclassical economics are not what is important. As Nick Schulz and I wrote in Invisible Wealth, intangible factors matter more. Wealth comes from innovation in the context of well-governed markets. We have arrived at what Jonathan Haskell and Stian Westlake called Capitalism without Capital.

I receive a transfer from a Dotcom IPO

I had a close-up view of stock market “wealth creation” during the Dotcom era. In the 1990s, I started a web site called Homefair.com. A competing web site, called Homestore.com, sold stock to the public. They bought Homefair.com with some of the proceeds.² More than ten years later, The FBI wrote,

The former chief executive officer and chairman of the board of Homestore.com was sentenced this afternoon to 4½ years in federal prison for presiding over a scheme to commit securities fraud by artificially inflating the publicly traded company’s advertising revenue to appear to be more profitable to Wall Street analysts.

…“round-trip” transactions that were designed to artificially inflate Homestore’s revenue in 2001. In the round-trip deals, Homestore paid millions of dollars to vendors for products and services that Homestore did not need or never used. The sole reason for paying the vendors was to start a circular flow of funds that would improperly return to Homestore as revenue.

Note that Bloomberg’s Matt Levine likes to say, “Everything is securities fraud.” The concept is sufficiently vague that perhaps no executive is innocent.

I knew nothing about what Homestore was doing. They were in California, and I was in Maryland. Shortly after we were acquired, I sent a memo to the CEO criticizing how the company was run. I forget what I complained about, but this is just typical behavior for me. He fired me, and I stopped paying attention to the company. The terms of the acquisition locked me out of selling the stock for a year, by which point its price had plummeted.

But the portion of the proceeds from Homestore that was in cash retained its value. In effect, some of the investors in the Homestore IPO transferred money to me.

What determines stock prices?

Share prices are no longer anchored in physical plant and equipment. Today, they are supposed to be anchored to corporate earnings. The behavior of corporate profits is the supposedly objective support for stock prices. And yet:

• SpaceX debuted on the stock market with a market capitalization of over $1 trillion, even though it had negative earnings. Even its sales were less than 2 percent of its market capitalization. Every pay period, in addition to being paid in dollars that are a consensual hallucination, many workers accept part of their pay in the form of 401(k) plans, which often invest in index funds. Every one of us who has shares in a broad market index fund will wind up an investor in SpaceX. (As I understand it, one year after the IPO, SpaceX will join the S&P 500.)

• So-called “meme stocks,” such as Gamestop, experienced sharp run-ups in share prices even though they were not profitable

• Strategy (formerly MicroStrategy), which purchased Bitcoin, had a market capitalization much above the market value of the Bitcoin that it held

Stock prices, like the dollar and like Bitcoin, are a consensual hallucination. If people stopped believing in them, there might be little to support them.

In theory, earnings should be the driver of share prices. But it can work the other way around. The managers of a firm that enjoys “meme stock” status can buy assets that generate earnings. Companies in the AI ecosystem can use investor funds to initiate purchases from one another, generating one another’s earnings. It would take someone with a sharper legal mind than mine to explain how what those companies are doing differs from what the former CEO of Homestore was accused of doing.

In addition to whatever real value is in stocks today, one can view them as chain letters. A chain letter is a wealth transfer from large numbers of people at the bottom of the chain to a few at the top.

To me, Bitcoin is like a chain letter. Today’s buyers of bitcoin are counting on tomorrow’s buyers to drive the price up further. Bitcoin transfers wealth from large numbers of people who invested late to a few people who invested early. When the supply of suckers runs out, Bitcoin’s price collapses, until new buyers come on the scene to start to pyramid upward again. When it finally crashes for good, even the early investors will not do well unless they happened to be the few who cashed out in time.

It could turn out that today’s tech stock darlings are also like chain letters. They transfer wealth from the broader public to the initial owners. When the supply of suckers runs out, the share prices will collapse. Even the early owners will not do well unless they cash out in time.

The alternative view is that stock prices are high because the companies are creating real wealth. That could be true. It is impossible to prove it false. The very term “real wealth” is undefined. So much of the economy is intangible. We have more stuff, but mostly we are better off because of innovation, specialization, and trade.

We are telling ourselves that we are wealthy. The government has borrowed money from us, and we expect to get paid. We own shares of stock, and we think that we can always sell them for a good price. It will all turn out fine in the end. Unless it doesn’t.

Have a nice day.

1. I allude to William Gibson’s 1984 novel Neuromancer, in which he coined the term “cyberspace,” calling it “A consensual hallucination experienced daily by billions of legitimate operators, in every nation.”

2. My share was deservedly small at this point. I had obtained partners who were entitled to most of the business, we had received an investment from a media company, and we had merged with a related web-based business.