When you look at a dollar, you’re looking at a piece of paper (well, cotton, actually, which is why money survives getting wet – but you get the idea). Why is it valuable? You can trade a dollar for food, but you can’t eat food. What props up this system? And what about investments – how can you be part-owner of a company that you have no say in and profit from a piece of paper proving that ownership – a piece of paper you may never personally see? Why do some investments come in physical form, while others are acts of faith?
The key to understanding all of these things lies in our concept of value, as well as in the reality and perception of powerful institutions like governments and companies.
Some things in our life are inherently valuable: the food we eat, for instance, or the clothes that shield us from the elements. But if we each spent our time creating each of things we needed, we’d be very inefficient. Imagine cultivating all the plants you needed for food and fabrics while also hunting and fishing, building your own home, and raising children. It would be nuts!
But if you just cultivated one type of plant, you’d have enough time to get the job done. And if you just cultivated one type of plant, growing five wouldn’t be much harder than growing one. In fact, you could grow a lot – and then trade the corn you grew to the gal who grew cotton, trade some more corn to the guy who has a loom, and bingo, you’ve got your clothes. That’s capitalism at work.
But bartering isn’t very efficient, either. You need clothes in the winter, too, and all your corn will be gone by then. So people started using currencies, which don’t have inherent value but are understood to be valuable.
Precious metals, as the name implies, were a popular choice for early currencies. They were seen as valuable due to their rarity. There is only so much gold in circulation, so we know what it ought to be worth, more or less. For a long time, many countries pegged their currencies to the value of gold.
But there are benefits to having a currency that you (as a country) print yourself. You can use this to help control the economy a bit. So if you’re a very trusted country – one that everyone agrees will be around for a long time – you can print currency and allow it to derive its value from you. U.S. dollars are a pretty stable currency because a lot of us agree that they are valuable, and they have the backing of the government, which will of course accept it as payment for as long as it’s around. Like gold, the U.S. dollar is used as a standard for some other currencies – smaller countries peg the value of their money at a certain amount of U.S. dollars, and then hang on for the ride.
Investments and value
When you invest, it pays to remember where value comes from.
Companies, of course, provide some kind of inherent value – if they didn’t, they wouldn’t earn money (no matter what currency). Doctors provide value, and so does American manufacturing. And when a big company (like one of those manufacturing firm) wants to grow, it may choose to sell stocks – essentially just ownership shares – and use the proceeds to build a new factory or hire new workers.
So when you invest in stocks, you’re betting on the value that the company will provide. You’re betting it will earn more money, grow, and provide even more value. And since you own some percentage of that company through your stock, you’re increasing in value, too – though you won’t get to use that money until you cash out by selling your stock.
You can also invest in other things. You can invest in gold bullion, for instance. Remember that gold was an early currency, something valuable even without government backing. This helps ensure that gold won’t plunge with currencies during a depression. While there are no guarantees, gold has traditionally been seen as fairly “recession-proof.”
You can also invest in other commodities, including things with inherent value. That corn you were growing in our early example can be invested in – you can go long or short on this year’s corn production in the commodities market, just as you can go long or short on a stock.
Understanding where value comes from is important. Thinking about the evolution of currencies and the ways in which modern currencies are backed helps us avoid paranoid fears about their future (while also helping us see how to hedge our bets with investments in thing that are inherently valuable or valuable independent of government support). There are plenty of complex ways to look at value, but a few basics can get you far when it comes to understanding money and value.