July 23, 2023
by Stephen Stofka
This week’s letter is about prices and two dynamic values, a use value and an exchange value. These two values can help us compare assets if not goods. I’ll review a short history of thinking on price and value. How does the passage of time affect different types of assets? Lastly, how sensitive are some assets to investor temperament?
The insights of prominent thinkers in the past can inform our perspective. Richard Cantillon (1680-1734) was a financier whose keen understanding of human exuberance enabled him to make a fortune in the stock market bubbles of the South Sea and Mississippi System. He argued that there was an intrinsic value to a commodity that was the sum of the inputs, land and labor (capital was included in land). The ratio of supply and demand as well as “humors and fancies” explained the variance between market price and intrinsic price. In a well-organized society, the market price and the intrinsic price tracked each other closely.
Writing a few decades later, Adam Smith would refine the classification of prices further. A market price included the rent of the land, the worker’s wages and a capitalists’ profit. A natural price was the average of market prices and a price that a customer expected to pay when going to market. Finally, there was an exchange price, a measure of purchasing power. Writers of that time distinguished between commodities, or subsistence goods, and goods of an artisanal nature, affordable only to those in the middle and upper classes.
In Book 1, Chapter 4, Smith distinguished the two meanings of the word value. The first was a value in use, the “utility of some particular object,” whose value is consumed. Utility depends on the person, their circumstances and preferences and cannot be measured. The second is a value in exchange, the “power of purchasing other goods.” Commodities like a pound of corn have both a use value and an exchange value but Smith made it clear that the use value of a commodity does not anchor its exchange value. He noted that many goods which have a high use value like water have a low exchange value, and those with a high exchange value like diamonds have little or no use value. Smith spent the following three chapters exploring the connection between exchange value and price.
As he compared standards of living in different ages and countries, from neighboring France to the American colonies, Smith was looking for a yardstick, a standard of measure. Economic institutions today compile extensive price and income indexes to compare prices across time and countries. Smith had limited manpower – himself. He chose a laborer’s toil as “the only standard by which we can compare the values of different commodities at all times, and at all places.” He was careful to note several caveats. It was “difficult to ascertain the proportion between two different quantities of labor” and the “real price of labor is very different upon different occasions” and in more advanced societies. Regardless of prices or the value of gold and silver in England and the American colonies, he could compare the purchasing power of laborers in each country doing similar work.
Smith’s grand thesis was that greater specialization of labor increased productivity and fostered economic progress. Within this framework, people would more frequently exchange their labor rather than consume the goods their labor produced. For Smith, labor was an “exchangeable value,” not some value inherent in a commodity. He used it to construct a measure of purchasing power. Almost a century later, Karl Marx would distort this yardstick of purchasing power into a qualitative claim that the labor input to a commodity was the intrinsic value of the commodity. Anything above that value was an exploitation of workers by capitalists, according to Marx.
Let’s extend this analysis to asset, which I will divide into two types: those that derive an exchange value based on ongoing operations and those that don’t. Ongoing operations can be likened to a use value because something is consumed in that operation, a depreciation. There is an explicit or imputed flow of income whose discounted value influences the market value of stocks and bonds. Time-sensitive financial instruments like stock options act like insurance and are very much anchored by ongoing activity and the expectations formed from those operations. The market value of real estate may rely on scarcity, like a collectible, but the scarcity aspect contributes to expectations of future income that the real estate can earn. Therefore, its market value is also anchored by operations.
Collectibles are an asset without any ongoing operation. They derive their market value from their scarcity or uniqueness. A painting may bring pleasure in the viewing but the enjoyment of that pleasure does not consume the painting. Time, yellowing and dust may introduce a depreciation expense but time usually increases the market value of the painting. Money can be a collectible but only if it is rare. Digital currencies behave very much like collectibles but there is nothing to hang on a museum wall. For traders, the chief attraction of crypto is the possibility of future trading gains. Unlike stocks, crypto does not represent ownership in operating profits. Unlike bonds, crypto is not a purchase of someone’s debt. Unlike real estate, crypto does not generate any cash flows from its use value.
Some assets with little ongoing use value have volatile valuations because their chief use value is the hope of future trading profits to the holders of the asset. Their use and trading values can collapse suddenly as though they were a time-sensitive financial asset. Being alert to that imminent collapse helped Richard Cantillon make a fortune. Investors in such assets must remain nimble.
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Photo by Sean Stratton on Unsplash
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