I’ve written a couple of posts about Labor’s social housing fund, showing that it’s smaller than it appears, and that hypothecation (linking housing expenditure to the fluctuating proceeds of an investment fund) is bad policy. But is the underlying idea sound? This is a complicated question, and the answer takes us back to the mixed economy of the mid-20th century
To recap, the key idea is to borrow $10 billion at the low rate of interest payable on government debt, invest it in higher-yielding assets and use the profits) to finance social housing.
The fundamental idea is the same as that of a sovereign wealth fund, of which Australia’s Future Fund is an example. Many other national governments have done the same, and even state governments, like that of NSW are getting into the act.
The source of such funds varies – it may be derived from foreign exchange reserves (Singapore) from resource royalties (as with Norway), from the sale of public assets (the privatisation of Telstra was the starting point for the Future Fund) or from new borrowing. In all cases, the creation of a fund of this kind involves a higher level of public debt than would otherwise be the case. This new debt (or the decision not to pay down existing debt) is used to finance public investment in shares or other financial assets.
The crucial question then, is whether the profits earned by a sovereign wealth fund are genuine or whether they are an accounting fiction like this used in a variety of infrastructure funding schemes. The idea that they might be a fiction rests on the observation that investments in shares and other assets are risky, so that the profits earned a sovereign wealth fund in normal years might be offset by big losses in bad years.
This argument would be correct if the observed higher returns to shares (called the ‘equity premium’) could be explained as a market allowance for risk, consistent with reasonable assumptions about the variability of returns and the risk attitudes of investors. But it’s been known for a long time that these factors would imply a small premium, probably less than one percentage point. This is the ‘equity premium puzzle’, first identified by Mehra and Prescott
I’ve been working on the equity premium for many years, and my conclusion is that it is the result of the way financial markets work, or fail to work, rather than a meaningful assessment of the social cost of risk. It follows that governments should treat the rate of interest on public debt (now close to zero) as the true cost of borrowing.
That makes borrowing to invest in the stockmarket an appealing option in the absence of any better investment opportunities for governments. The positive net returns that can be generated in this way are real but not limitless, for two reasons
First, if governments borrow enough and buy enough shares, we can reasonably expected that the rate of interest on bonds will rise and the rate of return to equity capital will fall, reducing the anomalous equity premium. Second, if this strategy is pursued far enough, governments will become major, or even majority, shareholders, effectively becoming owners.
Long experience suggests that governments are quite good at running some kinds of business, such as capital intensive infrastructure business, and not so good at others, such as retail trade. Once we accept the logic of large scale public investment, financed by debt, it makes more sense for governments to have 100 per cent ownership of infrastructure businesses and smaller, or zero, equity in businesses that belong under private sector management.
And that was precisely the way Australia’s economy worked during the brief period of broadly shared prosperity in the mid-20th century. Governments borrowed at low rates of interest and invested in physical and social infrastructure of all kinds. The success of sovereign wealth funds points the way to a return to this model.