One of the problems in todays world economy is that money needs to be recycled. We have a new version of that old problem in todays vortex that are the world’s financial markets.

The economy is often depicted as a system where great flow of funds go around, and that indeed is one way to understand the economy. In the world economy goods like commodities and manufactured products flow one way, money flows another way. Problems can emerge if somewhere flows accumulate into oversized stocks.

These need to be put back in the system, otherwise, like nowadays, the system will experience significant problems. Where there is accumulation, there must be depletion in some other location, and the nice thing is, we have markets to reconnect them.

That might sound promising (and usually it it), but demand and supply need to meet and agree upon a price, and here is where it gets more tricky. All this sounded a little too abstract perhaps, an example will make things clear.

In the 1970s we had a similar situation of large parties in the world accumulating funds (in that case it were the oil producing countries and big banks), and others (mainly oil-less developing countries) with a shortage of funds. This constituted the recycling problem.

OPEC countries deposited large amounts of funds with big banks, and these (often in a syndicated form, a rather novel phenomenon at the time) and prodded by governments of developed countries who worried about the deflationary effects on the world economy of the sudden transfer of purchasing power to OPEC lent that money out to those in great demand, developing countries who found themselves at the wrong side of the oil crisis.

Apart from the prodding from their governments, all that money had to be recycled to keep the world economy alive, banks lent very large quantities of money to developing countries because they assumed, wrongly, that countries could not go bankrupt. Sovereign risk was perceived to be close enough to zero as to not worry about it.

Now, there is nothing wrong with that, in principle. Many of those developing countries were very happy that they could borrow from some other institution than the IMF, and so escape the latter’s often stringent conditions.

Things would have been alright if the borrowing countries would have used the funds to invest (and as long as the returns on these investments would exceed those of the borrowed sums). Alas, many did not.

They used the funds to escape the adjustment that the first oil shock warranted and kept on consuming as if nothing had happened (often, these funds were wasted on military expenditures or building large prestigious infrastructure projects, or just palaces for the governing few).

This all came to an end with the following four-fould whammy:

• The second oil shock after the Iranian revolution of 1979 and the war with Irak
• The Fed under Volcker, who fought the resulting inflation with a huge increase in interest rates, also affecting the interest rates on those outstanding loans of many developing countries
• The rising dollar as a result of those interest rate increases (and most loans were denominated in US dollars…)
• The world recession that was a product of the conspiracy of the above three factors.

All this came to a sudden halt when Mexico, one of those countries which borrowed heavily, defaulted on it’s debt in 1982. For a while, we had a systemic risk in the world financial system because of the loan syndication, many banks were involved.

At least, and unlike today, it was more or less clear which bank was exposed to what risk, and by how much. The rest of the decade was lost in rescheduling plans, restructuring plans, Brady bonds, and a host of other more or less creative solutions.

Fast forward three decades and we have a new version of the recycling problem. Then we had all too real sovereign risk, now we have sovereign wealth funds. There are a few export led (commodities or manufactured products) booming countries that amass huge amounts of funds, and they have, smart idea (sort off, this depends on the particulars, but we won’t go into that here) put some of their new found wealth in crispy new funds, so called sovereign wealth funds.

Countries like Kuweit and Norway long had such sovereign wealth funds, but the idea has caught on, and now every self-respecting country with large aspirations wants one. The problem is, what to do with all that money, as the sums involved can be in the tens of billions of dollars.

For instance, China is now accumulating reserves at a rate of US$100m per hour, although the trade surplus looks like topping out (it has actually shrunk in the last month, not only a sign of increasing cost in China, and a rising currency, but also of slowing demand from the rest of the world, a sign of trouble).

In a world were cash is king and even Jim Cramer throws in the towel, what are you going to do with these sums of money? The whole idea of sovereign wealth funds it to invest the accumulating surplusses for a rainy day.

We’re not sure that it’s a good idea in the first place even in under more benign circumstances, and here’s why. Apart from the all to real temptation to just squander the money when it is politically expedient, the funds might even become a victim of their own success.

In business, this is known as the third generation problem, grandfather founded, father (mother anyone?) expanded, and they created… kids with trustfunds. We realize that not each and everyone of these would develop into a Paris Hilton (thank God for that, although, having said that, she at least is entrepreneurial, in her own way), but this might very well sap the entrepreneurial spirits out of future generations.

The Hungarian economist Janos Kornai has almost made it his life’s work to show the creativity inducing effects of ‘hard’ budget constraints. And if that’s not enough for you than you could consider what happened to the brimming Holland of the 17th century (it’s ‘golden’ age), changing into a not so brimming 18th century, of coupon clipping pensioners. Not every leading nation (as Holland was in that 17th century) will be doomed by the specacular last hurray brought on by imperial overstrech, some just ‘retire’ quietly, and like that lonesome cowboy, set off to into the sunset, sort off.

In many cases, we think that the funds can actually be best invested in the domestic economy, with the emphasis on invested. Transport, power generating, networks, schools, hospitals, universities, research centers, clean environmental technologies, etc., etc., these will all improve the chances for the next generation to be productive, rather than run the risk they’ll develop into lazy bums who might take everything for granted.

A nice effect of this would be that it would also solve the recycling problem. Investing in the items just listed requires spending the money, exercising effective demand for goods and services, keeping the world economy from falling off a cliff. And what better investment than that in future generations?