This is an edited version of a post that appeared on Eric’s own Sample of One blog.
David Hume is the first great thinker to identify language, law and money as ‘spontaneous’ institutions of social organisation. They are spontaneous in that they can emerge organically and become widely used because they make life simpler. Hume was on to something quite profound, which remains under-appreciated.
Language, law and money have very similar economic properties. Specifically, how widely they are adopted, or how resilient they are, is not based on their own intrinsic value. Instead it resides in a ‘network externality;’ the value which comes from others using them as well.
Hume does not use the language of ‘network externalities’. Instead he talks of ‘convention’ and a recognition of mutual interest. His description of the evolution of law remains profoundly insightful:
“I observe, that it will be for my interest to leave another in the possession of his goods, provided he will act in the same manner with regard to me. He is sensible of a like interest in the regulation of his conduct.
When this common sense of interest is mutually expressed, and is known to both, it produces a suitable resolution and behaviour… it arises gradually, and acquires force by a slow progression, and by our repeated experience…
In like manner are languages gradually established by human conventions without any promise. In like manner do gold and silver become the common measures of exchange, and are esteemed sufficient payment for what is of a hundred times their value. [Italics added]”
David Hume, A Treatise on Human Nature, Book III, part 2: Of the origin of Justice and Property.
Networks and the economy
How could this have an implication for investors? Let’s consider language as perhaps the clearest example.
We value language above all. If someone had a patent on language and could impose subscription fees for its use, we would be willing to pay a great deal for the service. Of course, individuals can invent their own language – it costs little to do so, it has no intrinsic value and minimal costs of production. But a personal language is of limited use. The value of language lies precisely in the fact that it is used by others – and its value to an individual increases with the number of others who use it. That is precisely what defines a network externality, and also explains why network effects tend towards monopolies.
Laws operate in a similar way. There is no point an individual setting some personal, idiosyncratic rules, which he or she alone follows. Assuming laws are just and efficient, the more widely they are adhered to, the more the legal system benefits each individual.
Eric D. Beinhocker points out that certain aspects of economics and technology share this property. He points to the internet as an example of a situation where the greater the number of users, the more useful it becomes. In his book The Origin of Wealth, he ties this to the the work of Stuart Kauffman and the concept of ‘tipping points,’ where networks reach a critical mass before usage ultimately explodes.
Money and Bitcoin
What about money? The economic properties of money may in fact be closest to those of language, and this may explain the confusion in economics over the fact that something with no ‘intrinsic value’ can be so valuable. Psychological discomfort with this attribute explains both recurrent desires to return to a gold standard, and the more fashionable idea – that money is a debt.
Money in fact works like language. I could create my own, but because no one else uses it, it will have no value. Governments are clearly in a great position to establish dominant networks. They can command widespread acceptance of their money by making it ‘legal tender’, and by requiring it be used to pay taxes. Although these are the means of establishing a network – it is the network externality that is the source of the enduring and resilient value of money (frequently in the face of considerable mismanagement by central banks).
All the artifices which have been used historically to give money ‘value’, are really means to establish networks. As Hume points out, even where money has ‘intrinsic value’ (which really means an alternate value), in the case of gold or silver coins, their value as money soon exceeds their value as gold or silver. The key point is that money is extremely useful, and its usefulness lies in its acceptance by a vast number of cooperating, voluntary, users. Its value to me, like language, resides precisely in its value to others. The process Hume describes is reciprocal, of mutual interest, and increases with the number of users. Disrupting such a network is profoundly difficult, which explains the extraordinary resistance of monetary regimes to repeated abuse (including, for example, hyperinflation). This is the true obstacle to innovations like Bitcoin – if the value of a money resides in the number of users – how can even a superior technology establish value? The very variability of bitcoin’s value is in part both a result of, and a factor behind, its lack of widespread adoption so far.
Facebook & Visa
The market capitalisation of two companies – Facebook and Visa – listed on the New York Stock Exchange trade at market values vastly exceeding their book values (i.e. the value investors are paying for a share in these companies is a high multiple of the value attributed to them in conventional accounting).
To Hume, it would be obvious why: Facebook is ‘language’ and Visa is ‘money’. Hume was more prescient than he could have imagined, because he also identified the source of value of some of the most successful technology companies we have ever seen.
Social media has much in common with language – it uses words, and it uses images, often symbolically. Snapchat is an image-based symbolic language, as is Instagram. But the value of Facebook resides primarily in a network externality. It is a source of its monopoly power. Facebook is more useful than a technologically-superior alternative with fewer users. That’s why network externalities are hard to break.
Visa operates like the money it intermediates: it has value because millions of individuals, merchants, businesses, governments etc., all accept Visa cards as payment. This will be the challenge any new payment innovator faces – superior technology alone cannot break a network externality.
So the market capitalisation of Facebook and Visa should not surprise us. One has patented language, the other has a license to print money.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.