Morningstar Magazine - April/May 2015 - 16

Dispatches

resources used to produce the good demanded by
the government could have been deployed
elsewhere in the economy. The government is
spending more, but we have to always ask: Do the
benefits of this spending outweigh the costs?
The spending fallacy is heard most frequently
during times of economic recession. Couldn't high
unemployment be alleviated by increased
government spending, in particular on goods that
unemployed people are good at producing?
Again, what looks logical at an individual level
gets more complicated for the economy as a whole.
The reallocation of labor is a highly complex
process, and government involvement will alter it
in important ways. It is questionable whether
any government has the requisite knowledge and
expertise to direct resources more effectively
than a decentralized economic system. There is
scant empirical evidence that governments
are capable of doing this well (arguably quite the
opposite appears to be true).
Suppose the government offered to employ the
services of unemployed people who used to make
t-shirts. What should the government have
them do? Any choice will affect a wide range
of prices and consumption and production choices.
As employment increases in one sector, it could
easily decrease in other sectors.
The reason the spending fallacy persists is most
likely that we control our own spending decisions
and see how they affect our lives, but do not
observe how our decisions affect other people's
decisions and lives, and vice versa. Each decision
we make has a minute effect on the market
as a whole, in particular on prices. So, when we
go to a store, it looks like the price is fixed and the
quantity that we choose to buy is up to us to
decide. But in fact, for the economy as a whole, it
is exactly the opposite: the quantity is fixed,
at least in the short run, but prices are flexible.
Example 2: Financial Markets

Discussions of financial markets are rife with

examples of fallacious economic reasoning. Again,
the source of confusion is usually the fact that
what is true from an individual's perspective is not
true for the market as a whole.
Probably the most common example occurs when
stock prices rise; we often hear that this is
because there was "a lot of money going into
stocks." And when stock prices go down,
there was a "sell-off." From our own individual
perspective, financial assets may seem a bit like
pillowcases that can be stuffed with more
or less amounts of money. But in reality, changes
in stock prices do not imply anything about
the total quantity of money or shares that exist,
and there cannot be a net sell-off, because every
trade involves both a buyer and seller.
A possible reason why financial markets are poorly
understood is that it is unclear what financial
assets actually are. So, again, let us review.
An asset is a legal ownership claim to goods and
services. This may be a claim on existing goods;
for example, the title to a house confers on its
owner the right to live in that house, or rent it out.
Alternatively, the holder of an asset may be
promised delivery of a (possibly uncertain) quantity
of goods at a future point in time, in which case it
is called a financial asset.
How are financial assets created? The simplest
example would be this: Two people engage
in a trade. Person A provides a service on the spot,
while person B issues a "B" note promising
the delivery of goods or services at a future point
in time. Continuing, suppose person A uses
this B note in an exchange with person C, who in
return issues (to A) a new "C" note promising
goods in the future. The number of financial assets
in existence has thus increased from one to two.
Vice versa, the quantity of financial assets
decreases whenever a person pays off some of his
or her outstanding liabilities; for example, when
someone pays off his or her mortgage.

(and services) increases the quantity of goods
one is entitled to receive from others, while buying
goods decreases one's balance.
Now that we understand what a financial asset
is (a promise to deliver goods or money in
the future), we may wonder what determines the
value of a financial asset today. Various factors are
involved, including the quantity of goods (or
dollars) that is expected to be received, the
uncertainty about that quantity of goods, and the
rate at which people are willing to forsake
consumption today for consumption in the future.
Finally, the value of financial assets could be
measured in many ways. Typically, money is used
as the unit of account. In addition, the vast
majority of transactions involve the "buying" party
paying in money, so that the unit of account and
medium of exchange coincide. Money is just
another financial asset. Specifically, money is a
liability of the federal government, just like
Treasury bills, notes, and bonds. Essentially, money
is zero-maturity debt.2 Money represents only a
fraction of financial assets. A deposit account at a
bank, for example, is an ownership claim to that
bank's assets, which consist mostly (at least
traditionally) of personal and small-business loans,
which are not money.
Exposing a Flaw

Many years have passed since Milton Friedman
provided a persuasive reason for why most
economic misunderstandings are examples
of a singular fallacy-namely that what is true
for an individual is not necessarily true for
the overall economy. Nevertheless, this fallacy has
persisted and is as widespread as ever. This
is unfortunate; society is better off when people
have a solid grasp of economic principles. K
Gideon Magnus, Ph.D., is a senior quantitative analyst
with Morningstar.

At its core, the financial system is best understood
as a scorekeeping device. Selling goods

2 The best way to see why money is a government liability is the fact that the government accepts money (in fact, only money) as payment of taxes. Government liabilities would decline to the
extent the government does not spend its tax revenues.

Morningstar April/May 2015

Morningstar Magazine - April/May 2015

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