Answering Adam Ozimek’s Skepticism about a US Sovereign Wealth Fund

image source (2013)

image source (2013)

In many blog posts and Quartz columns, I have argued that major economies such as the US should establish sovereign wealth funds even when issuing bonds is required to capitalize the funds. Sovereign wealth funds are already standard for countries that have positive net liquid assets. The new idea is to say that major countries that have negative net liquid assets should also have sovereign wealth funds as stabilization tools. A good post to turn to first for this is “Roger Farmer and Miles Kimball on the Value of Sovereign Wealth Funds for Economic Stabilization.”

In my tour of central banks to advocate eliminating the zero lower bound, I point out that even if monetary policy is someday done well enough to essentially keep the economy at the natural level of output all the time, there could still be a financial cycle. This possibility becomes clear if one writes down an entirely real general equilibrium noise trader model (as I have done in some very early stage research with Jing Zhang that might involve other coauthors before we are through). Even if the business cycle is entirely conquered in the sense of a zero output gap from sticky prices at all times, the financial cycle can cause welfare losses. Welfare losses can occur even when high enough equity requirements have taken away the implicit bailout subsidy for leverage. A contrarian sovereign wealth fund can help counteract the messed-up price signals caused by the noise traders.

In a July 19, 2015 post, “Skepticism About A U.S. Sovereign Wealth Fund,” Adam Ozimek worries about implementation difficulties for a sovereign wealth fund or other major economy. The first thing to say is that in general, institutions tend to be better in countries that–apart from natural resources–would be the richer ones, and so the right benchmark for the likely quality of a US sovereign wealth fund is Norway’s sovereign wealth fund rather than, say Saudi Arabia’s.

The second thing to say is that both Roger Farmer and I recommend a rule that the sovereign wealth fund is only allowed to invest in (low-fee) exchange traded funds. The importance of this is to keep the government from (a) micromanaging the investments and to keep the government from (b) voting the shares and micromanaging the behavior of the firms that way. In the US at least, if a sovereign wealth fund such as I recommend could ever be established, such aspects of the initial design of the fund can be maintained by the difficulty of getting changes opposed by one party through both Congress and a potential presidential veto. An initial bipartisan agreement on principles could not easily be broken.

The third thing to say is that I know in practice how to get the fund started off with a contrarian philosophy: I would recommend appointing John Campbell as the first head of the US Sovereign Wealth Fund.

On the objective of a sovereign wealth fund, the more I think about it, the more I realize that calculating the optimal policy for a large country’s sovereign wealth fund given a concern with overall social welfare in the usual way is a very interesting research problem. Basically, there is a technical answer to this question in the same sense that there is a technical answer for optimal monetary policy, after what I think is easier math than for optimal monetary policy.

The small country problem is, of course, even easier: a small country faces something much more akin to the standard portfolio problem, with the issue of what level of risk aversion to use when investing on behalf of a nation’s citizens. And of course, just as an individual household needs to integrate human capital into its portfolio decision, a small country sovereign wealth fund needs to integrate a wide variety of assets the country’s citizens and government already hold into its portfolio decision.