June 22, 2012

Frank Newman's Six Myths -#2: Treasuries "crowd out" financing for the private sector

Charles Perrottet
Partner

Today we examine the second “myth” from Frank Newman’s book Six Myths That Are Holding Back America – the belief that treasury bills compete with private sector organizations for available capital.

Some of this confusion comes from the “fallacy of composition.” Paul Samuelson defined this as “A fallacy in which what is true of a part is, on that account alone, alleged to be also true for the whole.”  A simple example from arithmetic would be that since 1 and 3 are both odd numbers, then the number 4, which is made up of 1 and 3, must also be odd.  In economics it is clear that if a person spends money it is no longer available to him.  But when money is used to buy Treasuries it has not reduced the amount of money in the economy.  Money raised from the sale of Treasuries is spent by the government, either to retire other Treasuries or to buy goods and services.  The total in the system is not changed and the amount available to the private sector is not diminished.

 It is also important to be aware of the amount of money in the system.  Banks are required to hold a portion of deposits as reserves.  Any amount held above that requirement is dubbed as “excess reserves.”  Logically, a bank would like to earn a return on these funds if it could find investments that justified the lending risk.  Historically, excess reserves were about $2 billion for the entire U.S. banking system.  In the wake of the 2008 financial crises, however, these “excess reserves” rose to about $1 trillion by 2011 – there was lots of money available.

Ironically, when the economy is hot (full employment), spending by the government could compete with spending by the private sector, contributing to inflationary pressures.

In summary, when the U.S. issues Treasuries, it has no effect on the total amount of money in the system.  When the government buys Treasuries and “uses” that money, there is no need for the private sector to “use” less.  The money has not disappeared, it has merely passed through the government on its way back to the private sector.  There remain some vital questions about the most effective use of that money, and these questions should be explored…perhaps, as you might have guessed we would say, by creating a set of alternative scenarios. 

Next myth: “If everyone tries to save more, the nation will save more, and investment, GDP, and employment will increase.”

Thoughts?