As we work through the worst economic upset in decades, remember the differences between the “real economy” and the “money economy.” The two are linked but are not the same. The crucial question now is how much dramatic problems in the money economy will affect the real economy.
While people use tangible resources such as labor, raw materials and machinery to produce equally tangible products like food, clothing and shelter, this important real economy is obscured by what the Austrian-American economist Joseph Schumpeter called the “veil of money.” The use of money for nearly all transactions obscures the value of underlying real resources and products. Prices and credit and financial markets dominate our thoughts.
In the money economy, the wealth of our society as a whole has declined by trillions of dollars since the beginning of 2007. Some of that decline was in the value of houses. Some was in the drop in the value of stocks, mutual funds and pension plans.
The total amount of what we can expect to consume in the future — or pass on to others — is now markedly less than we once thought.
Nevertheless, the real economy remains virtually unchanged. Our country has more workers now than at the height of the housing bubble two years ago or the stock market peak a year ago. There are just as many acres of farmland and forest, just as many oil and gas wells and mines. We still have about as many factories; as much machinery; as many roads, railroads and airports; as many computers and cell phones as we did before the bubble burst.
Moreover, people still need to eat. They still need clothing and housing and transportation. Kids need to be educated and we still need to see doctors and dentists. We still demand entertainment and recreation.
So if we still have real resources and real needs for goods and services in the non-money economy, why should a drop in how wealthy we think we are affect how we meet society’s true physical needs?
That was a key question in 1929. Then, a historic upheaval in the money economy fed into unprecedented slowing of the real economy. Deprivation became deep and widespread.
Some slowing — probably significant slowing — is inevitable. The decline in money or financial wealth did not occur in a vacuum. It happened because of a complex debacle in financial markets.
That debacle is drying up credit, a valuable human invention that facilitates the transformation of real resources into real goods and services. For a modern economy to function efficiently, we need money to serve as a medium of exchange and we need institutions that channel money from savers to those investing in productive activity.
Fear in financial markets can choke off the flow of credit and make it difficult to borrow even for socially productive purposes like housing (for a financially prudent household) or well-founded business ventures. The just and the unjust both get hurt when credit disappears.
Financial market crises also frighten people. People worry about what will happen if they lose their jobs, so they tighten their belts and consume less.
They go out to eat less often and skip vacations. They drive the car another year and put off remodeling the kitchen. They forgo new equipment for their businesses. They don’t hire additional workers.
Such caution is smart for any single household or business. In the long run, greater thrift is good for society as a whole. But the sudden, fear-driven contraction of spending in a financial crisis further slows economic activity. Demand for all sorts of goods falls. Businesses of all sizes become less profitable. More people get laid off. Prices may fall, especially for primary inputs from farming, forestry or mining.
That is what happened in our country in 1929. That is what happened in Japan in 1989, in Sweden in 1992 and in Argentina in 2002. It is starting to happen here now.
We don’t want it to become a vicious circle now as it did in 1929. In 1936, British economist John Maynard Keynes argued that government manipulation of the money supply, taxes and spending could ward off such downward spirals. His theories came to dominate economics, but their application isn’t easy.
Japan quadrupled its national debt, relative to the size of its economy, in the past two decades. It increased the money supply to keep interest rates low for years. But after nearly two decades, Japanese growth remains very slow and output per person only modestly above what it was. Japanese stock prices linger at one-fourth of what they were at the peak. So recovery is not easy or certain.
© 2008 Edward Lotterman
Chanarambie Consulting, Inc.