How a US Sovereign Wealth Fund Can Alleviate a Scarcity of Safe Assets

In a number of recent posts, I have defended the idea of a US Sovereign Wealth Fund:

In this post, I wanted to give a different angle on a benefit of a US Sovereign Wealth Fund. A number of economists have stressed the importance of having a robust supply of assets that can easily serve as collateral. In addition to discussing electronic money in “Overcoming the Zero Bound on Interest Rate Policy,” Marvin Goodfriend has a good discussion of balance sheet monetary policy, in which he discusses the concept of “broad liquidity services”:

I define liquidity broadly as a service yield provided by assets according to how easily they can be turned into cash, either by sale or by serving as collateral for external financing. Liquidity services defined broadly are valued because they can be used to minimize one’s exposure to the external finance premium in the sense of Bernanke and Gertler (1995).

Assets considered safe are particularly valuable in this regard, so much so that Yichuan Wang argues that Federal Reserve purchases of long-term treasury bonds has not been ideal:

These purchases of treasuries have been problematic for the shadow banking sector, notably the oft maligned money market funds, as the purchases have drained the financial system of safe collateral. 

In his January 16, 2013 post “Safe Assets and Government Debt,” Simon Wren-Lewis makes the point especially well:

The financial system, partly as a result of the entry of emerging markets, has a large and increasing desire for safe assets. This led, before the recession, to low real interest rates (supply and demand: if the demand for an asset rises faster than its supply, the return from it will fall): this was the topic of Bernanke’s savings glut story. (In terms of monetary policy, it influences what theory calls the natural interest rate, which is the medium term reference point for policy.) In an effort to satisfy this growing demand, the private sector attempted to create its own safe assets through securitisation and the like. This failed spectacularly, and we got a financial crisis. Only governments with their own central bank can create really safe assets. So we need more, not less, government debt.

… is the distinction between net and gross debt important here? Suppose a government did reduce its long term need to raise taxes by reducing its net debt position, but did this by buying assets rather than reducing its gross debt. Obviously by holding private sector assets it increases its exposure to macro shocks, but it retains its ability to cover those through either taxation or money finance, so its gross debt may remain safe.

If the government issues more safe assets, (based on its relatively large capacity to bear risks) it must do something with the proceed. The basic options are 

  1. government spending
  2. buying other safe assets
  3. buying risky assets

The size of our net national debt argues against adding any more to government spending than we absolutely have to. Buying other safe assets does not increase the total supply of safe assets available to the private sector at all, but only changes the type of safe assets available. In my view, the standard way for the government to increase the overall supply of safe assets available to the private sector is for the government to buy risky assets. Hence, my proposal for a US Sovereign Wealth Fund.

Side note: I have had some correspondence suggesting that a US Sovereign Wealth Fund would be unavoidably corrupt. I would be very interested in learning more how well Norway’s sovereign wealth fund has done in that regard, but that proposition does not seem right to me;  I have not heard of big scandals involving portfolio managers of large endowments such as the endowments for Harvard or Yale or the University of Michigan, which seem good analogues for many aspects of a US Sovereign Wealth Fund. I am much more worried about congress meddling in the details of what the US Sovereign Wealth Fund does, which is why I think independence comparable to the Fed’s is crucial.