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A U.S. Sovereign Wealth Fund?
By James Broughel
Neither markets nor governments are perfect. Both can waste resources at times, and the ideal system of government should strive to counteract such waste. Sovereign wealth funds—state-owned investment funds that exist for the purpose of managing national (or subnational) savings—have unique characteristics that could help address the failings of both the private and public sectors. These funds could even dramatically change the way governments pay for themselves and the way citizens interact with their leaders as co-producers of policy, but to do so, the U.S. needs to be willing to experiment with different methods and modes of governance.
Market failures occur when mutually beneficial exchanges that would make society better off fail to take place. One important type of market failure arises when the economy doesn’t achieve as rapid a rate of growth as could sustainably be maintained. Production lies below what it otherwise might be, and so many beneficial exchanges never happen.
One reason growth can be suboptimal is a lack of investment. Today, just under 70% of U.S. national income constitutes personal consumption: Many Americans would prefer to consume their incomes today, rather than save and invest for the future. This may make sense at the individual level, but it is undesirable at the societal level because over time the lack of investment means that living standards fall below what they would otherwise be.
This is one way in which the free market underdelivers. More production could take place, which would increase societal well-being, but without some external stimulus it doesn’t happen.
The government is not perfect either. Two common problems plague the public sector: limited knowledge and poor incentives. Knowledge problems occur when the government acts without the information it needs to know whether its actions are having their intended effects. Knowledge problems are especially common when activities take place outside of markets and therefore lack the guidance of prices.
Prices inform decision-makers about the relative benefits and costs of using resources in a particular way to help ensure they are not wasted. Although governments do use market prices in some instances—they work with private contractors, accept bids through procurement processes and auction off spectrum to technology companies, to name a few examples—most government actions take place without the assistance of the price system. Without reliable information about the value of resources, government officials find it hard to be wise stewards of the public’s wealth, and waste follows.
Public officials also lack incentives to allocate resources efficiently and by extension to maximize the well-being of society. In the private sector, corporate managers have an incentive not just to maintain the value of their investors’ wealth, but to increase its value each year by earning a positive rate of return. In exchange, managers are rewarded with a high salary or a bonus. Similarly, homeowners have an incentive to take care of their houses so that they are more valuable when the time comes to sell. But because it is so hard to gauge the value of what government does, government workers’ salaries are only very loosely tied to their contributions to society. Even with altruistic motives, most government employees don’t have a strong incentive to be good stewards of public funds, not because they are bad people, but simply because we are bad at measuring the social utility of government services.
The problems with government and the problems with the private sector are not mutually exclusive. Governments participate in markets, and just as consumers in the market tend to save too little relative to what is optimal, much of what governments do—from sending billions of tax dollars to defense contractors to encouraging leisure in its various forms and taxing productive work—can be understood as wasteful, conspicuous consumption.
Similarly, much, if not most, of private human activity takes place in the absence of market prices, just like much of government activity does. Our interactions with our friends, family and even our co-workers are usually not market-based. This may help maintain social bonds to some extent, and certainly not every good thing should be put up for sale. Nevertheless, a good deal of activity surrounding our interpersonal relationships is wasteful from an economic-efficiency point of view. Our time and energy could be more productively spent in other ways.
A Possible Solution: Sovereign Wealth Funds
Because of the imperfect nature of both markets and governments, there are countless missed opportunities for economic growth. Many of these problems exist because the scope of market transactions—in both the private and public realms—is narrower than it could be. A solution therefore is to expand the domain of activities that take place within markets, and there is an institution with a proven track record of success at doing this: a sovereign wealth fund. A sovereign wealth fund has the potential to accomplish two aims at once. First, the private sector’s undersaving problem can be addressed by increasing national savings through a public investment vehicle. Second, knowledge and incentive problems found in the public sector can be overcome by having governments rely more heavily on the price system.
Sovereign wealth funds have largely been established by countries with abundant natural resources, typically oil and gas. The first sovereign wealth fund was the Kuwait Investment Authority, established in 1953. Two of the largest government investment funds in the world are Norway’s Government Pension Fund Global and Japan’s Government Pension Investment Fund, both of which currently manage more than $1 trillion in assets. Sovereign wealth funds need not be set up only in economies with a heavy dependence on natural resources or large trade or budget surpluses. In the U.K.—a country where annual budget and trade deficits are common, much like the United States—a sovereign wealth fund has been proposed.
One of the main benefits of any investment fund—public or private—is its ability to take advantage of the compound interest that can accumulate on monetary investments. When money is not involved in an exchange, the potential to produce compound growth by reinvesting the benefit is limited. A sovereign wealth fund can increase the overall rate of investment in society and reinvest the returns on those investments, thereby contributing to national economic growth. Increasing national wealth makes it more likely that society can support needy citizens in the future. It also means more resources are available for improvements to the public health system, infrastructure, the environment or indeed any other social purpose.
Beyond helping address the failure of the free market to accumulate resources at an optimal rate, sovereign wealth funds can address the failings of governments too. A positive or negative rate of return on a sovereign wealth fund signals to government authorities when their strategy is working and when it isn’t. When rates of return are negative, the government knows it should do something different, and the citizens know it too. This does not mean that the government will always manage resources well. Sometimes it will not, just as entrepreneurs in the marketplace often lose money. The point is that the informational problem is partly overcome.
Similarly, sovereign wealth funds can limit government actors’ incentive problems. When a fund’s annual return is transparent, it becomes easier to tie managers’ salaries to their performance, and therefore to connect the interests of society at large with the motivations of the typical civil servant. In fact, the same logic can be extended to voters: If you live in Alaska for over a year, you can earn a dividend payment from returns on the Alaska Permanent Fund—Alaska’s sovereign wealth fund. A payment gives voters a stronger incentive to monitor the government’s management of the fund, and votes may be better informed as a result.
Pros and Cons of Sovereign Wealth Funds
Obviously, sovereign wealth funds are not going to solve every problem with governments or with the free market. Moreover, the dangers associated with starting these funds have to be considered, such as the tendency for a large surplus of wealth to stimulate profligate government spending, which could necessitate bailouts later.
But there are also huge potential upsides to sovereign wealth funds. The usual method of raising government revenue, taxation, reduces citizens’ incentive to invest and to work. What if the government financed itself in a way that generates wealth rather than discourages its creation? Governments already have experience managing investments in other contexts, such as through public pension funds or central banks. Additionally, sovereign wealth funds may be relatively easy to start. A small seed fund—financed through a special bond issuance, through tax revenue or central bank reserves, or by diverting funds from existing programs or agencies—would not be hard to establish in the United States.
The question is not whether sovereign wealth funds are perfect, but whether on the margin they could make both markets and government work a little better. On both these fronts, there are reasons to be optimistic. Many failings of the private and public sectors occur because there is not a market for something people value. Sovereign wealth funds can create new markets because the government has the size and borrowing capacity to fund projects that are out of reach for the private sector. A sovereign wealth fund won’t solve all our problems, but its potential is vast. Governments would be wise to consider whether establishing such a fund would fit in with other existing priorities.