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25 Aug

The First Principles of Wealth — Part 3: Money

Links to Part 1 and Part 2:

The First Principles of Wealth — Part 1: Information and Knowledge

The First Principles of Wealth — Part 2: Energy and Entropy

Ahh, money!
The enabler of all my desires,
The object of all my capitalistic pursuits.
'Tis not merely a tool for transaction;
It's a symbol of power!
A measure of worth!
A catalyst for human progress!
In my hands, it becomes more than paper and metal
It's a key that unlocks opportunities,
A bridge that connects disparate economies,
A language that transcends cultural barriers!

And yet, money is only useful to me insofar as I can buy life's most indulgent and lascivious luxuries with it. Give me a billion dollars in a pastoral village on a remote island — where the only things I can buy are a mud hut, clay pots, and fish, I'd still feel quite poor. All those dollars would hardly be able to buy anything for me, for there'd be nothing much to buy at all!

But give me the same million dollars in a city like New York, and suddenly I have so many avenues I could spend my money on, in exchange for some earthly delights. I could buy the grandest mansions, the fanciest cars, the artsiest artworks. I could hire the best chefs in the world seven chefs who have mastered seven cuisines; one for each of the seven days of the week. I could hire the best musicians in the world to play for me while I'm having breakfast, lunch, and dinner. I could host parties like Gatsby and invite the best in the world to network with them and unlock further opportunities for myself.

What I'm trying to say is:

It isn't merely the absolute level of income or the money I have that makes me wealthy: it is also the incredible variety of goods, services, and access that the money can buy. A billionaire in a decrepit economy will be vastly rich by local standards, but she will still be quite poor compared to a median employee in a first-world city.

And yet, the world largely continues to think of money as an object worthy of pursuit in itself, whereas, without the creation of wealth, money would scarcely get you anything beyond what you would get in a rudimentary farming/sustenance economy.

The Nature of Money

You see, money is not just a mere medium of exchange that eradicates the clumsiness of barter; it's a sophisticated unit of account and a robust store of value that empowers economic transactions across both time and space. To perform all these functions optimally, money has to be

available: participants in the economy should have it in order to trade

affordable: participants should be able to afford the means to get access to it in order to start transacting in the economy

durable: it should last as a record of value

fungible: it should allow anyone in the economy to engage in trade with anyone else; it should be interchangeable

portable: it should allow for convenient exchange and passing of hands; it should be liquid

reliable: it should be trusted for its authenticity by all participants in an economy

Metals such as gold, silver and bronze were for millennia regarded as the ideal monetary raw material because they fulfilled all these criteria.

But when metal becomes currency, the value of metal itself isn't absolute. Money is worth only what someone else is willing to give you for it. And you only earn money insofar as someone deems your product or service valuable, to the extent they deem it valuable.

An increase in the supply of money itself will not make a society richer. Without the production of new goods and services, i.e., wealth, monetary expansion will merely make prices higher.

Essentially, possessing money is the record of having created wealth in some way, shape, or form. And the money possessed is in itself a potential to create or unlock new wealth.

How so?

“... money is a matter of belief, even faith: belief in the person paying us; belief in the person issuing the money he uses or the institution that honours his cheques or transfers. Money is not metal. It is trust inscribed. And it does not seem to matter much where it is inscribed: on silver, on clay, on paper, on a liquid crystal display. Anything can serve as money, from the cowrie shells of the Maldives to the huge stone discs used on the Pacific islands of Yap. And now, it seems, in this electronic age nothing can serve as money too.”

— Niall Ferguson, The Ascent of Money

Money crystallizes the relationship between lender and borrower. It is a measure of debt or an IOU (an acronym for “I owe You”).

“Say, for example, that Joshua were to give his shoes to Henry, and, rather than Henry owing him a favor, Henry promises him something of equivalent value.

Henry gives Joshua an IOU. Joshua could wait for Henry to have something useful and then redeem it. In that case, Henry would rip up the IOU and the story would be over. But say Joshua were to pass the IOU on to a third party — Sheila — to whom he owes something else. He could tick it off against his debt to a fourth party, Lola — now Henry will owe that amount to her.

Hence, money is born, because there's no logical end to it. Say Sheila now wishes to acquire a pair of shoes from Edith; she can just hand Edith the IOU and assure her that Henry is good for it. In principle, there's no reason that the IOU could not continue circulating around town for years — provided people continue to have faith in Henry.

In fact, if it goes on long enough, people might forget about the issuer entirely.”

— David Graeber, Debt

Now, even if Henry were to hand Joshua a gold coin instead of a mere piece of paper, the underlying principle would remain unchanged. A gold coin, after all, is essentially a pledge to deliver something else of equal worth. Its intrinsic value is not in the metal itself, which has little practical use, but in the trust it represents. People accept gold coins not for their inherent utility but because they believe others will do the same.

In this context, the value of a currency is less a measure of an object's worth and more a reflection of faith in the issuer of the currency who promises to back it with value. It is information that conveys promise and potential.

Modern banknotes work on the same principle.

Notice what is written on any currency note issued by the Reserve Bank of India:

“I promise to pay the bearer the sum of Five Hundred Rupees.”

And the promise is signed by the Governor of India and guaranteed by the Central Government of India.

In some sense, the Reserve Bank of India is the original debtor. In the parable of Henry's IOU, the RBI is Henry, who every other participant in the economy holds good for paying back their debt. Over time, the original debt doesn't matter, what matters is the belief that the IOU and its issuer are good for the money.

Your trust in money is your trust in the Reserve Bank of India.

The physical form of money, whether it's pure silver, alloyed silver, leather tokens, or even dried cod, is of little consequence. What matters is that the state recognizes it for tax payments. Whatever the state accepts becomes currency by definition.

In fact, this is also how money brings markets into effect.

Ancient kings faced a problem: they had to support their armies, sometimes constituting up to fifty thousand soldiers. Feeding this army was a big headache. Such a force naturally had ravenous food and subsistence requirements. And if they were on the march, they would need to employ almost as many men and animals just to locate, acquire, and transport the necessary provisions.

So, here's how crafty kings solved this problem:

If there were gold and silver mines in their territory, they would usually take control of them. And then, they would mine the gold and silver, mint them into coins, stamp their picture on it, and hand it out only to their soldiers. The king would then demand that every family in the kingdom pay one coin back to the king's treasury.

This would essentially mean that the families were now obliged to support the king's army in whatever way possible, in exchange for those coins, so that they would be able to pay the king his tax.

And they were also now sufficiently incentivized to trade amongst themselves to earn more coins, bringing a whole market into effect!

Money and its relationship to value

At the core of money lies the question of value. What is value, and how do we figure out the right value for any product or service?

Now, it is easy to casually handwave the problem of the value of a product as being entirely subjective to what the person buying it is willing to pay for it.

But not quite. Some objective measures of a product or service's value reveal themselves, as triangulated bottom-up by the market over a history of transactions. And these objective measures have to do with how complex and useful the given product or service is to the buyer.

Each industry and occupation gravitates toward its own level of income, as dictated by some objective factors.

For instance, have you ever wondered why is it that skilled software developers are paid well, no matter where they are located, and fruit pickers are paid poorly, no matter where they are picking fruit? Surely, there must be some measure of objectivity to how markets as a whole perceive and measure value, wouldn't there?

The answer here has to do with Economic Complexity.

As in our village economy vs. New York city example, one way to think about economic complexity is the complexity and diversity of products an individual or an economy makes and exports. This is what determines your level of income.

Economic complexity is not merely a theoretical concept; it's a tangible reflection of the knowledge, skills, and interconnectedness that a society or individual embodies. This complexity often translates into the ability to create sophisticated products and services, which in turn, manifests as higher income levels.

Consider the economic powerhouses of Germany and Zambia.

While Zambia's economy is heavily reliant on mining, particularly copper, Germany boasts a diverse industrial landscape. From advanced automobile manufacturing to precision engineering in the field of robotics, Germany has embedded complex know-how into various sectors.

Zambia's reliance on a single commodity with a lot less relative complexity results in a more substantial economic struggle and a lower income per capita. Germany, on the other hand, possesses skills and know-how to create products of very high complexity and intelligence using that copper, which translates to a higher GDP per capita.

Drawing an analogy closer to the individual level, compare a specialist surgeon to a general laborer.

A specialist surgeon has invested years in education and training, accumulating intricate knowledge and expertise in performing complex surgeries — with knowledge and know-how that operates at multiple levels of analysis, not just one. This level of specialization and complexity in their skillset allows them to earn substantial incomes in the market.

A general laborer, on the other hand, while performing essential work, is often involved in more repetitive, mechanical, and less complex tasks. Consequently, the laborer's earning potential remains relatively lower.

Silicon Valley is another embodiment of complexity translating into wealth. The hub of technological innovation, it has fostered an environment where complex ideas are turned into reality. Companies like Apple, Google, and Facebook have not only revolutionized technology but have created ecosystems that weave numerous intricate layers of services, software, and hardware.

These companies’ ability to navigate and master complexity has led them to unprecedented success, significantly contributing to the United States' GDP and providing high-paying jobs.

The Economic Complexity Index (ECI) is a modern tool that attempts to quantify this relationship between economic complexity and income levels.

Nations with more diverse and interconnected industries tend to score higher on this index. Not surprisingly, these countries also demonstrate higher income levels and a greater resilience to economic shocks.

“The Economic Complexity Index is a ranking of countries based on the diversity and complexity of their export basket. High complexity countries are home to a range of sophisticated, specialized capabilities and are therefore able to produce a highly diversified set of complex products.

Determining the economic complexity of a country depends not only on the productive knowledge of a country. Information about how many capabilities the country has is contained not only in the absolute number of products that it makes, but also in the ubiquity of those products (the number of countries that export the product) and in the sophistication and diversity of products those other countries make.

Economic complexity expresses the diversity and sophistication of the productive capabilities embedded in the exports of each country. The Economic Complexity Index (ECI) has been shown to explain income differences across countries and predict future growth better than any other single measure.”

For example, Japan and Germany have high ECIs, meaning they export a wide variety of uncommon goods. This shows that their economies are diverse and sophisticated.

On the other hand, countries like Angola and Botswana have low ECIs. They export only a few products, which are commonly found, i.e., not scarce or hard to produce, and come from countries that aren't very diverse. This suggests that these nations have simple economies, and the products they export are not very advanced when it comes to their sophistication or complexity.

Look at China's growth in the rankings since 1995. And look at India's growth in the same time period.

In 1995, China was ranked 46 on the index. As of 2021, it is ranked 18.

In 1995, India was ranked 60 on the index. As of 2021, it is ranked 42.

Singapore, on the other hand, jumped from Rank 20 in 1995 to Rank 5 in 2021!

You can access the tool here.

Why did China make such leaps in economic complexity in the past three decades while India couldn't make the same level of advancement? The answer has a lot to do with China's focus on incentivizing enterprise that is fundamentally more complex in nature: manufacturing.

Here are the Top 11 countries with the highest economic complexity, as of 2021:

The complexity and sophistication of products and services in an economy, and the skills and know-how of its people, place an upper cap on how much wealth its money can potentially create or capture.

Money can't buy anything knowledge didn't produce. And complex economies make money more valuable.

This is what people often mean when they mention “standard of living”: even when money is adjusted in purchasing power parity terms, money in the United States of America has more potential and can buy more things and experiences that the same money cannot buy in India. Because the former simply has a much more complex and diverse economy, with higher quality infrastructure, products, and services.

You can import many of these products and services that lend themselves to imports — like an iPhone or a Microsoft Excel or a Notion, but you cannot import public infrastructure and offline services you use on a daily basis, like the roads, the public transport, the libraries, the clean air and water, skilled craftspersons like carpenters, plumbers, and electricians who, unlike their Indian counterparts, really know what they are doing, or any other goods or services that add to your quality of living.

You see, capital and credit have existed in various forms long before even money did.

Even before people backed currency notes with stores of precious metals like gold and silver, they used to back their IOUs with cattle.

So, the value in money is never in the money itself, but what it was capable of unlocking for you.

If you're in a country full of violinists, but what you really like to listen to is sitarists, your money doesn't do anything for you in that regard, unless you can invite sitarists from foreign lands to play for you.

And you will pay the sitarist in exchange for their performance, which was an outcome of the skillset and know-how they've embodied over years of practice; know-how you cannot simply pick up by reading a book. The wealth of the sitarist is in their embodied know-how that they use to perform, not the money they earn. The money is simply a proof of their ability to provide value to someone, and potential to unlock someone else's know-how in exchange for it: say their driver or the crystallized know-how they're getting access to when they buy a smartphone or a laptop or a set of speakers.

What's more? That sitarist could only travel to your country after a bunch of geniuses in some economy have invented a way for people to easily travel between countries. That is where the economic wealth and complexity was created, for such a thing would not be possible in a world where ships or airplanes weren't yet invented.

And economic complexity begets even more of it; it compounds, as it facilitates human enterprises that weren't previously possible. New tools, new platforms, new modes of manufacturing and transport — all of these enable us to do things that we weren't able to do so far. And the more wealth you can create, as measured by how complex and hard it was to create, the more money the markets reward you with. This applies to individuals, organizations, and nations alike.

Money is a promise of value. But not all value creates wealth. A lot of it is simply spent in unproductive activity that doesn't increase our collective wealth but destroys it by sapping us of valuable resources like time and energy.

But in the right hands, it is the potential to create wealth — be it by unlocking existing know-how and expertise, or by creating tools and services that make it easier to unlock know-how, or by facilitating information and knowledge transfer between two or more parties that weren't communicating or collaborating previously but now can, and by virtue of their collaboration, increase the collective wealth of the economy.

You get paid to bring utility to the world.

What do we mean by utility?

Let’s the simple example of a food delivery business like Zomato.

In a world without Zomato, to get food at your place, you would have to get out of the house, travel to the restaurant, place your order, wait there till the food was being prepared and packaged, take the parcel and travel back home. It would be a lot of energy and time expenditure that one would find not much value in. In fact, one would be happy if it were someone else’s headache. So much so that they would be willing to pay a small premium for it.

This is Zomato and Swiggy for you. They essentially abstract and take away a lot of operational complexity you would otherwise have to deal with in their absence. And they charge an appropriate value for reducing that headache.

If you think about it, any business, essentially, is a simplified and abstracted layer between point A and B. Point A is where you are right now and point B is where you wish to be.

You have a block of iron right now. You can’t do much with it. Perhaps, it would be more valuable if you could turn that block of iron into a bunch of nails, or utensils, or a tool like a hammer. But how do you do that? To do that, someone with enough process knowledge and skill has to go through the effort of melting that block of iron in a furnace and then fashioning it into a more useful form.

In fact, this is a great mental model to quickly understand where the economic value lies in any activity:

Think about what kind of headaches it’s taking care of for you. Money is one source of potential to solve headaches for yourself and for others.

Once you understand this, there are a lot of potential questions you can delve into:

How do banks and institutionalized lending create wealth?
How do investors create wealth?
How does the stock market create wealth?
How does a marketplace create wealth?
How do managers/designers/engineers/doctors/lawyers/other professionals create wealth?
How do food delivery startups create wealth?
How do real estate agents create wealth?
How does Stoa Daily create wealth?
How does <insert entity here> create wealth?

Most importantly,

How do you create wealth?
Is the money you're making in line with the complexity and ubiquity of the headaches you're solving for the market?
How many others can do the same job you're doing and solve the same problems you're solving?

Try answering these questions honestly, and in good faith.

The reason I feel obliged to say this is because today, it is easier than ever to latch on to cynical explanations that make you feel that most people do not deserve to make the money they're making. So, I'd like you to think about it, not from a moral lens that values imaginary and ideal outcomes, but from a real-world account of things, and you will understand why the free markets are a fair arbiter of value — for the most part.

Corruption and unethical behaviour is rampant in many industries, sure, but hastily alluding to it every time you encounter someone who is “filthy rich” doesn't help you understand a plethora of genuine and ethical ways in which you can make more money.

Once you have a good answer to this question, you know where you stand and you know what you will need to do in order to command even more money in the market. And generally, the more complex problems you solve, and the larger the number of people you solve them for, the more money you'll make.

Curious to know more about Stoa?

If you find our essays valuable, it's highly likely that you may find our flagship 6-month management programme valuable as well.

Our Admissions Director is hosting a public InfoSession tomorrow — Saturday, August 26, 2023 — at 12:00 pm. Join in to understand what the Stoa GMP is about, and get your questions answered.

Register for the InfoSession here.

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