Monday, January 28, 2008

Economics or finance?

From a fun baseball story about a minor league player selling shares in his career:

"Newsom has decided to use that economics degree he got from Tufts, and along with two friends he's started a new company called Real Sports Investments. It's a company that allows baseball fans to invest in minor league baseball players by purchasing shares of the player."

Being from Britain, it reminds me of those human interest stories you sometimes read about a father laying a bet that their son will one day play soccer for England (here's merely the first example I got from Google). More to the point, how is Newsom's economics degree helpful?

The short answer is not at all. The study of economics isn't "business", or management, or whatever you call the skills and knowledge that would be useful in setting up or running a company. It also isn't finance, so it can't help him understand how a stock market works.

What's the difference between economics and finance? A good starting point might be this, from Brian Hollar:

"Finance typically focuses on maximization of wealth. Economics focuses on the optimization of subjectively valued goals. Conceived of in this way, finance is a specialized subset of economics."

That gives the correct impression that finance is the one that's interested in the study of the management of money and assets. I might go further and say that finance is arguably vocational; I don't think economics courses hold a great deal of value for aspiring investment bankers (perhaps one of the commonest misconceptions held by undergraduate economics concentrators) - finance courses are the ones that will teach them how asset markets work. Economics, being more of a method than a body of knowledge, is not really vocational at all, even though students of economics will certainly develop other applicable skills like data analysis, applied math and writing. Economics probably uses optimization rather than "focusing" on it.

Just to complicate matters, the unfortunately named field of "financial economics" is, as the name might suggest, something of an intersection of the two. Financial economics is the application of the economic method to the particular case of the trade in money and assets like stocks and bonds: how do financial markets and the trade of assets affect the allocation of resources? How does the financial system affect the decisions made by people, companies, governments? Financial economics, being part of economics rather than finance, fits Hollar's definition of "optimization of subjectively valued goals"; it's again a descriptive tool rather than practical training or a recommendation of a course of action.

Finance and economics are terms often used interchangeably in the press. I think the best illustration is the word "socioeconomic", which to my mind really means "sociofinancial" - what's your social status, and how much money do you have? If we start using "economic" to mean the amount of resources a person has at their disposal, the nuance of the word as signifying the allocation of resources is obscured.

I always wondered why The Economist magazine has a composite section for "Finance & Economics". It might be worth emphasizing the distinction between these two concepts a little more cleanly. In an ideal world we might even have a third word: economics for the economic method, finance for asset markets and a shiny new one to talk about the "world economy". What does "America's weakening economy" really mean?

1 comment:

Justin Cui said...

Economics is the study of the trade of good and services.

Finance is the study of the financial market, which is the market that coordinates the interests of borrowers and lenders.

As such, finance is a subset of economics.