The problems inherent in plans for a UK Sovereign Wealth Fund

One of the features of economics is the way that ideas get recycled, repackaged and then re-presented. Sometimes this is a good thing as life can be circular and human behaviour changes much less than we might like to think over time. However it is also true that the boat can have sailed and we have simply missed it. This was my major thought when I saw proposals for the UK to create a Sovereign Wealth Fund. After all we would need some sovereign wealth would we not? An opportunity to create a Sovereign Wealth Fund was available around 30 years ago if we had used part  of the North Sea Oil revenues for this purpose. Sadly the main bulk of such revenues have been consumed -some would argue wasted- and the future will be for them to be a declining force in UK economic life.

Sovereign Wealth Funds (SWFs)

If the Sovereign Wealth Institute is correct there are 72 such funds although not as many countries as some have more than one. Ironically a UK territory has recently started one as the Falkland Islands has decided to follow the economic model of Norway in this area as it looks to manage its own oil bonanza. Approximately US $6 trillion of assets have been accumulated into the various sovereign wealth funds.

The largest such fund is Norway’s Government Global Pension fund at around US $727 billion and it provides a substantial war chest for the Norwegian people. It also gives the UK a clear example of how that boat sailed without us as it was started 23 years ago to take advantage of her North Sea oil and gas revenues. In itself it has been a success.

However not all ventures in this area have been a success as the case of the National Pension Reserve Fund in Ireland has demonstrated. It started so well back in 2001 when it was conceived as a way of building a fund to have pay for Ireland’s future pension liabilities. Unfortunately a danger of a “pot of gold” was seen as Irish politicians changed the law so that the fund could be directed on these grounds.

To prevent potential serious damage to the financial system in the State and ensure the continued stability of the system.

Regular readers of this blog will be aware that this change allowed the Irish government to divert fund to Irish banks who often collapsed anyway! So not only was pensioners fund misused but necessary reforms were delayed as banks were able to claim they were viable when they were not. Along this road the NPRF shrunk from 21.1 billion Euros at its peak to 14.7 billion at the end of 2012 in spite of continuing annual contributions of 1% of Gross National Product until their suspension from 2012 onwards.

Thus the Irish situation demonstrates one of the dangers of a SWF which is that in times of trouble politicians can change the law and divert it’s funds and objectives away from the original one. This means that the original promises can be eliminated by political whim.

The proposal for the UK

This has been suggested to the UK Parliament by Roger Farmer and goes on these lines.

It involves the creation of an actively traded sovereign wealth fund designed to manage stock market volatility.

Where will the money come from?

This was plainly an issue as we were in danger of a SWF without the sovereign wealth! But never fear he intends to borrow it.

It would be paid for by issuing gilts.  On the liability side of its balance sheet, it would make interest payments to holders of Financial Policy Commitee debt.

So the proposal is to borrow the money which means that there is a commitment to pay interest on the borrowing. If we look for how much I note that the plan seems confused at best.

paid for by selling long duration gilts onto the private market, would put upward pressure on long-term interest rates and facilitate a return to a more normal functioning of the financial markets.

Whilst some would welcome a rise in long-term interest-rates and bond yields it would be odd for our authorities to pursue such a plan when they have spent the credit crunch years trying to lower them through policies such as Quantitative Easing. Indeed it would put upwards pressure on the very same mortgage rates that the Chancellor and the Bank of England are trying so hard to reduce.

Also in another example of the boat sailing if we move from Roger Farmer’s plan into the real world UK Gilt yields have risen substantially in 2013. Our 30 year Gilt yield which was 3% when this paper was presented to Parliament in late April is 3.62% now. Academia and markets often collide in an inconvenient way for academia’s plans as he would be driving the bond yields that UK taxpayers have to finance higher.

What would we invest in?

Mr Farmer wants the UK taxpayer to become a stock market punter although I am sure he would prefer the word investor.

 The FPC should control a broad market aggregate. An acceptable fund should be value weighted and include all publicly traded companies.

If you think about it this part of the proposal is somewhat vague, but let us carry on and consider the next question which is the size or how much?

 An initial purchase of £150b would be a good starting point. (He means billions)

But he has much larger plans as matters progress.

But: it is important that no upper bound should be placed on the possible size of an intervention in order to avoid private investors from gaming the fund.

These sort of plans always end up going this way as I highlighted back in the early days of this blog with my theme of “More,More,More”. Indeed later in the piece he really gets the bit between his teeth.

Stock market stabilization is different since there are no bounds to feasible intervention on either the upside or the downside. A solvent national treasury has the potential to buy the entire market if necessary.

He does not seem troubled as to whether the UK Treasury which has been running fiscal deficits of around £120 billion per year in recent times has possible solvency issues or that his plans could create them. For example what if Gilt yields surged as he found himself issuing tens and and perhaps hundreds of billions of them?

In Essence

This plan is gambling that buying equities will prove more valuable over time than the costs from selling the debt via issuing Gilts to finance it. If we accept that for a moment then the obvious question is what good would it do. According to the plan it would do this.

When household wealth increases, households spend more. Increased spending leads to increased employment and increased profits. The existence of a stable connection between stock market wealth and unemployment implies that unemployment can, potentially, be used as a target to guide financial policy.

Thus according to this the economy will be boosted and unemployment reduced by raising the level of the stockmarket. Indeed as if by magic it would pay for itself.

That policy would create a virtuous cycle of increased spending and employment that would generate the earnings necessary to justify the initial increase in equity prices.

The problems

If we move from the alternate universe in which Professor Farmer’s plan exists and move to the real world there are a myriad of problems and issues. One is the Lucas Critique.

The Lucas critique states that every policy change affects the circumstances under which different situations occur. Thus, a policy that worked under one set of circumstances may not apply under a different set.

This would apply here in that equity markets usually rise for a reason and let us for example say that a rise is due to expected higher profits. This will be missing in the Farmer inspired rise as his civil servants plough into the stockmarket. So there are good reasons to believe that the impact will be different from a “genuine” rise. This is reinforced by the fact that existing efforts in the credit crunch era to move markets to different levels such as Quantitative Easing have disappointed in their economic effect.

Also the connection or wealth effect between a rising stockmarket and a strengthening economy is much weaker in my opinion in the first place than implied in the paper.

Asset Bubbles

By definition such a policy would be prone to creating equity market bubbles as prices are pushed to levels they would not otherwise achieve. Yet this apparently is not a problem.

A bubble is only dangerous to the real economy if it is allowed to burst.

So we just keep inflating the bubbles then? The whole economy would then become like a West Ham fan at Upton Park.

I’m forever blowing bubbles,
Pretty bubbles in the air
They fly so high, nearly reach the sky
And like my dreams they fade and die

By forcing prices to a “wrong” level the overall price level will be distorted. For example whilst those holding equities now will gain future buyers will have to pay a higher price and for example paying into a pension will get lower returns.

Moral Hazard Alert

There are several here. Let me start with those running our major companies who will now face a scenario where it will be almost impossible for their share prices to fall! We have seen in recent years how greedy bosses can be and I suspect we will not have seen the half of it should this plan begin. Nice for share option schemes! Also exactly how would we know that a company is being run badly?

What about the group of  civil servants running the scheme? There will be enormous incentives for larger investors to find out the timing of their buying. The record of the public-sector in keping such matters strictly private does not inspire confidence.

Who will operate this?

I recommend that the Fund be managed by the newly created Financial Policy Committee, operating in consultation with the monetary policy committee, (MPC).

So another unelected (supposed) elite would take charge of this just as we have experienced five years which have demonstrated that such elites have feet of clay at best. As the plan would be to buy the whole market they would not be “picking winners” but they would have control over the timing of the expenditure of vast sums of money. In my opinion they are completely unfit for such a role.

The air of unreality is added to by this.

Independence is important for the same reasons that informed the creation of Bank of England independence.

It would appear that the news  that the Bank of England is no longer independent has not reached UCLA.

What about Losses?

Here there is outright confusion as if we examine paragraph 17 we see this.

active trade of a Treasury portfolio has the potential to create both gains and losses to the taxpayer

Okay so we might win or lose but suddenly it becomes a sure fire bet!

it would not cost the taxpayer a penny and would instead be likely to raise revenue for the Exchequer.

I shall leave it in its confusion in this area. I can add that if it were to issue 30 year Gilts (it is after all a long-term plan) it would be issuing them at 3.6% against a FTSE yield of 3.3%. So there would be an interest-coupon/dividend deficit. This would be before any allowance is made for a rise in Gilt costs due to the potentially vast amount needed to be issued.

The International Issue

It is nice to think that the UK stockmarket can stand in isolation. Unfortunately for this plan there is the rest of the world to consider which may respond to the equity market purchases by selling to us if UK equity prices get out of line. This would depress the value of the pound and if it let to a sterling crisis would mean that the plan would become a debacle.

What about the 1%?

There are plainly dangers in a scheme which benefits existing investors at the expense of future ones. This is illustrated below.

It is true that stock ownership is concentrated predominantly among the wealthy

How many more plans will benefit the wealthy at the expense of everyone else? If you think about it tucked in there is a clear flaw as exactly how will making them even more wealthy provide a substantial boost to the UK economy

Exit Strategies

As we observe the problems created by the mere talk that the US Federal Reserve may exit from its Quantitative Easing policies there is a genuine issue here. But never fear.

the central bank has the power to sell the market short if it deems that the market is overheating.

Now.exactly how would that work? Is the UK Financial Policy Committee George Soros in disguise?

In practice this would be yet another policy with no apparent end.

Comment

In my career I have seen plenty of these types of plans. In essence they offer a seductive future where someone or something offers theoretical control,central planning and success. In practice the issues are manifold and many as the financial world is a complex place and will often adjust to negate all the effort. Also there are always moral hazards inherent in them. But let me return to the concept of central planning how is that currently going? It is nice to have fantasies of a better future but without a better plan than this they are likely to prove a nightmare rather than a dream.

If we were unsure about the quality and ominisicence of our leaders in the UK the HS2 saga is fast becoming a salutary lesson. The likely costs are spiralling as more and more question the economic benefit and point out the enviromental issues. Yet it would in comparison to the plan above have the advantage of  at least producing some high-speed railway lines.

 

 

This entry was posted in Currency, Debt, Financial crisis, Gilts, Quantitative Easing and Extraordinary Monetary Measures, UK Inflation Prospects and Issues, Yield and tagged , , , . Bookmark the permalink.
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  • James

    Hi Shaun
    Great article but I have a couple of questions
    1. Are you sure that it isn’t an April fool a few months late
    2. Is it really possible that someone proposing such utterly stupid ideas is a professor?
    I just fail to see how anything so obviously stupid could see the light of day. The awful thing is that I can see politicians and civil servants loving this as it will give them even more funny money to play with.

  • rowland

    Shaun, absolutly brilliant! I am reminded of the prospectus for the Great South Sea Company-didn’t end too well, did it?

  • Anonymous

    Shaun,

    Could we put Royal Mail, and HMG’s share of RBS & LLoyds in this fund?

    As with your earlier piece lack of assets post UK privatizations is now apparent without even including PFI deals!

  • Andy Zarse

    Hi Shaun, great blog!
    Sadly the UK SWF has just been introduced already! It’s called NEST and it will see millions of UK employees auto-enrolled into either their employer’s pension scheme of the State run Stalinist style NEST. By 2017 they will be paying 8% of their relevant earnings. This will mean £billions per year with the vast majority of the money going into either UK FTSE tracker funds and/or other plain vanilla “default funds”. What you might call a self-inflating bubble!
    “Tulips! Lovely tulips! Get your tulip bulbs here!”

  • ernie

    Hi Shaun
    I know you need to keep people informed and many thanks for that. However, I’m not sure you needed to post this – the fellow obviously either needs medical attention or is simply making a sort of unfunny joke to highlight the lunacy of current economic thinking. For the sake of his sanity I hope it’s the latter.

  • Jim M.

    Hi Shaun,

    As a West Ham fan of some 50 years standing, I am obviously pleased to see you reference The Academy.
    West Ham have long been recognised as a club that, whilst highly capable of identifying, supporting and developing talented young players of the highest calibre (Lampard, Ferdinand, Cole, Pennant etc), somehow lacks the extra something that would enable them to exploit these assets for the club’s long-term benefit. Supporting that for half a century hasn’t always been easy, I can tell you!

    Thank heavens the country isn’t run along the same lines, eh?

    Oh….

  • forbin

    hello shaun,

    this guy hasn’t been talking to charlie bean has he ?

    musical connection

    Fun Boy Three – The Lunatic’s have taken over the asylum

    Forbin

  • Rods

    Hi shaun,

    An excellent and interesting blog.

    Why not put the ex-chancellor Gordon Brown in charge, after his management of our gold reserves, what could possibly go wrong?

    I’m sure a fund run by civil servants would be as effective and profitable as the BOE / FCA regulation was of the banks. An expensive group of people who we will know are good they are, as their expensive PR department would be always telling us, very well managed, where their expensive compliance and PR departments constantly bombarding with radio and TV adverts and a permanently loss making disaster.

    What is totally ignored is our pyramid welfare system, especially for state pensions. With more entrants need than new pensioners and claimants we will eventually need to go to infinity and beyond with our population to fund it. We need a system like Hong Kong or Singapore where over your career you build up your own welfare fund, with an insurance element incase it is depleted through bad luck or long term illness. Being on an individual basis, this would make it much more difficult for governments to steal. The transition time would have to be long (about 40 years) where they not only have to fund the current generation of pensioners, but also pay into their fund. In Hong Kong if you are young (under 30) and have built a good fund, they you are allowed to draw up to a 25% deposit on buying your first property. Our current welfare system (along with most Western countries) is clearly unsustainable in its present form and also not very effective with its one size fits all, hence record numbers using food banks. Will it happen, no as no politician will be brave enough, it is easier to kick the can down the road, until the country runs out of credit and has to default on our sovereign debt and current welfare system and then the cuts will be savage whereas something in place now would soften this future blow.

  • forbin

    “…. they you are allowed to draw up to a 25% deposit on buying your first property…….”

    you almost had me going then….. what could go wrong ?

    Forbin

  • Rods

    Seems to work well in Hong Kong. where it is a compulsory welfare savings system, this is sensible where it is your money, rather than our current deposit scheme where it is taxpayers money. The majority of people have little need for much medical care when they are young, so it makes sense to help people get on the property ladder with saving more over 30 to cover future medical bills and pensions.

    A big problem with our current younger generation is they want everything now and that means no savings. A car, foreign holidays etc, etc. Previous generations needed to save with a building society and then join a queue to get a mortgage. Without a decent deposit you knew you could not get a mortgage. Something that seems to have been forgotten by many people. So they ran old cheap cars, didn’t bother with regular holidays as getting married and buying a house was a higher priority.

    All Western countries need to look at how they are going to fund their welfare systems as the current systems of each generation paying the bills for the last is not sustainable as globally the birth rate is decreasing.

  • Loaf

    The ‘wealth effect’ is indeed minute, as the inestimable Dr John Hussman has pointed out many times in his weekly letter:

    http://www.hussmanfunds.com/wmc/wmc130805.htm
    http://www.hussmanfunds.com/weeklyMarketComment.html

    We need a lot LESS central planning from our inept leaders, not more.

  • Anonymous

    Hi James

    Professor Farmer did present his testimony Parliament on the 23rd of April so we cannot entirely run out the possibility that he had thought this up just over 3 weeks before! But sadly and much less amusingly he appears to be serious about this.

  • Anonymous

    Hi rowland

    Yes it too was involved with the national debt wasn’t it? If I recall it wanted to take it over for a while. My favourite from this era was however this

    “A company for carrying on an undertaking of great advantage, but nobody to know what it is.”

    You might not be surprised to read that once he had raised £2000 a princely sum for the time he shut up shop and disappeared.

  • Anonymous

    Hi Andy

    You are of course correct. The NEST pension scheme will have a flow effect on the UK stock (and bond) markets. However they would find themselves buying shares which had already been pumped up in price by the Financial Policy Committee. You really could not make it up.

  • Anonymous

    Hi Ernie

    I had seen the plan before and had not dissimilar thoughts to you but it came to my attention again over the weekend. Also another American based economist Miles Kimball had given it his backing so I decided it was time to put the arguments against as some really silly ideas do get implemented!

  • Anonymous

    Hi Jim

    I have a long-standing friend who is also a fan of the Hammers and the conversation over many years invariably turns to where did the money go from all these sales? It has been like the episode where the USS Enterprise gets stuck in a loop where the same sequence of events are stuck on repeat play.

  • Anonymous

    Hi Forbin

    I had forgotten that song,thanks for reminding me.

  • Anonymous

    Hi Loaf

    The US National Bureau of Economic Research estimated the wealth effects to be as follows.

    “They estimate that on average, a single dollar increase in housing wealth raises consumption by between five and eight cents. In contrast, the same dollar increase in the value of securities wealth raises consumption by less than two cents. ”

    So it would seem that the Bank of England and George Osborne are exploiting the main game leaving this proposal with the also-ran!

  • Justathought

    And our youth must be “educated” by those type of people??? Well insanity on a personal basis is very rare but on the societal basis it seems the norm…

  • Paul C

    Shaun,

    Thanks for sharing a vision of the future, just imagine the marketing messaging…

    S.Sovereign: sounds like the queen, smells of gold, strong and British

    W. Wealth: Well obviously a nice sounding word, and hey so many UK residents are wealthy in assets, just look at the price of houses and they’re going up now too.

    F. Fund: Well in the City of London there at lots of those and they’ve rarely been losers, indeed the UK is re-balanced towards banking and funds, not one, even a small one has gone bust in the downturn.

    SWF sounds like a great fit for us, it would hark back to days of empire and power. As you say other countries have these things and they are successful in those countries. It must be the answer. With a S.W.F. we could “invest” in new infrastructure, HS2 would be a drop in the ocean, we could do a Boris airport, trams in every city, even build the schools that Brown promised us.

    After the next election we will be promoting this new device to keep the housing “feel-good” pumped-up. As the professor said there’s nothing wrong with bubbles as long as you don’t let them burst, it could be argued that building the SWF would be just a massive emergency air bag (to make a safe landing in case of accident) it would indeed be a sensible insurance scheme.

    I’m for it, indeed any similar “positive-feedback” device that accelerates the final reset trigger :-o

  • Anonymous

    The adjective “sovereign” suggests that an SWF is controlled by a sovereign state, but I believe it also applies to funds controlled by provincial and other regional governments. wealth fund” suggests that it is controlled by a sovereign state, The largest such funds in the US are controlled by the Alaskan and Texan governments.

    In Canada, our largest SWF is the Alberta Heritage Savings Trust Fund (AHSTF), founded by Premier Lougheed in 1975, with a value of CAN$16,8 billion (about £10.3 billion) as of March 31, 2013. It has been a subject of almost continuous controversy ever since it was established. (See for example, the article by Jesse Kline, “Alberta let rainy day Heritage Fund dwindle as the storm gathered”, October 18, 2011.)

    Does Scotland have any plans to set up an SWF?

  • Anonymous

    But is it unsustainable over an electoral cycle? If not, politicians will suggest it is made *more* generous because they *know* none of the boomers+ will object. Only this demographic can break the cycle.

  • Eric

    Even so, it would have been a good piece to save for April 1st.

  • colin west

    Shaun,
    Could we not build a fund as in Norway from the (presumed) profits of Fracking?