I don’ think there’s any reason to be snippy. The theory of economics as applied to cabbages is both well understood and not germane to this discussion. Money, stock shares and loans can be treated as representation, or they can be treated as text. Money originally was used to manipulate real “stuff”; however, because it is itself “stuff” (at least items are individually definable) money can manipulate itself. Matt is trying to make a point about interpretation of value of abstract representations of value (loands and stock shares). What I understand of his position I think is incorrect, or I don’t fully understand his position, but it is certainly not subject to trivial refutation.
The phenomenon of money is weird, and it can lead to some seemingly bizarre results (e.g. valuing a stamp or coin at greater than its face value), but unless money is actually created by a bank, brokerage (stock purchase on margin), or government, the macroeconomic consequences are benign. The current credit economy is a giant Ponzi scheme. What keeps it working is the constant influx of new wealth. Without that new wealth the whole system collapses into depression.
Let’s go through the whole company creation process in some detail. Perhaps we can point to the exact transaction where our interpretations differ.
I wish to create a widget factory. Widgets are currently selling for $11, and they typically cost $9 to make, an 18% profit margin. Demand exceeds supply; the $11 price includes a premium, since buyers are competing for available widgets. I think I can create widgets for $8. Since I will increase the supply, I can’t count on the premium, so I have to calculate the price at $9, a 12.5% profit margin.
In order to create a million widgets a year, I need $1m to buy the widget-making machines and $1m to hire, train and pay the workers, salesmen and administrators until sales get going. Of the second $1m, $200,000 will go to startup costs and $800,000 will go towards ordinary costs of creating and selling the first 100,000 widgets.
I create an empty corporation. This corporation has 1m shares. What is the value of the shares and how many should I sell? They have zero intrinsic value, they don’t represent a dime of physical wealth (except for my own intelligence and creativity). I need to raise $2m with X shares, so I must sell shares for $2m/X each. If I sell all the shares, I must receive $2/share. This is the minimum cost.
Because I’m honest (and I fear the police), an investor knows that some portion will go into actual physical wealth (the factory equipment). That makes the expected present physical value of the share $1 ($1m in equipment/1m shares). This is the minimum value. The shares also have a future value. I should be making $1m/per year in profit. Essentially, I will be creating this much new wealth. Lets assume a 10:1 P/E ratio is expected. This makes $10 the maxiumum value.
There is risk involved. I might not be as good a businessman as I think I am; it might cost $8.50, $9 or even $10 to make a widget. Obviously if it will cost me $10 per widget, and my increased supply drives the price down to $9, I’m going to go bankrupt and the shares would have a future value of exactly $1. So the negotiation of value of a particular share will float somewhere between $1 and $10 depending on the perception of risk. I analyze people’s perception of risk and think that people will buy for $8/share. Note that if the perception of risk makes the stock price go below $2 a share (the minimum cost), it becomes impossible for me to start my business.
I now sell 125,000 shares (12.5%) of stock for $8. I now have $1m in the bank. The company is now “worth” 8 million dollars! Since I’ve granted myself 125,000 shares, I’m worth a cool $1m. Where did this money come from? The answer is, it didn’t. There’s still only $1m of actual money floating around. It’s merely been tranferred from the investors’ pockets to mine. Has $7m of wealth been created? Yes and no. It is expected that over the next ten years I’ll create at least $7m in new wealth (I’m projecting that I’ll create $10m). This future value has been represented in the present value of the stock. But it’s still a phantom; we can’t eat the future value.
What’s happened to the dollar, though? Has its purchasing power been eroded? No! There are still the same amount of dollars chasing the same amount of physical resources. Nothing important has changed about the present representation of currency. If anything, the currency has deflated; There is $6m of new value (representation of future value) for the same number of dollars to chase.
The day after my IPO, Matt comes along. Matt thinks I’m the greatest businessman since Bill Gates. Not only does he think there is little risk that I can make $1/widget, he thinks I can make $1.50/widget! He therefore assigns a maximum value of $15/share to the stock. He wasn’t stupid; rather than entering the IPO and driving up the price to $10, he looks for people who bought the stock at $8 and are willing to sell for $9. He is exploiting a differential in perceived risk. So he buys 100 shares from a Mel, a pessimistic investor, for $9. Mel has “made” $100 from doing absolutely nothing productive! Not only that but the value (market capitalization) of Acme Widgets is now $9m. By transferring a mere $900, Dave has “created” $1m in perceived future value!
Moments later, Dave, who bought 100 shares for $800, decides I’m a complete idiot. He becomes convinced that I’m going to run the company into the ground. His perceived value of a share has dropped to $1 (the physical value). He wants to sell to Matt, but Matt has spent all his money; he can’t buy any more shares. He shops around and finds Karl. Karl thinks I’m a so-so businessman. He didn’t buy anything in the IPO; he doesn’t think a share is worth $8. But he’s willing to buy Dave’s share for $7. Dave is thrilled to cut his losses and exchange 100 shares that he perceives have $100 in value for $700 in cash now. Poof! Acme Widgets is now worth $7m; $2m in value has been magically erased in moments.
Now let’s look at what’s been happening with the money. “Money” is usually considered to be a representation of present value only. No money has been created. No wealth has been created. Money has been moved around, and because it has become concentrated, the money as text has perhaps overall gained some value, but that new value is still speculative. But, fundamentally, nothing has changed. Money has changed location, but the actual physical wealth and the amount of money are still both the same and still both in pretty much the same balance.
Now the banking system comes into play. I go out with my checkbook, buy a building and equipment. I’m now broke but I have $1m in in physical assets. I go to the bank and borrow $1m at 10% p/a interest, using 125,000 shares of stock as collateral. The bank now owns $125,000 worth of present physical value, $875,000 in expected future value, and $1m in the asset of an outstanding loan. By lending me the whole $1m, they have now indeed inflated the currency; There is now an additional $1m chasing the same amount of present physical value. However, as I actually make a profit and create value, I will pay back the $1m plus interest. The potential value has been converted to physical value, and by making 1m widgets, I allowed the physical value to catch up to the currency. After a year there is now an additional $1m in currency and $1m in the value of the newly created widgets. Everything is now in balance.
How has that $1m in new wealth been distributed? After a year, I pay a $1 dividend to my stockholders. That accounts for $125,000. I pay the bank principle and interest; that accounts for $100,000 in principle and ~$100,000 in interest; some of that money is passed to the bank’s depositors. The rest I can use to either expand my widget factory (thus reducing my price by economy of scale), buy another company’s now unprofitable widget factory, or invest in yet another potentially profitable business.
Sorry to be long-winded, but when examining subtle questions such as Matt’s, I’ve found it useful to break things down and examine the situation step by step.