There are five main components to the economy: money, purchasing power, wealth, production, and psychology. In this article, I will discuss how each of these relate (and provide examples).

Wealth is a measure of the amount of desirable goods attained. Wealth is created. When one converts raw materials into usable goods, wealth is created in the process. Any further refinement of that product further increases wealth. For example, not many people have use for a felled tree. However, if one could use talent to convert that tree into lumber and a desk. When that happens, wealth was created; labor converted raw materials into a good that is usable by more people.

Additionally, wealth can be created through exchange. As a simple example, let’s consider two people: A and B. A is hungry but has plenty of water. B is thirsty but has hamburgers. A can exchange some water for some hamburgers with B and BOTH people become wealthier.

Production is the amount of wealth that is created. Production is often measured on a yearly basis. A common measurement of production in the United States is the Gross Domestic Product (GDP). The following chart shows the GDPs of the United States and China versus time. The current GDP of the US is approximately $20 trillion (or approximately $60,000 per person). This chart makes it look like we’re doing great; our production is way up from just 1960! Or is it? Let’s take a closer look at the numbers.

Of course, production is actually a giant set of numbers. And a great deal of information is lost when that giant set of numbers is reduced to a single number, similar to the metric of inflation. And measuring production in dollars has its own flaws, since the value of a dollar changes due to inflation/deflation, stimulus, interest rates, etc. Additionally, it benefits our government officials to show increases in production, so they have hacked at the GDP metric to make it look better than an accurate metric of production would be. For example, GPD only considers “end products”; it does not take intermediate production into account. So, if one harvests steel and then sells the steel to a vehicle manufacturer, that steel is not included in GDP. And you can see a problem. If you buy a truck and you use that truck to drive you and your family around, then that truck is an “end product”. However, if your truck is used on a farm to help produce crops, then it is an intermediate product. Since GDP compresses the information from gazillions of prices into a single number, attempts to isolate end products, and is measured in dollars, the metric is inaccurate.

We can get a more accurate metric of GDP by pricing it in gold. The chart below shows this amount [1]. And here we see an issue. Our current production rate is approximately that of 1960. With computers, improved communications, and the internet; and their resulting increases in efficiency; our production should be WAYYYYY up, but it’s not. (I may discuss why in a future blog post.)

Note that there is another way to measure production, which includes intermediate products, called Gross Output [2]. This is a relatively new metric, though. It is more difficult to find analyses of this metric. As you can see in the figure below, Gross Output is reduced more than GDP in recent years. This more comprehensive metric is indicating a worse reality than GDP.

Onto money. Before money, there was bartering. I would make a thing, and you would make a thing. And if I wanted your thing, I would offer you some of my thing. For example, I could make stools and you could make cheese. If I wanted cheese, I would offer you a stool.

Bartering works somewhat, but there are major drawbacks. What if I wanted cheese but you didn’t want a stool? I may have to find someone who needed a stool, who would be willing to trade me for something you wanted. The chain would get longer and longer. Currency (or money) was invented to address this problem. I would sell my stool for currency to whomever wanted it. And you would sell me cheese for currency. The entire system became more efficient, based on the trust that the currency I exchanged my good or service for today would be worth something tomorrow. In extreme cases, when currency fails, bartering is still utilized [3,4].

There are properties that a currency should have to be effective. It must be rare and limited. In ancient times, marked bones were used as currency [5]. More recently, gold was a currency used up until the 1930s (and completely eliminated from common in the 1970s – governments still trade in gold).

A fiat currency is one that is not limited; it is a currency provided by a government and not backed by a material good. The United States dollar is currently a fiat currency. It has worth because the government demands dollars in taxes. Therefore, one must supply dollars to stay out of jail. Since we want to stay out of jail, dollars have value. However, this value is limited to the amount demanded by the government. To retain additional value of the dollar, the US government has outlawed exchanges with other currencies. One cannot exchange goods and services for the value of the legal tender on American gold currency.

The purchasing power of the dollar is reduced by the amount of dollars in use. A simple example will illustrate how this works. Suppose there are 100 people on an isolated island. In order to improve production, the people agree on a currency. Their currency is island-trinkets. A government is instituted to create the trinkets. Each person is given 10 trinkets to start. And every month, they gather to exchange trinkets for goods. After the first month, they gather at the market to conduct their exchange. In our example, the government will spend all of their trinkets during the first month. What is the government to do? It still wants goods, but it no longer has trinkets. The government simply makes more trinkets; let’s say it makes 1000 trinkets for itself. The next month, it goes around purchasing goods. In competition for the same goods as the public, the government realizes increased purchasing power (it has more trinkets than anyone else). The people realize a decreased purchasing power; they have a reduced fraction of total trinkets. Additionally, the cost of goods in trinkets has gone up. Whereas the first month, there were 10 trinkets per person x 100 people = 1000 trinkets available for all goods; this month, there are the original 1000 plus the new 1000 that the government made. And so there are 2000 trinkets total to buy stuff. So the average cost will go up by 2 (assuming no increase in efficiency during the last month). Moreover, those people closest to the government are able to raise their prices first. Those people farthest from government are the last to see the new prices. If anyone on the island was on a fixed income or if someone loaned their trinkets to anyone else for a fixed interest rate, they lose out because of the creation of additional currency. The government’s actions have created inflation.

This simple example is in play today. The following chart shows how the purchasing power of the dollar versus time. Whereas there have been major increases in efficiency of production, which would naturally lead to an increased purchasing power, the dollar currently only purchases 1/20 of what it did in 1913.

We can see something else in our analogy. By creating currency, the government does not generally increase production. Instead, it shifts production from those goods that people want to those goods that the government wants. This, in turn, makes the goods people want more expensive (because there is less effort available for that production, leading to a reduction of supply). We also see this happening today. Those on social security have lost much more purchasing power (for the goods that they desire) than the average [6]; they retain only 34% of their purchasing power since the year 2000.

Finally, there is psychology. As economics is a study in people’s behavior, it is a subset of psychology. One might ask, for example, why are the people permitting the government to take away their purchasing power with the creation of new dollars? The answer, I think, can also be seen in the chart above. Initially, we exchanged gold. Then, paper dollars were used, but they could always be exchanged for gold. Then, citizens could no longer exchange the paper for gold, but banks still could. And now, our paper currency no longer has any gold backing. Making small changes over time was a trick that prevented the public from realizing the total consequence in any single timepoint.

“Government is the only institution that can take a valuable commodity like paper, and make it worthless by applying ink.” -Ludwig von Mises

Psychology plays a huge role in the stock market. Stock prices are not immediate reflections of differences in company value largely because of people’s beliefs. At the moment, most of our metrics of the economy show significant dangers. And yet (even when measured in gold) the stock market continues to reach new highs. I think that this is because of psychology. When people realize the current state of the market and when the Federal reserve is no longer able to artificially bolster the stock market with additional drops in interest rates, that realization will come. I think we will see a much more accurate representation of the value of the stock market (when compared to gold) at that time.

[1] https://pricedingold.com/us-gdp/

[2] Skousen, Mark. The structure of production. NYU Press, 2007.

[3] https://smile.amazon.com/Bakers-Secret-Stephen-P-Kiernan/dp/006236958X?sa-no-redirect=1

[4] https://www.dw.com/en/argentinias-new-bartering-economy/av-44466435

[5] https://en.wikipedia.org/wiki/Tally_stick

[6] https://www.usatoday.com/story/money/personalfinance/retirement/2018/11/21/social-security-benefits-have-lost-a-third-of-their-buying-power-since-2000/38562483/