The Speculator’s Edge, Three

The Speculator’s Edge, Three

Basic Economic Concepts essential to Speculation

3) Money and Price

  

Now suppose Fred takes a box of burgers over to Murray, the roof repairman. As it turns out, Murray has just returned from the doctor, who told him to cut down on cholesterol. This puts Fred in a spot because, while Murray has something Fred wants, Fred doesn’t have anything Murray wants. Or does he? It turns out that Murray is a sportsman who likes to hunt on weekends for fun. Murray sees Fred’s new club and says he would gladly re-roof Fred’s hut in exchange for one just like it. So back Fred goes to Barney’s, where he trades the box of burgers for another club. Then he returns to Murray’s and makes the deal.

Something important has happened here. Instead of purchasing the second club for his own consumption, Fred traded first with Barney for the purpose of entering into a second transaction with Murray. In other words, Fred’s demand for the second club reflected nothing more than its exchange value to him. Its consumption value was important only to Murray. This is called an indirect exchange. Virtually all exchanges made in advanced society are of this nature.

Fred, Barney, and Murray now have a problem. Obviously, clubs and brontosaurus burgers are not particularly useful media of exchange. What is needed is something easier to carry, more durable, with generally recognized beauty or utility. Nails, gems, copper, nickel, silver and gold are all candidates, and, in fact, have been used by one society or another. One by one the alternatives get whittled down, usually not by any formalized decision process, but by custom and usage. Today the most universally recognized medium of exchange (excluding for the moment bank notes of the U.S. Federal Reserve and other currencies) is gold.

We are now in a position to define money…In the narrowest sense; money is a commodity that is universally employed as a medium of exchange. I say in the narrowest sense, because as we have become more sophisticated we have often replaced commodity money with other forms of money that have no underlying commodity value. Like dollar bills or the bits and bites in a computer and/or cyberspace that represent dollar bills.

 

It is astonishing that, for all the fuss we make about money, so few of us understand its nature or from whence its value derives. Money originated as commodity money. Initially, it had no value other than its consumption or production value. However, as its usefulness in facilitating indirect exchanges grew, its value also grew to a premium over its commodity value. It acquired money value. Unlike other goods, the value of money as money depends solely on its usefulness in facilitating exchange. Take away its exchange value, and the value of commodity money reverts back to its commodity value. From 1873 until the early 1930s, the value of silver declined as most countries demonetized it in favour of gold. During World War I, as many countries replaced gold with bank notes and Treasury notes, the value of gold declined as well.

The almighty dollar is the ultimate expression of the evolution from commodity money to what we call fiat money. Not long ago it was backed by silver – that is, the paper money could be exchanged for (substituted) for a given quantity of silver, a commodity that had both commodity value and money value. Once liberated from its precious metal backing, the dollar became nothing more than paper money – that is, its commodity value disappeared. The dollar is called fiat money because it is created out of paper by fiat of the United States government. Its current value is based on custom and belief only. If anything happened to destroy that belief, its value would revert to its consumption value only – that is, it would be worth the paper it is printed on, nothing more. 

Now that we know what money is, let’s return to our friends, Fred and company, to find out a little more about price and utility.

Let’s suppose Fred had five pieces of gold. Let’s suppose that Fred knew Barney would give him a club for ten pieces of gold and that Murray, who decided not to follow his doctor’s orders, would exchange five pieces of gold for a box of brontosaurus burgers. Obviously, Fred’s best course of action is to sell the burgers to Murray and then take the ten pieces of gold to Barney’s and buy a new club. We could say that one club cost two boxes of burgers, and indeed it did. We also could say that one club cost ten pieces of gold (or ten dollars if dollars happen to be the common medium of exchange), and we usually do. In other words, the price of a good can be expressed in terms of any other good for which it can be exchanged, or it can be expressed in terms of money. Remember, money is a commodity in most respects like any other commodity.

Now, is one club really worth two boxes of burgers simply because Barney said so?...Of course not.

Remember, it takes two to make a trade. A trade takes place when and only when there is disagreement on the utility of the goods exchanged. In fact, there is no such thing as fair value or true value in an economic sense. The market is nothing more than a series of trades among individuals who disagree as to the utility of the goods or services traded.

You now know all you need to know about what prices are and how they reflect the basic needs of the individuals who come to the markets. But what causes prices to be one thing and not another? What can we say about how objective prices are discovered?

Stay tuned…

The Speculator’s Edge,

Albert Peter Pacelli