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?
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.
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.
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
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.
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.