The "Real" Economy

Just the goods and services bit

Economics, at heart, is the study of the production, distribution and consumption of goods and services. This is the “real” economy—the focus of this article.

There’s also the “financial” economy, which consists of all the debts which are created, transferred and eventually written off. This supports (some people say it lubricates) the real economy, by making it run far more smoothly. For example, in an earlier article on money and banking we saw two different ways in which using debts can allow a group of people to split an inconvenient multi-person trade into a number of simpler trades, so they can take place at different times, and each one only needs to involve two people.

Sometimes it’s interesting just to concentrate on the actions in the real economy, and ignore the financial economy. Let’s look at the banking example at two different stages:

1. At the end of the complete scenario, and

2. Half-way through

Complete scenario

The scenario is that Alice has some amber but wants a book, Bob has a book but wants a cake, Charlotte has a cake but wants a DVD, and Dom has a DVD but wants some amber.

The scenario

Alice doesn’t have any amber with her in the bookshop, and Bob won’t accept her personal IOU. Fortunately, Eve happens to be in the shop, and everyone trusts her IOUs, so Alice swaps IOUs with Eve.

Here, side-by-side, are the complete set of actions, and just the actions from the real economy.

All actions (left) and just the real economy actions (right) for a 4-way transaction supported by a bank loan.

Even this simple example involves quite a lot of actions, so let’s go through them two by two:

1. (Lending). Eve (operating as a bank) writes Alice an IOU for 1 piece of amber; Alice writes Eve an IOU in return.

2. Alice swaps Eve’s IOU for Bob’s book.

3. Bob swaps Eve’s IOU for Charlotte’s cake.

4. Charlotte swaps Eve’s IOU for Dom’s DVD.

5. Dom swaps Eve’s IOU for Alice’s amber.

6. (Repayment). Alice and Eve write off their debts to each other.

Notice how these 12 actions in the whole economy lead to the desired result in the real economy, as though all 4 people had met together, formed a circle, and had passed their goods around to the next person.

Half-finished scenario

Now let’s look at the scenario just up to the point where Bob has swapped Eve’s IOU for Charlotte’s cake.

All actions (left) and just the real economy actions (right) for a half-complete 4-way transaction supported by a bank loan

In the half-finished scenario, only looking at the results of the actions in the real economy:

• Alice’s RNW has increased by the book.

• Bob’s RNW has decreased by the book but increased by the cake (so he’s achieved his aim).

• Charlotte’s RNW has decreased by the cake.

Just looking at the real economy diagram doesn’t tell us why Bob gave the book to Alice, or why Charlotte gave Bob a cake. It could just as well be two gifts as trades involving debts (or one of each). But in one sense it doesn’t matter. We can see the effects of these actions on each person’s RNW. The effects of the debt-related actions can be added separately if we want the full picture. One thing which should be clear is that, when there’s no production, people can only gain goods if those exact goods are given up by someone else. There is nothing in the financial economy which can affect this truth.

Sometimes it’s enough to consider just the actions in the real economy. That tells us what has happened with the production, distribution and consumption of goods and services. For example, if we want to know how much the world’s raw net worth¹ has changed, we only need to look at the production and consumption in the real economy, and can ignore all the debts.

But never forget that there are lots of reasons why we might need to look at the financial economy too, and that is a key point of the One Lesson. In particular, RNW helps us to understand:

• People’s motivations (e.g. why Charlotte gives Bob a cake without getting any goods or services in return),

• What we might expect to happen in the real economy in future (e.g. Dom giving Charlotte a DVD, and Alice giving Dom a piece of amber),

• How much wealth someone has in total (since this is affected by what they are owed and owe), and

• What the result of someone not being able to pay all of their liabilities is.

Summary

It can sometimes be useful to look at just the actions from the real economy (the purple and/or white arrows) by themselves. While it doesn’t help us to understand why people have performed their actions, it does allow us to concentrate on what people are trying to achieve with their economic activity: the production, distribution and consumption of goods and services.

1. Someone’s raw net worth (RNW) is what they own plus what they’re owed minus what they owe. It is a “heterogeneous” sum/difference, meaning that things of different types are added and subtracted, not monetary “values” which have been assigned to them.