This is the first post of what I hope will be a series about some useful economic ideas.
As fascinated as I am by economics, I have been frustrated by the way politicians and pundits discussed economic issues during this last election season. They just weren’t talking about economics the way I’m used to. So I’m going to try to fill that gap a little by talking about some of the economic ideas that I’ve found most useful in thinking about public policy.
To be clear, I’m not a trained professional economist. But I’ve read a lot about the subject, and as always, my goal is to not make my readers stupider for having read my posts. (Readers are invited to point out when I fail that test.)
I might as well start with the Wikipedia definition of economics:
Economics is a social science that studies the production, distribution, and consumption of goods and services.
The most important part of this definition is “consumption of goods and services.” That’s the reason we have an economy: To consume goods and services.
Don’t mistake this for some kind of vulgar consumerism, which usually refers to the selfish and frivolous consumption of goods and services at harmful levels. Economically speaking, consumption is the act of using goods and services to improve the quality of our lives, starting with consumption that provides the most basic necessities of human survival: Food, shelter, and clothing.
Of course, we all want more from life than bare survival. We don’t just want food, we want nutritious food that travels well, stores well, is easy to prepare, and tastes good. We want shelters that include waterproof roofs, climate control, internal lighting, and entertainment systems. We want clothing that lasts long, protects us well, and looks stylish. Beyond that, we want transportation, communication, medical care, drugs, and safe streets. We want sports stadiums, music venues, good books, streaming television, and video games. We want it all.
We want to live good lives. And while there’s more to the good life than consumption of goods and services, consumption helps a lot. It’s a lot easier to have personal growth and a close family when you don’t have to worry where your next meal is coming from. So we need to go through the complicated process of deciding what we want most.
In order to consume goods and services, however, we first have to produce goods and services, and that involves a lot of decision making about what to produce and how to go about setting up production — where to get resources, what kind of factory to build, how many people to employ, and so on. Finally, we somehow have to decide how to distribute these goods and services. Which consumers get to consume which goods?
In an ideal world, all these decisions would be simple: Just produce everything everybody wants and distribute it to everyone who wants it so they can consume all that they want. Problem solved.
In reality, however, it’s not that easy because of an important constraint: Scarcity. We face insurmountable limitations in natural resources, labor, and capital. And so we cannot simply produce everything that everybody wants and distribute it to everybody who wants it. We have to make decisions and tradeoffs. Thus many economists would modify the Wikipedia definition of economics to read:
Economics is a social science that studies the production, distribution, and consumption of goods and services under conditions of scarcity.
And so consumers need to prioritize and decide which goods and services are most important to consume. Producers need to decide which goods and services to produce. And collectively we have to decide how the produced goods and services will be distributed to the consumers. All these difficult decisions, including all economic public policies, are necessary because of scarcity.
It’s important to notice what’s deliberately omitted from this definition of economics. There’s no mention of money or exchange rates. Nothing about banking or finance. Nothing about stocks and bonds, financial markets, or options trading. Nothing about mutual funds, hedge funds, or venture capital. No mention of mortgages, payday loans, or credit cards.
That’s because what ultimately matters in economics is the production, distribution, and consumption of goods and services, which economists usually refer to as the real economy. It’s not that all those financial and legal entities are unimportant to the economy, but they are of secondary importance. That is, they are important only to the extent that they affect the real economy.
For example, when the sub-prime mortgage crisis hit the U.S. around 2007, it started with the failure of a bunch of complex mortgage-backed financial securities, but it ended with a crushing recession that caused people to lose their jobs and their homes. Overall, from the initial decline until production finally caught up to where it should have been, the U.S. economy produced about $10 trillion less than it could have over the life of the recession. We were collectively $10 trillion poorer, and there was no way to fix it.
On the other hand, when a hedge fund called Long Term Capital Management failed in 1998, it sent shockwaves throughout the financial markets. But thanks to some careful interventions, the problem mostly stayed in the financial markets — eventually leading to a massive bailout/liquidation — without ever spilling out into the real economy. That’s why everyone remembers the Great Recession of 2007, but only a few of us economics nerds remember the LTCM failure.
The real economy is the ground truth behind the financial side of the economy. Every story we tell about the economy has to make sense when translated to the real economy.
Consider how a car loan works: Depositors put money into the bank, and the bank lends it out to someone to buy a car. Eventually, the car buyer pays the loan back, with interest, and the interest they pay is used to pay interest to the bank’s depositors. That’s the financial story.
Now here’s the same story in the real economy: Depositors make the decision to postpone immediate consumption by saving their money in a bank rather than using it to buy consumable goods and services. Those goods and services no longer need to be produced, which frees up production resources, which is convenient because the person who took out the car loan will use that money to direct the economy to use resources to produce a new car. Then, in order to make the loan payments, the car owner has to divert money away from the consumption of goods and services. As the payments are returned to the depositors, those goods and services are available for depositors to engage in the consumption they previously postponed. And since immediate consumption is always preferrable to future consumption, the borrower has to agree to additional interest payments, thus freeing up resources that allow depositors to consume more goods and services in the future as compensation for delaying their consumption.
When thinking about confusing economic policy ideas, I’ve often found it illuminating to figure out how the real economy is affected. If you can’t make the real economy side of the story make sense, then the whole story probably doesn’t make sense either.
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