June 18, 2012

Book Review: Six Myths that Hold Back America

Charles Perrottet
Partner

Our work in scenario consulting makes us keep an eye open for alternative viewpoints on major issues. Once in a while someone with whom we are acquainted propounds a view we think is worth sharing. Frank Newman is well positioned to know how international finance works.  He has been CEO of a major American bank, Deputy Secretary of the U.S. Treasury, and CEO of a large Chinese bank (the only American to hold such a position). His new short book, Six Myths That Hold Back America, exposes what he says are six false beliefs that are widely held in the United States – even or especially among people who are in a position to make policy.  That said, the purpose of the book is not to suggest particular policies, but rather to explain how the international financial system works.  Only with a correct understanding of these mechanisms can people evaluate policy alternatives.

In coming days we’ll examine each of the “Six Myths” in more detail, but here is a very brief listing of all of them:

1. Asian nations are bankrolling the U.S. Most dollars (except for cash carried by travelers) never leave the U.S.  They are merely moved from one U.S. bank account to another.  Moreover, they can only be used to buy dollar-denominated goods and services or to invest in dollar-denominated assets.  Technically, a third choice is to exchange dollars for assets in another currency, but then the new holder of the dollars will be limited to the same choices.

2. Treasuries “crowd out” financing for the private sector.  When an investor buys a Treasury bond (thus transferring money to the government) the government spends the money it receives.  The result is that there is just as much money available for investment as there was before purchase of the Treasury.

3. If everyone tries to save more, the nation will save more, and investment, GDP, and employment will increase.  The truth reflects the “Paradox of Saving.”  Money that is not spent reduces the amount of products and services that are bought.  Thus, if everyone saves more, the saving of the country cannot increase and employment and GDP will decline.

4. If the deficit is reduced, then national saving and investment will increase.  Since all receipts come from the private sector and all spending ends up in the private sector (at the end of the chain), a reduction in the deficit must mathematically reduce GDP and disposable income.  Unless the economy is in full employment and overheating this is not desirable.

5. Deficits create great burdens of repayment and taxes for our children. There is no need to eliminate the existing debt and, in fact, it has never been done dating back to 1791.  Only the interest must be covered.

6. If the U.S. does not get its fiscal deficit reduced soon, U.S. Treasuries will face the same problems as bonds of Greece and Ireland.  The U.S. is unique because of the size of its market, which is a closed system.  If Greece pays off a bond the Euros can be reinvested anywhere in the Euro-zone (e.g., Germany), but when the U.S. pays off a Treasury the dollars can only be invested in the U.S.

As stated at the outset, there are still numerous policy alternatives that can be explored in a variety of future scenarios, but Newman believes that analysis should include an understanding of the underlying economic principles.  We’ll examine each of these “Myths” in more detail in coming days.

Comments  | 

Dear Charles, As an educator, I am curious about the sources of the myths and about the reasons for their persistence. Do Newman or you have a view on either of these matters? Sincerely, Jeremy
Charles Perrottet
Jeremy, The myths are to some extent based on mistaken intuition, compounded by a misunderstanding of the differences between an individual or organization and the total economy. Then, of course, the media and politicians have also contributed.
Frank Newman
Jeremy, Interesting questions – both the sources and the persistence. Charles hit the high points. Analogies between a family’s finances and the nation’s sound good, but do not necessarily apply to the nation as a whole and the fimnacial system in total. I also think that traditional economics courses have entrenched some views. For example, models used often assume full employment, and students get used to the models, which do not apply in the real-world conditions that we have now and most of the time. Once political leaders and journalists repeat those positions often enough, others assume they must be right. So, in thinking about Six Myths, I tried to step back to careful logic, without assuming any conclusions in advance. Of course, it’s really hard for people to change their views. You saw the quote from JMK: “The difficulty lies, not in the new ideas, but in escaping from the old ones. . . .” I hope you found the book thought-provoking. Frank Newman
Robert Carroll
As an outsider to the world of international finance I am most intrigued by the concepts presented in this very clear and understandable synopsis of Newman's work. I am like one entering a dark forest looking for a clearing and since I have trust in the reviewer's perceptions I will now continue to read the reviews and actually obtain the book itself. Thank you for your pathway to further insight.
Mark Safford
As a non-economist I am intrigued by the "Paradox of Saving" in number 3. What I take that to mean is that if a person saves some money in a bank account, they are really just transferring the decision about where to invest that money to the bank that holds the account, which will invest it based on the bank's own criteria, i.e., to make more from the investment than it has to pay in interest to the account holder.
Charles Perrottet
Mark, Your observation is an interesting one but not what this is referring to. The "Paradox of Saving" here is about the fact that mass saving reduces output and, therefore, demand for investment. I'll cover this in more detail in a further blog in a few days.
Cambria Allen
I'm not particularly familiar with international finance, so I am very interested in the author's discussion of "myths" one and six. I am in complete agreement with the author's assertions about the "Paradox of Saving" and deficit reduction, although I am curious to see how he presents these issues. I think a large part of the problem in getting folks to understand many of these issues is our innate tendency to conceptualize based on what we see in our day-to-day lives.

Thoughts?