Recycling
Petrodollars and the Current Crisis
The problems caused by the recycling of petro-dollars have been identified and much discussed as the ultimate cause of global financial crises in the 1980s and 1990s. It is curious, therefore, that this subject has not come up in the current debate over the causes of the present financial crisis, especially since there has been a record accumulation of dollars not only by petro-countries but also central banks and prepaid social program systems.
Just how big are these funds? The data are not official but best estimates are that the money accumulated in sovereign wealth funds (SWF), which mainly came from profits on the sale of oil and gas, amounted to $2.3 trillion at the beginning of 2008.
The accumulation of international reserves by central banks has reached $5.5 trillion early in 2008, with $1.2 trillion accumulated in 2007 alone.
Prepaid social program funds exist in a number of countries. The one in Canada for its public pension program had reached $123 billion early in 2008. The Provident Fund of Singapore is estimated to be about $200 billion.
The total global holdings of assets by these three types of funds in 2008 were around $8 trillion. To get a perspective on such this figure consider that the much discussed publicly held debt of the US government recently was about $5 trillion (another $5.5 trillion is held by other US government agencies).
How and why does the accumulation of savings by the three funds create problems for the world economy? The process is equivalent to forcing citizens to save what in the absence of these funds they would have earned in wages and profits and spent on goods, services and investment. If they had done so, global demand and supply of production would have been in equilibrium.
But since the public did not have these earnings, the world economy faced deflationary pressures through reduced spending, unwanted accumulation of inventories, reduced production and higher unemployment possibly resulting in a recession. These problems with the world economy did not happen because of deficit spending by the US government and consumers that matched the savings accumulated by these institutions. Instead of recession, the world experienced a period of unprecedented growth.
The IMF had repeatedly called for a more equitable sharing of the burden of responding to the large global savings by the funds, but the European Central Bank and the Bank of England were pre-occupied with combating inflation while Japan already had a large deficit and very low interest rates. So the entire burden of preventing a world recession had fallen on the United States.
For US politicians, taking on this burden came easily as the global supply of savings offered great opportunities to spend without taxing since the resultant supply of securities was exactly what the surplus funds wanted to buy after financial intermediaries had transformed them into a variety of derivatives and other obligations. As a result, there were none of the upward pressures on interest rates and inflation that normally accompany such deficits and constrain them.
In the early years of this decade the Fed kept interest rates low to stimulate consumer spending and investment to get out of the slump caused by the bursting of the high-tech bubble. Unfortunately, the low interest rates did not induce much manufacturing investment due to the stiff competition from Chinese imports and consumer spending did not increase enough until Congress took extra-ordinary measures to force financial intermediaries, in particular Fannie Mae and Freddy Mac to reduce lending standards for low-income Americans. This policy generated higher house prices, a construction boom and increased willingness of consumers to borrow on their rapidly growing home equity.
The supply of savings from the funds permitted these phenomena to develop without the normal constraints from the availability of domestic savings. Innovations in the financial industry that now draw so much criticism helped along the entire process of recycling petro- and exchange-funds.
In retrospect it is clear that this process had to come to an end, just as it had in the 1980s and 1990s when the petro-dollars were recycled to governments in developing countries. Too much spending had then gone into projects of questionable economic value. The housing bubble burst and with it came down the entire house of cards built up by the financial industry.
What does this analysis imply for the future? Fixing the financial system and other free market institutions through regulation may succeed for the short term in dealing with the symptoms of the crisis and raise hopes about preventing future crises of the same type. But as the preceding analysis suggests, unless the world comes to grips with the basic problems generated by SWFs and exchange funds, the need to recycle will arise again, find another way to get accomplished and then lead to yet another crisis, the nature of which cannot be foreseen or prevented by regulation.
Future crises can be avoided only if these funds stop their accumulation of savings or if all countries make coordinated efforts to share the burden of adjustment. This policy would see the need for much smaller deficit spending by governments and consumers in each of these countries than occurred in the United States in recent years since the smaller increases by a much larger number of agents would sum to the same amount. The excesses caused by the US carrying the burden alone would be avoided.
The present recession will reduce the accumulation of funds by the SWFs, but chances are that they will adopt oil pricing and supply policies to continue earning surpluses. China may be expected to continue with policies that encourage export-led payments surpluses to shore up development of its economically needy regions.
This leaves global coordination on interest rate policies as the only policy with any likelihood of success in the longer run. The BIS is able to produce such coordination but before it will take place, there has to be a turning away from the pre-occupation with palliative, regulatory policy initiatives and a realization for its need.
Herbert Grubel
Professor of Economics (Emeritus), Simon Fraser University,
Senior Fellow, The Fraser Institute