The 2008 Financial Turmoil and Sovereign Debt Funds







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.


Exchange Rate Stabilization Funds


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. 



Table 1

International Reserve Holdings by Eleven Countries with largest Holdings




Billions of US Dollars

Percent Increases in 2007

Recycling Petrodollars long paperPR of China (Mainland)















Republic of China (Taiwan)



South Korea









Hong Kong






Notes:  Holdings around the middle of 2008.

Source:  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.


Social Program Prepayment Funds


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.



Policy Implications


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 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

International Monetary Fund, “Sovereign Wealth Funds – A Work Agenda”. Washington, DC: IMF, February 29, 2008

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


[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] 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.