Roger Farmer and Miles Kimball on the Value of Sovereign Wealth Funds for Economic Stabilization

As macroeconomic theorists, Roger Farmer and I have very different perspectives, but we have both come the conclusion that advanced economies should create institutions that treat sovereign wealth funds as a tool of economic stabilization. Sovereign wealth funds are already routine for governments that have more paper assets than liabilities. The new idea is that it is worthwhile for governments to borrow if necessary to finance sovereign wealth funds as a tool of economic stabilization. Here is my brief appeal for a US sovereign wealth fund in “Off the Rails: How to Get the Recovery Back on Track”:

Establishing a US Sovereign Wealth Fund to do the purchasing of long-term and risky assets would give the Fed room to maneuver in monetary policy, and restrict its job to steering the economy rather than making controversial portfolio investment decisions. And a US Sovereign Wealth Fund could stand as a bulwark against wild swings in financial markets.

The same argument holds for the UK or any other large advanced economy. 

In his academic research, Roger Farmer focuses on models with multiple rational-expectations equilibria, and takes that perspective in discussing his prescription for dealing with financial instability. By contrast, along with Robert Shiller and George Akerlof, I tend to think of genuine financial instability as arising from irrational swings in expectations with no firm foundation in fundamentals. Despite this stark theoretical difference, our policy views about sovereign wealth funds as agents of economic stabilization are remarkably similar. (This is not just my assessment: Roger was actually the first one to notice the similarity of our policy views some months back, and we have corresponded since then.)

Yesterday’s post by Matthew C. Klein, “Buy $3 Trillion in Stocks. What Could Go Wrong?” is a good source of links to others who are talking about a US sovereign wealth fund. I think what follows answers some of  the objections that Matthew raises. In particular, the institutional architecture for a sovereign wealth fund must be very carefully designed, and should be more like the way central banks are set up than the way current government investment funds are designed. And Roger solves the problem of how to vote shares for what the government owns.

Let me lay out references and quotations for the key elements of our argument.

1. Purchases of Long-Term and Risky Assets Work to Stimulate the Economy, Even When Short-Term Rates are at the Zero Lower Bound, But Such Purchases Deserve a New Institutional Framework

This is the gist of the argument in my first column on this issue:

Several other posts detail my thoughts on setting up such an institution:

Roger calls such an insitution a “fiscal authority,” while I call it simply a “sovereign wealth fund,” even though it would have key new features relative to existing sovereign wealth funds. But our essential idea is the same. Here is the relevant passage Roger’s John Flemming Memorial Lecture, given at the Bank of England on 16 October 2013: “Qualitative easing: a new tool for the stabilisation of financial markets” (pdf):

The institution that I would like to promote is a fiscal

authority, with the remit to actively manage the maturity

structure and risk composition of assets held by the public.

This authority would continue the policy of qualitative easing, adopted in the recent crisis, and by actively trading a portfolio of long and short-term assets it would act to stabilise swings in asset prices. I will show that asset price instability is a major cause of periods of high and protracted unemployment, and I will argue that by varying the maturity and risk composition of government debt, we can control large asset price fluctuations, and prevent future financial crises from wreaking economic havoc on all of our lives.

It is clear from other passages that Roger intends the sovereign wealth fund to deal with risky private sector assets as well.  In the design of how such an institution would handle stock holdings, Roger solved one problem I was stumped by: how to avoid government interference in the private sector by the way the sovereign wealth fund votes the shares of stock it owns. Exchange traded funds provide the solution. Here is the relevant passage from Jason Douglas's Wall Street Journal blog post about Roger’s proposal “How to Stop Financial Panics? Say Hello to Qualitative Easing”: 

In an interview, Mr. Farmer said he isn’t advocating government agencies buy individual stocks in such operations. Buying a stock index through a fund might be a less controversial approach, he said. He added international cooperation between such these qualitative-easing institutions would also be highly desirable.

Roger’s lecture at the Bank of England gives an extended defense of the efficacy of government purchases of long-term and risky assets. Roger uses the term “Qualitative Easing” whenever QE is done as a “twist” without increasing the money supply:

Following the 2008 financial crisis, central banks throughout the world engaged in an unprecedented set of new and unconventional policies. I would like to draw upon a distinction that was made by Willem Buiter, a former member of the Monetary Policy Committee, between quantitative and qualitative easing (Buiter (2008)). When I refer to quantitative easing I mean a large asset purchase by a central bank, paid for by printing money. By qualitative easing, I mean a change in the asset composition of the central bank. (2) Both policies were used in the current crisis, and both policies were, in my view, successful.

But when short-term rates are at zero, either way the oomph from QE comes the purchases of the long-term and risky-assets, not from whether that is done by issuing money or by issuing short-term safe bonds, so I am content to lump both quantitative and qualitative easing together as QE. Here are some things I have written on QE that I especially recommend:

2. Central Banks Should Not Be Too Quick to Worry about Financial Instability as a Result of Central Bank Action

Roger explains how QE works in this way: 

If confidence is low, the private sector places a low value on existing buildings and machines. Low confidence induces low wealth. Low wealth causes low aggregate demand, and low aggregate demand induces a high-unemployment equilibrium in which the lack of confidence becomes self-fulfilling. Qualitative easing works to combat this vicious cycle by increasing the value of wealth as governments absorb the risks that private agents are unwilling to bear.

I would say “partially self-fulfilling” rather than “self-fulfilling,” but otherwise this is very much like what I write in my column

There I argue that monetary policy has to work either through raising wealth or by making it possible for people to borrow who couldn’t borrow before. If increases in wealth due to monetary policy and people who couldn’t borrow before becoming able to borrow are always seen as dangerous financial instability, then there is no room for monetary policy to do its job during a serious recession without someone complaining of dangerous financial instability.

3. A Sovereign Wealth Fund Can Reduce Financial Instability by Countercyclical Investment Policies

Here is the case I make: 

For the case Roger makes, let me start with what Jason Douglas says in his article about Roger’s plan, “How to Stop Financial Panics? Say Hello to Qualitative Easing”:

How can governments stop financial panics wrecking their economies? A paper published by the Bank of England on Friday proposes a radical solution: a new breed of central bank-like institutions that buy and sell assets to prevent destabilizing swings in prices.

Mr. Farmer writes that financial crises are a frequent occurrence and often hurt citizens not yet born, never mind those who have to live through them. Citing evidence from past stock market crashes and the more-recent fallout from the subprime housing collapse in the U.S., Mr. Farmer argues that asset market volatility wreaks havoc in the real world. Some people will pay twice as much for a home than a neighbor who purchased theirs only a few years earlier. School leavers seeking work in a recession may earn far less throughout their lives than near-contemporaries lucky enough to have found a job in a boom. Mass unemployment frequently follows financial collapse.

His solution: “qualitative easing,” and new institutions to implement it.

Here is Roger himself, in his lecture at the Bank of England:

The efficient markets hypothesis has two parts that are often confused. The first, ‘no free lunch’, argues that without insider information, it is not possible to make excess profits by buying and selling stocks, bonds or derivatives. That idea is backed up by extensive research and is a pretty good characterisation of the way the world works.

The second, ‘the price is right’, asserts that financial markets allocate capital efficiently in the sense that there is no intervention by government that could improve the welfare of one person without making someone else worse off. That idea is false. Although there is no free lunch, the price is not right. In fact, the price is wrong most of the time.

The crisis was caused by inefficient financial markets that led to a fear that financial assets were overvalued. When businessmen and women are afraid, they stop investing in the real economy. Lack of confidence is reflected in low and volatile asset values. Investors become afraid that stocks, and the values of the machines and factories that back those stocks, may fall further. Fear feeds on itself, and the prediction that stocks will lose value becomes self-fulfilling. …

In my view, the policy of qualitative easing should be retained as a permanent component and new tool for the stabilisation of financial markets. Initially it was considered a radical step for central banks to control interest rates. The use of interest rate control to stabilise prices has proven to be effective and should be continued. But one instrument, the interest rate, is not sufficient to successfully hit two targets. …  The remedy is to design an institution, modelled on the modern central bank, with both the authority and the tools to stabilise aggregate fluctuations in the stock market.

Since the inception of central banking in the 17th century, it has taken us 350 years to evolve institutions that have proved to be successful at managing inflation. The path has not been easy and we have made many missteps. It is my hope that the development of institutions that can mitigate the effects of financial crises on persistent and long-term unemployment will be a much swifter process than the 350 years that it took to develop the modern central bank.

A Final Thought: High Equity (Capital) Requirements as the Key to Minimizing the Harm from Remaining Financial Instability

A sovereign wealth fund, investing in a contrarian way, can reduce financial instability. But there is likely to be some financial instability remaining. The harm from this remaining financial instability can be reduced dramatically by high equity requirements. What do I mean by dramatically? The Financial Crisis of 2008 is the kind of thing that happens as a result of financial shocks when equity financing is only about 3% of the relevant asset class–mortgage-backed securities in this case. The crash of the internet stock bubble in 1999-2001 is the much less damaging kind of thing that happens as a result of financial shocks when equity financing is more than half of the relevant asset class.

I don’t know Roger’s views on this, and it is something that became clear to me only after much of what I have written on sovereign wealth funds. But I feel passionately about the importance of high equity requirements, which seem highly relevant to the topic of this post. So let me lay out here some of what I have written on high equity requirements as a way to protect the economy from the worst effects of financial shocks:

On the topic of equity requirements, my views are very close to those of Anat Admati and Martin Hellwig, which you can see at their website on this issue: