What have we learned from economics? You may say: of course, we have learned how the economy works. But many people without learning economics also seem to know much about how the economy works. Notably, businessmen often think that they know better than economists in this aspect. Occasionally government officials, stock analysts, etc. may also think that they know better, despite their lack of formal economics training. Hence, the point is: what things that we really have learned from economics, but not from elsewhere, can make us have a better understanding of the economy.
I have been thinking about this question for long. In fact, I thought about this even when I was an undergraduate student (a long time ago). I studied economics but I was, and am still, critical: I wondered what I had learned from my teachers was really useful.
At that time I was struck by an approach used, or a perspective adopted, in economics (but often not elsewhere), and I truly thought that the approach was not only striking but also truly important. Today I am an economics teacher. I still think that approach or perspective is truly important and sound.
What is that approach? Answer: The economy is not about money. It is about the real activities in it. To understand it, one must see behind the veil of money.
Well, this perspective is exactly the contrary of what normal people see the economy: they always think in terms of money.
From which topics in economics we learned that the economy is about the real, but not the money? In fact, this proposition has permeated everywhere but we may not be aware of it. In microeconomics, we discuss resource allocation via markets. It is not about money gain or loss but about how different goods and services are used by people such that efficiency is attained. Well, we may not be very much aware that the terms are not money, but real values. In macroeconomics, however, the distinction between real values and nominal values is made explicit. So, students must be aware of it.
Then, what is real? What is nominal? Is that really an important distinction?
Perhaps a little bit paradoxically, real variables are not the so "real". We can't directly observe a real value. It is more an artificial construct that is obtained by purging price effects from a nominal value. The data that statisticians collected is about nominal GDP, nominal consumption expenditure, etc. The former is the money for which the output of final goods can be sold. The latter is the money spent on consumable goods. They are the true data encountered by businessmen, producers or consumers, who either actually incur the expense or estimate it.
The real values, real GDP or real consumption, however, are not the true data as used or estimated by these businessmen, producers or consumers. The real GDP is obtained by dividing the nominal GDP by the price index. Similarly, the real consumption expenditure is obtained by deflating the nominal consumption expenditure. They are not the data handled or estimated by the original data generators, i.e. the businessmen, producers, or consumers. Of course, each of these people knows how many units of goods each produces or consumes. But the real value of an aggregate variable involves adding the money (nominal values) generated from these units (real values) and then deflate the total value by the price index. In the process, the data of individual units (real) is no longer preserved.
Perhaps because real values in macroeconomics are an artificial construct, and perhaps because businessmen never handle these real values, they tend to ignore the reals, they simply think in terms of money, and they can't appreciate the economics way of thinking (think in terms of reals). From the discussion above, you should also know why the situation is worse in macroeconomic issues than in microeconomic issues.
Let me use two examples to illustrate why thinking in terms of reals is correct while thinking in terms of money can lead to mistakes.
The first mistake is made by an "economist". I say "economist", not economist (without quotation marks) because the person I mention is in fact not an economist, though media often misuses the term "economist" and call the person concerned, actually without formal training in economics, an "economist" simply because the person is a scholar who often wants to comment on the economy. But even a historian can comment on the current economy though the person is not, and should not be called, an economist.
Anyway, what this "economist" said? He said buying stocks is always a wise move in the long term because central banks everywhere keep printing more money in the long term. This generates inflation. Money value is depreciating in the long term and so holding money simply loses out.
I must admit that my first feeling when encountering this argument was: it looked reasonable and smart. Upon reflection, I know my first feeling came by because at that time I forgot what an economist should think and used businessmen's way of thinking. But economists should not be confused by money value. We should look at the reals.
What the mistake has this "economist" made? I must make clear that I don't dispute that holding stocks is in the long term a wise move (I won't say it is wise or not; I simply won't dispute this claim). But it is not because printing money generates inflation. It should be due to holding stocks is worthwhile for its own good. If inflation is all that matters, then any financial assets (not only stocks) must deserve holding in the long term. But that's clearly not true.
Take a simple example. Gold price sharply declined from 1980s to 2000s for about 20 years. During the same period, global inflation rate is high while the rate for advanced countries is also high on average, especially during 1980s where gold price declined particularly sharply. Then, was holding gold a wise move during 1980s to 2000s? True, money value depreciated with inflation. But holding gold was worse. Obviously, the demand and supply situation in gold market generated this worse situation. Inflation couldn't help boost gold value.
In fact, even holding stocks are not necessarily a wise move. Though most stock markets perform well in the long term, some markets didn't, For example, France stock market fell between 2000 and 2012. Then, it took about 10 more years to recover the loss (reach the peak level achieved in 2000 again). In the meantime, inflation rate was positive at between 1 to 2 percent. For another example, Italy's market is even worse. Its index is still below the peak achieved in 2000 while its inflation rate was mostly about 2 percent or above. For these markets at least, holding stocks didn't seem to be wise for 20 years or even longer.
These examples illustrate that holding stocks could still be bad in spite of inflation. The "economist" mentioned above can't be right in general. Perhaps he is right for the stock markets that normally he would invest. But that is because the stocks he invested have merits in themselves. That's not simply because of inflation.
More importantly, the economics logic involved in this "economic" argument is not right. Yes, as stock price is increasing in the long term, holding stocks could normally give the investor more money. But don't forget money becomes less valuable, given inflation. So, having more money is not sufficient. The stock market return must at least beats inflation, or the purchasing power of the stock holders may not become higher over time. Even if it is higher, don't forget that, holding stocks, one sacrificed the goods that could be bought by the money for stocks, and also borne investment risks.
Just looking at money and forgetting the reals (the goods sacrificed and the risks) is the crucial mistake involved in the "economist's" argument for stocks. Such a perspective diverts our attentions from analyzing the demand and supply factors in stock markets (the reals). But it is the reals that matter, not the money.
Now, we turn to the second mistake of thinking in terms of money. Interestingly, the mistake was also made by a person who considers himself as someone "knowing economics" (though he seldom calls himself economist). He is a columnist who writes on some international economic issues and investment advising.
In a case, he analyzed why UK can have a good economic performance since 1990s until before 2008 (where global financial tsunami occurred). His point is mainly that the UK policy and some other events attracted investment inflows from Europe and elsewhere. His point concentrates on exploring factors that can attract these fund flows.
Again, this is a point reflecting how businessmen understand the economy. Businessmen run their companies. They want to attract more money inflows to their companies. If they succeed in doing so, their companies can prosper. Naturally, they may also apply the same logic in analyzing the whole economy. If an economy can attract fund inflows, it can prosper.
Again, my first feeling when encountering his point was that this analysis looked reasonable and smart. But, upon reflection, the argument can't be right. The argument associates an economy's wealth with fund flows. But fund flows is a zero-sum game. When a country gets more funds from other countries, others get less. So, there is no way for different countries to enjoy mutual gain. Of course, this is exactly what many businessmen would think for the economy. They want their own countries perform well and they fear losing out to other countries.
Why such an analysis can't be right? Well, from the very beginning, economics refutes such zero-sum based analysis. Economic prosperity is not about more funds. It is about more outputs that can be produced as this is truly beneficial to people living in a country. Even if people have more money or funds in their bank accounts, they won't be better when money can't be converted into more goods. In contrast, more goods for use can benefit them. But this needs more production.
Yes, fund inflows may enable a country to use more resources and so more goods can be produced. But why would funds flow in a country? Meanwhile, at given resource, more goods can still be produced if productivity is improved or resources are used more efficiently. In fact, when these two things happen, funds will flow in as fund holders find their resources can be better utilized in a such country.
So, things must be done better in real term: productivity and efficiency. Of course, one way to improve is well known now (though may still be forgot). It is (almost) the first principle in economics. It is about trade and specialization: by international trade, countries can specialize in what they can perform best, and so produce more for both trading countries. Trade and specialization is about the reals, not about money gain or loss (trade surplus or deficit).
So, by concentrating on fund flows (the money), the above economic analyst ignores the first principle in economics (the reals). If he is right, there is no mutual gain in trade or even in interactions between countries (via fund flows, etc). If he is right, the whole framework of economics collapses.
Well, since 1990s, the whole world has seen global trades rising rapidly and the world economy prospering rapidly. What is most undisputed in these decades is the wonderful effect from trade. The gain is quite obvious. Yet, if we look at the money, we may interpret that when the money earned by foreign countries (trade deficit) is big, it must be bad for a country. But what we should look at is the reals: the goods that a country can get via trade (one get more than goods from foreign countries when deficits occur) is increasing.
From the two examples above, the lesson is that what truly matters to us (a person or a country) is the goods one can get (the reals), not the money counted. If we confuse them, we make either bad investment policy or bad economic policy. In fact, one important task of economics is to remove the clouds, letting people see through the veil of money.
