What Does Economy Mean? The Difference of Real vs. Financial Economics

What do you think of when you think of “the economy?” We hear that word all the time—on the news, on the lips of politicians and policymakers, and in casual conversations, too. But what is it, exactly? Do you feel like it’s something you have a meaningful role in? Or do you feel like changes in the economy are made out there, outside of your control, by other people like stock traders, senators working on trade deals, the Treasury Secretary, and places like the World Bank and the International Monetary Fund?

Well, we’re going to break it down a bit and focus on a powerful distinction within the economy—the difference between the financial economy and the real economy.

DEFINING THE ECONOMY

Webster’s Dictionary defines the economy as, “the structure or conditions of economic life in a country, area, or period.”

Since it’s included in the definition of the noun, we have to look at the adjective “economic,” which Webster’s defines as, “of, relating to, or based on the production, distribution, and consumption of goods and services.”

We can bring these two definitions together to say that the economy is the way that people organize to produce things, distribute them, and consume them within their time period and geographic area.

What’s interesting about this definition is that money or finance, the first thing that comes to mind when we think of the economy, is not included here. Depending on the time and place, all of these economic activities (production, distribution, and consumption) could be achieved through bartering—no money required.

Of course, the structure and conditions of our economy are much more complicated. For example, we use digital and paper money to exchange value. Rather than being paid in something like burritos for your work, you can take your paycheck and use it to buy a whole variety of foods or tuck it away and save it for a lot longer than a burrito would last… I mean, I love burritos, but they don’t taste so great after a few days!

The way people organize within our economy today makes it possible for people, organizations, and governments to borrow money, loan money, or invest it in other people, organizations, governments, or financial products like mutual funds. As activities become more specialized and move farther away from the direct exchange of work for a tangible product to consume or own, the economy becomes increasingly impersonal and removed from the actual, physical activities of production, distribution, and consumption, which are the basis of the economy. These more complex activities, such as investing in the stock and bond markets, are layered on top of basic, direct economic activities like drawing a paycheck or buying a home.

Most of us feel comfortable with direct economic activities—getting paid in cash for hard work or buying something that we bring home to use or consume. We know it, we can touch it, and we understand it at a tangible level. When the action gets further into financial investments or economic policy, it can be very hard to follow and easy to feel like it’s something out of our hands.

DISTINGUISHING THE REAL FROM THE FINANCIALSo, with the complex ways that our economy works, it’s possible to feel overwhelmed. One way to sort through all of it is to make a distinction between the real economy and the financial economy. The way to distinguish the two is a matter of degrees.

Remember that burrito?

When I pay for a burrito at a restaurant or food truck, that’s direct economic activity. I’m exchanging money for a physical thing that someone cooked. If I’m short on cash and need to borrow money from a friend to buy that burrito, my friend is one step away from direct economic activity. My friend has a direct relationship with me. My friend gets an IOU note and I get fed.

Now, if my friend takes that IOU note, puts it in an envelope with IOU notes from a bunch of other people, and sells the envelope of IOUs to another person, that sale two steps away from the burrito sale. I may not know the person who now holds my IOU, and they might not know me! They may have bought the IOUs thinking about the value of what is owed, rather than who I am and where I got that burrito.

This happens with student loans, home mortgages, and even medical debt. Sometimes you know it because your billing changes—like in the three times this happened with my student loans. But other times, it can happen subtly because the “servicer” of the loan (the organization that collects payment) might not change. However it happens, these exchanges are more about finances than tangible goods and services or the person who originally took out the loan (or wrote that IOU).

The Global Alliance for Banking on Values has a helpful visual to show the degrees of distance from real economic transactions, and where the real economy ends and the financial economy begins.

The real economy includes the direct exchange or purchase of goods or services and the lending or savings services that are one step (or degree) away. Once we go two or more degrees away from the actual product purchase, we’re in the financial economy.

At its most basic, the real economy is concerned with the production and sale of physical goods and services with direct, close-contact lending. On the other side, the financial economy is concerned with selling and buying on the financial markets, such as stocks, bonds, mutual funds, or more complicated instruments like mortgage-backed securities and collateralized debt obligations.

WHY DO VALUES-BASED CREDIT UNIONS AND BANKS FOCUS ON THE REAL ECONOMY?

Now that we have an understanding of the different areas of the economy, why does it matter? And why do banks and credit unions that lead with values choose to place their assets in the real economy? Here are three important reasons.

• Stability—By being close to the purchase and the borrower, these lenders can have a much better understanding of the benefits and risks of making a loan. With a greater understanding of the product, the borrower, and the place where it’s happening, they can make loans that work better for the borrower and for the credit union. All of this helps to maintain stability, which is essential to keeping the promise to the membership that credit unions are a safe, secure, and trustworthy place to do your banking.
• Local Recirculation—When deposits are lent out into the community for a home, car, or business, the money goes back into the local economy and enables greater vitality in their shared community. Each time a person makes a payment on their loan, the money can go right back out for another person’s needs. The more the money cycles through the local area, the more activity and vitality there is. Activity and vitality are key to making improvements to the quality of life, and who doesn’t like that?!
• Sustaining and Improving Lives—Focusing on the real economy is one powerful way values-based credit unions and banks can do that. When a loan helps a young family buy and move into their first home, that improves the quality of their life. When access to credit helps a person get that vehicle to get to work and play, that improves the quality of their life. When a business loan helps a company grow and hire local talent, that improves the quality of life.

NOW IT’S YOUR TURN

Now that you have a way to distinguish between them, you can notice when your economic actions are in the real economy or in the financial economy. Both types are useful and understanding them can give you more choice and power in what you do with your money.

One choice you can make to put your money in the real economy is to buy direct from producers when possible. Farmers’ markets are a great example, but generally, when you buy from a local business, more of your dollar stays in circulation nearby. Another good choice is to do your banking with local banks and credit unions. The business models for these are weighted towards real economy transactions, such as your neighbor’s new roof or the new business opening on main street.

When you can see how your actions affect the economy, it’s easier to see how we are connected to the economy, where we have control, and how our choices can make a real impact.