Herbert Grubel
Professor of Economics Emeritus, Simon Fraser
University
Senior Fellow, The Fraser Institute
Abstract:
This paper argues that the ultimate cause of the financial turmoil in
2008 is not incomplete regulation of the financial sector, but the substantial
accumulation of financial assets by Sovereign Wealth Funds, Exchange Rate
Stabilization Funds and Social Program Prepayment Funds in a number of
countries.
This accumulation of financial
assets is matched by an increase in real savings, which reduces global demand
and generates recessionary pressures. The
loose monetary policy of the US Fed and the financial innovations in the market
for mortgages saved the world from the recession that otherwise would have taken
hold.
To avoid a repetition of the
2008 problems requires that future, extra-ordinary growth in financial asset
holdings by governments will lead to a coordinated global loosening of monetary
policy, a sharing of the adjustment burden among all major industrial countries.
Note:
I acknowledge useful comments on an earlier draft of this paper by my
former SFU colleagues James Dean and Peter Kennedy and participants at a
conference on international financial issues held at the Palazzo Mundell in
Siena, Italy at the end of June 2008.
Financial
analysts, governments, international organizations and the press were virtually
unanimous in blaming the central banks and financial intermediaries in the
private sector of the Western industrial countries for the financial turmoil
that swept the United States in the wake of defaults on the secondary mortgage
market in 2008 and threatened financial stability in the rest of the world.[1]
In response
to these financial problems, the Bank of International Settlements has proposed
the creation of more regulation and oversight of financial intermediaries in the
private sector, which like the 1988 Basel accord on bank capital ratios is
almost certain eventually to be adopted as new standards by national regulators.
These new
regulations will involve high costs of administration and stifle competition.
Most important, like most regulations, they will prevent a repetition of
past problems, but will not prevent the private sector from adopting another set
of innovations in the future when financial conditions encourage it, which may
ultimately result in a new crisis.[2]
The
contention of this study is that the 2008 financial turmoil, much like the
financial crises that swept the world in the wake of the energy crisis of the
1970s, is due to the rapid growth of financial assets held by governments and
governmental agencies in the Middle East, China and other countries.
The motives, mechanics and effects of the accumulation of these funds are
discussed in the next section.
The main
problem arising from this accumulation of financial assets is that its
counterpart is the creation of a fiscal surplus for the world. Such fiscal surpluses, especially if they are large and
sudden, result in recessionary pressures.
In the
closed economy of the world, these recessionary pressures in the longer run tend
to be eliminated by the lowering of interest rates and the resultant higher
spending on investment and consumption. In
the new equilibrium the world has a higher level of savings and investment than
it did before these government savings took place.
However, in
the short run and in a world where individual central banks pursue price
stability, there is no guarantee that the increased spending induced by lower
interest rates is sufficiently large and quick to prevent recessionary pressures
and an economic slowdown.
As it
happened and will be discussed in more detail below, only the US Fed was willing
to lower interest rates and stimulate investment and consumer spending, while
the European Central Bank, the Bank of England and the Bank of Japan failed to
do so because they pursued other policy objectives.
The Fed’s
task was complicated by the fact that pressures on US manufacturing caused by
massive imports from China made domestic investment less than normally
responsive to lower interest rates. For
this reason, the bulk of increased real spending came from the housing sector
and consumer spending, which eventually led to overspending and the 2008
turmoil.
The policy
implications of the preceding analysis is that future extra-ordinary increases
in savings by governments require the major central banks to share the burden of
adjustment and stimulate aggregate real demand through a coordinated lowering of
interest rates.
The Nature
and Size of Financial Asset Holdings of Governments
It is useful
to distinguish three different types of government agents that accumulate
financial assets. All three types
of agents have in common that their activities are backed by the coercive powers
of government, that they accumulate of assets at the expense of the traditional
factors of production labour and capital and that they do not possess sufficient
expertise to invest in real productive enterprises, which induces them to place
their funds in bonds and equities.
The first
group of what will be called resource funds accumulate financial assets through
profits or royalties from the sale of exhaustible natural deposits of oil, gas
and other sources of energy. These
agents either own the resource firms outright (as in the Gulf States) or
indirectly (as in Russia) or they earn royalties imposed by governments (as in
Norway and Alberta).
The main
justification for this activity is that these resources will eventually be
exhausted and that the resource wealth should be shared equitably between
present and future generations.
These
resource funds are widely known as Sovereign Wealth Funds and have attracted
most of the attention of politicians and the media because of their efforts to
purchase national assets in Western countries that are either involved in
activities affecting national security or they are icons symbolic for
countries’ development and sovereignty. However,
as will be seen below, there are other funds, which engage in the same offending
activities but have completely different sources of income and which therefore
are usefully referred to by a different name.
Unfortunately,
resource funds do not publish information about their size.
Interested parties in the international financial community have
estimated what is known about their investment portfolios, mainly to study the
use of the financial surpluses that affect their business interests.
The IMF has
published the results of a survey of estimates by interested parties (IMF
(2008)). According to this source,
in early 2008 the five largest resource funds were under the control of the
governments of UAE ($875 billion), Norway ($380 billion), Saudi Arabia ($289
billion), Kuwait ($219 billion) and Russia ($157 billion), for a total of $1,914
billion.
These
estimates are in US dollars and are at the upper end of the available range.
The lower end is about 50 percent less.
A number of
other countries have resource funds with upper estimates ranging from $54
billion (Australia) to $0.5 billion (Trinidad and Tobago) as the lowest.
The list includes other than national jurisdictions like Alaska ($40
billion) and Alberta ($16 billion). In
total, these smaller funds amount to as an upper estimate $354 billion.
Important
for the analysis of the creation of these funds and the development of the
financial turmoil around 2008 is that the bulk of their surpluses is likely to
have occurred in a few preceding years. Unfortunately,
data on growth figures are not available, but it may be surmised that it
occurred since 2005 and while energy prices rose rapidly and stayed at high
levels.
The second
group of agents accumulating financial assets are the exchange rate
stabilization funds of central banks. These exchange rate stabilization funds
increase when the central bank buys foreign currency to prevent an appreciation
of the exchange rate and sells them to prevent a fall.
The motive
for these operations in the foreign exchange markets in principle is to limit
the influence that random real economic or financial developments have on the
country’s economic conditions and growth.
There is no
need to discuss here controversies about the alleged practice of some countries,
China in particular, to accumulate considerably more reserves than are necessary
to meet their needs for exchange rate stabilization. When this happens, a country in fact engages in mercantilist
policies of increasing exports and decreasing imports at the expense of other
countries.
This effect
is modified whenever central banks increase the domestic money supply as a
by-product of purchasing foreign exchange from private agents.
In principle, such money supply increases result in lower interest rates,
capital outflows and more spending by consumers and investors until the balance
of payments surplus is eliminated and no more central bank purchases are needed
to keep the exchange rate stable. Countries
with flexible exchange rates have these adjustment forces assisted by changes in
the value of the currency, foreign capital flows and changes in trade balances.
However, in
practice, this classic adjustment mechanism to payment imbalances involves time
lags and politicians often interfere with its operation in order to pursue
different domestic policy objective. Such interference causes the sterilization
of the effect of the purchase of foreign exchange on the domestic money supply.
The
continued accumulation of large amounts of funds by China for prolonged periods
is clear evidence of the fact that the effects have been sterilized and the
money supply and exchange rate have not been allowed to increase sufficiently to
eliminate the balance of payments surpluses.
The most
important aspect of the growth of these funds in the present context is that it
takes place at the expense of labour and capital, which earned less than the
true value of their production or who have to pay more than the true value for
imported goods.
Under the
assumption that the owners of labour and capital would have spent a large
portion of the income if they received it, the central bank accumulation of
reserves leads to a net increase in real savings and brings with it the adverse
consequences for the balance of real demand in the country and world noted
above.
International Reserve Holdings by Eleven Countries with largest Holdings
Country |
Billions of US Dollars |
Percent Increases in 2007 |
Recycling Petrodollars long paperPR of China (Mainland) |
1,809 |
43.3 |
Japan |
1,004 |
8.7 |
Russia |
578 |
56.8 |
Eurozone |
568 |
16.6 |
India |
308 |
64.4 |
Republic
of China (Taiwan) |
291 |
2.7 |
South
Korea |
260 |
9.7 |
Brazil |
199 |
105.9 |
Singapore |
176 |
19.1 |
Hong
Kong |
160 |
14.6 |
Germany |
144 |
20.3 |
Notes: Holdings around the middle of 2008.
Source: http://en.wikipedia.org/wiki/Foreign_exchange_reserves.
This source provides references to the official publications where these
data are found.
The IMF tracks the
level of international reserve holdings by individual countries.[3]
Table 1 shows the reserves of the 11 countries with the largest holdings in
2008, accounting for about 60 percent of all such reserves in the world.
The value of
the reserves held by the 11 countries around the middle of
2008 was $5,497 billion. This
represents an increase of $1,244 billion in the year 2007 alone and is
indicative of the size of the effect that the growth of reserves has on
aggregate global demand.
The third group
of agents accumulating financial resources may for convenience be called
prepayment funds. They were created
in some industrial countries in order to deal with inter-generational inequities
that have arisen in the administration of social programs, mainly pensions and
health care.
These social
programs had originally been designed so that contributions by presently working
persons paid for the needs of pensioners. The
expectation had been that this pay-as-you-go system would permit contributions
to remain low and relatively constant through time.
However,
because of unexpected demographic developments - low birth rates, increased life
expectancies and a bulge in the number or retiring baby-boomers – the
contributions required over the next 40 years or so will rise to very high
levels and will impose heavy burdens on workers.
The high rates
of contribution required from workers in the future are not only unfair, they
also discourage work effort and encourage the growth of the underground economy.
For these reasons, the Government of Canada in 1996 raised the rates of
contribution of workers to levels greater than were needed to pay the
government’s public pension obligations at the time and in the near future.
The resultant
fiscal surplus of the system was removed from the general budget of the federal
government and thus has not been available to pay for spending increases or tax
reductions. The funds were invested
in bonds and equities, which early in 2008 had grown to C$123 billion.
This amount is expected to increase further until in about a decade from
now, at the existing contribution rate the payments to pensioners exceed the
contributions of workers. The
resultant deficit will be covered by withdrawals from the prepayment account.[4]
The government
of Singapore from the start funded the public pension system with contributions
from workers, which the government kept in personalized accounts for them in the
so-called Provident Fund and which were used to invest in bonds, equities and
firms in Singapore.[5]
The details of
Singapore’s public financial affairs are not transparent, but it is certain
that the amount of funds controlled by the Provident Fund run into many
billions. It is also not clear what
is the relationship between the Provident Fund and Singapore’s Government
Investment Corporation, which according to the IMF (2008) study holds
investments worth between $100 billion and $300 billion.
In the light of
the preceding analysis it is safe to conclude that different government owned
funds in the world together hold at least $8 trillion in financial assets.[6]
[7]
Market Failure?
Why did the
purchase of securities by the public funds not result in a lowering of interest
rates to stimulate increases in real consumer and investment spending equal to
the savings made by these funds?
There are
two answers to this question. The
first involves timing.
After a drop
in the real rate of interest, it takes firms time to plan and execute extra
investment and consumers to take out loans to increase consumption.
Such lags are not important whenever the economy develops smoothly and
levels of saving and investment are relatively stable and grow predictably.
However, the
levels of savings that gave rise to the problems of 2008 appear to have been
very much out of the ordinary and unforeseen.
Few analysts had predicted the dramatic and sustained increases in energy
prices responsible for the growth in the resource funds, the rapid development
of the Chinese economy and exports responsible for the growth of Chinese reserve
holdings and the establishment and growth of social program prepayment funds.
The second
part of the answer is found in the behaviour of central banks.
The large increase in the purchase of securities by the funds raised
their prices and put downward pressures on interest rates.
However, the major central banks of the world tend to set interest rates
often without regard to pressures in capital markets.
Instead, they pursue inflation targeting.
It so
happens that during the period when the funds grew rapidly, the same energy
price increases that drove them also created inflationary pressures in the major
industrial countries of the world. As
a result, the interest rate policies of the European Central Bank and The Bank
of England remained unchanged and focussed on the control of inflation.
The Bank of Japan, another one of the most important central banks in the
world, already had extremely low interest rates.
As a result
of the conditions, the burden to lower interest rates and increase real
expenditures fell on the US Federal Reserve, which had been pre-disposed to
easier monetary policy already because of efforts to escape from the economic
downturn that had occurred in the wake of the bursting of the high-tech bubble
in 2001-2002.
During the
period when the funds grew rapidly, American manufacturers were not particularly
responsive to real investment opportunities created by lower interest rates.
There were not only the overcapacities from the high-tech boom but, more
important, profitability was lowered by the massive imports from China.
This left US
consumers to make up the global shortfall of real expenditures.
The idea of stimulating consumers to spend more on housing has always
been politically popular in the United States, and when financial innovations by
private financial intermediaries efficiently channel funds in the mortgage
market, the developments were widely welcomed.
The
increased demand for housing led to higher prices of existing homes, encouraged
new construction and borrowing by consumers for furnishings and general
consumption. The US economy driven
by these expenditures and aided by fiscal deficits of the federal government was
the engine that matched the savings of the international funds, causing the
trade deficits deplored by many.
However,
this prosperity ended when defaults occurred on mortgages that under more normal
circumstances never should have been issued.
These defaults caused a tightening of credit by banks, growing economic
distress, unemployment, more mortgage foreclosures, falling house prices, a
collapse of the building industry, in a vicious cycle that is all too familiar
from past crises.
The further
regulation of banks, credit rating agencies and other financial intermediaries
proposed by the Bank for International Settlements may well prevent a future
repetition of exactly the same pattern of overspending and credit restrictions
that have resulted in the present global financial and economic turmoil.
However, the
preceding analysis suggests that if government funds in the future will again
accumulate large quantities of financial assets, the same problem will arise as
one or more central banks once again lower interest rates by too much and
financial intermediaries invent new and unforeseeable methods to get borrowers
to take out loans and increase real expenditures.
This
forecast is consistent with historic experience.
During the late 1970s and early 1980s the financial assets accumulated by
petroleum exporters were funnelled into investment projects in developing
countries, which ultimately led to defaults and a major international financial
and economic crisis. BIS-sponsored
regulations of financial markets were designed to prevent a repetition of this
process, but could not prevent the new problems of 2008.
A more
appropriate policy response to the future growth in government savings outlined
above is for the major central banks of the world to engage in coordinated and
appropriate lowering of interest rates to eliminate the deflationary pressures
stemming from the increased global savings.
This policy response can and should be coordinated through the efforts of
the BIS, where the heads of the major central banks of the world meet regularly.
The main
feature of such a coordinated effort should be the sharing of the burden of
adjustment among all industrial countries.
Details of the relative amount of burden imposed on each country will
have to be worked out in negotiations that take account of economic conditions
in and the size of each of the countries in the group.
It may be
worth mentioning that if the world had a global currency and thus only one
central bank, the problem of coordination and assignment of responsibilities
would not exist. There are a number
of other benefits for the world arising from such a global currency.
Robert Mundell, the Nobel laureate and “father of the Euro” in
several recent publications discusses them.
They are also outlined on a website http://www.singleglobalcurrency.org/. However, for a number of reasons, the creation of a
global currency at present is elusive.
One may
speculate that possibly the ability of energy producers to accumulate large
surplus funds may be reduced significantly in the future once the incentives
provided by persistently high prices result in the development of alternative
supplies and reductions in demand. However,
the timing and success of these developments is highly uncertain, as is the
result of international efforts to get the Bank of China to stop the growth in
its international reserve holdings.
Because of
these uncertainties it makes sense for the heads of the major central banks in
the world to be prepared to deal with possible future needs for real
expenditures to match the financial savings by creating a secretariat at the BIS
charged with tracking the growth of government investment funds, alerting
national central banks and working out coordinated programs for dealing with the
developing problems, all in coordination and with the help of researchers at the
IMF and national central banks.
Bank for International Settlements, Financial Stability Forum, “Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience”, Basel: BIS, April 7, 2008 http://www.bis.org/press/p080412.htm
International Monetary Fund, “Sovereign Wealth Funds – A Work Agenda”. Washington, DC: IMF, February 29, 2008 http://www.imf.org/external/np/pp/eng/2008/022908.pdf
Mundell, Robert “The
Case for a World Currency“, Journal of Policy Modeling, (2005), June,
pp. 465-475
Single
Global Currency Association, "The Single Global
Currency: Common Cents for the World", found at http://www.singleglobalcurrency.org/
Endnotes
[1] The
Financial Stability Forum of the Bank for International Settlements (BIS) in
Basel in its Report of April 7, 2008 summarized the dominant views of the
causes of the current crisis. It
notes that in the years leading up to the present turmoil, there was “an
exceptional boom in credit growth…fed by benign economic and financial
conditions, including historically low real interest rates and abundant
liquidity”.
According to the Report, these conditions induced
financial intermediaries to engage in damaging policies:
poor underwriting standards, shortcomings in firms’ risk management
practices, poor investor due diligence, poor performance of credit rating
agencies, weaknesses in disclosure, and weaknesses in regulatory frameworks.
[2] For example, the Basel accord on bank capital ratios
prevented excessive lending that affected the banks’ loan to capital
ratios, but induced banks to shift lending activities off balance sheets and
to the securitization of subprime mortgages, which is now seen as a problem
needing the new regulation.
[3]
http://www.imf.org/external/np/sta/ir/8802.pdf
shows global holdings of US$7,341 billion of reserves in total in the middle
of 2008. The holdings consisted
of securities in US dollars (about 60 percent), in Euros (about 30 percent)
and gold and other assets, converted into US dollars at the prevailing
exchange rate.
[4]
A similar prepayment fund has been established in Luxembourg but no
information on its size could be found.
[5]
It has been suggested that the
subsidization of Singapore business is responsible for an unusually high
capital labour ratio and low marginal productivity of investment in the
country, which amounts to a wasteful use of the savings of Singapore’s
citizens.
[6] As
in the case of resource funds and exchange rates stabilization funds, for
the present purposes of analysis the exact value of the securities held by
the prepaid social program funds is not essential.
The main point is that they exist, are large and will continue to
grow[6]
and as a result will require easier global monetary policy to maintain
equality of global output and real spending on goods and services.
[7] It
is tempting to argue that this sum is empirically insignificant in the light
of the fact that it respresents less than 5 percent of the world’s
outstanding supply of financial capital (bonds, equities and bank assets)
estimated at $190.4 trillion by the IMF (2008).
However, it must be remembered that these financial assets were
created over a long period of time and when there mostly was macro-economic
equilibrium in the world. The
2008 problem has arisen through a process that disturbed this normal
macro-economic equilibrium at the margin, making it wrong to consider the
size of the funds’ holdings in the light of stock figures.