Fair value is not the same as market price

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Anyone who comments publicly on economic affairs receives regular correspondence from monetary cranks, who espouse schemes for securing peace and prosperity by reforming the world’s money.Bitcoin, the private cyber currency whose supply is fixed to prevent inflation, is only the latest entrant to a lengthy catalogue.Bitcoin also attracts anarchists and libertarians. The web should be free, they cry, blithely disregarding its dependence on telephone networks funded by middle-aged people in grey suits, servers provided by large corporations and protocols negotiated in international conferences.

Finally there are the nerds and quants, for whom the computational complexity behind the Bitcoin software is itself a virtue. The algorithms behind it are so elaborate that their implementation imposes a significant load on power supplies. Goodness knows the nature of the problem such effort is designed to solve.

The Bitcoin story stumbles towards its inevitable sad conclusion, and we will probably never penetrate the mixture of naivety and venality that lies behind it. But these events prompt reflection on the relationship between price and value. The growth of the trading culture has encouraged the belief that the only measure of value is what someone is willing to pay. The terms “fair value” and “market price” are today used almost interchangeably. But this is a mistake.

The fundamental value of an asset is derived from the cash or earnings or utility the asset generates. Prices can deviate from fundamental value because future cash or earnings or utility are uncertain, or because of momentum – the belief that overvalued or undervalued assets may become yet more overvalued or undervalued. But there are few cases where prices are forever divorced from fundamental values – that was the lesson of tulips, dotcom stocks and collateralised debt obligations.

The value of gold is that it is both beautiful and scarce. These characteristics made the display of gold a symbol of wealth, enhancing the value of the metal further. Diamonds acquired similar cachet in the 20th century as a result of inspired marketing. Yet the value of diamonds still lies in the utility they offer the wearer, even if that utility derives from the envy of others.

I sometimes wonder about art masterpieces – how can owners obtain $100m of benefit from a painting so valuable that the original must languish in a vault? Still, many people can own a copy of a Picasso that only a few experts could distinguish from the original, but only one person can own that original. The utility derives from the owning – and perhaps from being known to be the owner – of the painting, rather than the joy of looking at it. The price of diamonds and old masters does not deviate from their fundamental value in use, even though the use and the fundamental value may be influenced by the price.

Gold is different. Since gold had high value relative to its size and even weight, gold was employed as a convenient means of storing wealth and settling accounts for many hundreds of years before people realised that certificates of title to gold would do just as well. Many more years passed before the further realisation that, so long as people believed in the general acceptability of the certificates, there could be more certificates than gold. The rest is monetary history.

The transition from the world in which money is valuable because it is valuable to the one in which money is valuable because it is money could happen only because centuries of experience had established confidence that such money would be accepted. There are two commodities – paper money and gold – whose price permanently exceeds fundamental value. But only two. And, with gold looking as volatile as Bitcoin, perhaps only one.

Yet the Bitcoin enthusiasts who believe the internet changes everything have a point, even if they misunderstood that point. Today’s technology allows records to be dematerialised and transactions to take place instantaneously at distance. These developments potentially eliminate the need to carry stores of value in our pockets.

The writer Mark Boyle wrote a book describing a year lived without money. His was not a lifestyle I would enjoy. But the need to tip the bellboy is now the only obstacle to a life of luxury lived without cash.

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