One of the more challenging proposals in the ConservativeHome manifesto is a call to set up a UK sovereign wealth fund. This has raised eyebrows. After all, if we do eliminate the deficit, why wouldn’t we want to use any subsequent surplus to reduce the level of our public debt?
As a way of thinking about this question imagine a heavily indebted company in which two senior executives vie for control. One of them is a spendthrift called Bill Somebody. His great rival is called Prudence Personified – and currently she’s in control of the finances. By cutting overheads she hopes to have the company breaking-even and making a profit within a few years.
But what happens after the break-even point? Her first instinct is to start paying off the company’s debts. However she knows that the shareholders are a fickle lot who might put Bill back in charge. With the debt level back below the danger zone, the first thing he’d do is exploit this leeway and start borrowing again – thus undoing her good work.
But then Prudence has an idea. Instead of using the surplus to pay off the company’s debt, she sets up a special investment fund to purchase an expanding portfolio of assets. These assets would offset the liabilities on the company’s balance sheet – thus ensuring market confidence. Furthermore, while the shareholders might not care about debts that are payable in the future, they do care about the assets which they own in the present. Bill would encounter much more resistance trying to raid the investment fund then he would trying to ramp up the company’s debts.
Just as Prudence puts the finishing touches to her plan, she has another thought – another perfectly sound reason why the company should use its surplus to purchase assets instead of paying off debt. What she realises is that if the company is viewed as fundamentally solvent (thanks to its investment portfolio), then it can charge others for the privilege of holding its debt!
At this point you might think that Prudence has lost it – surely no one would lend money to a company or a country at a negative interest rate. However, as Matthew Yglesias reports for Vox, this is exactly what is beginning to happen in the real world:
“Something really weird is happening in Europe. Interest rates on a range of debt — mostly government bonds from countries like Denmark, Switzerland, and Germany but also corporate bonds from Nestlé and, briefly, Shell — have gone negative. And not just negative in fancy inflation-adjusted terms like US government debt. It’s just negative. As in you give the owner of a Nestlé bond 100 euros, and four years later Nestlé gives you back less than that.”
Yglesias explains how this seemingly insane situation developed. It’s all terribly complicated, but in large part it’s the Eurozone and quantitative easing that’s sent us down the rabbit-hole.
Weird things also start happening when people and institutions with lots of spare cash don’t have enough safe places in which to put it:
“A bond is backed by the full faith and credit of the government that issues it. Bank accounts are only government-guaranteed up to a certain extent — most European countries cover 100,000 euros. Very rich people and big companies have more money than that and need to do something with it. Obviously you could fill shoeboxes with paper money, but there are safety risks with that, too…
“Because people thought negative interest rates were impossible, few institutions have rules in place that were designed to accommodate this situation. Pension funds, mutual funds, and other impersonal investment vehicles have rules and formulae they’re supposed to be following. To the extent that those rules call for the holding of safe bonds, some bond-buying can simply happen on autopilot…”
How long this weirdness can hold up is anyone’s guess. The widespread practice of QE was meant to result in rampant inflation, but there’s not much sign of that yet. For the time being, the laws of the economic universe have been suspended.
Even if negative interest rates aren’t quite achievable on UK bonds, very low positive rates still offer an opportunity. If a UK sovereign wealth fund could achieve a higher return – for instance by investing in new infrastructure and housing – then it would make sense to use a UK budgetary surplus to purchase assets of this kind rather than to pay off cheaply financeable sovereign debt.
The catch is that to keep it cheap, Britain must retain the confidence of the markets. That means achieving and maintaining a budgetary surplus – and using it to a build-up genuinely sound assets.
In other words, Prudence Personified must stay in charge and Bill Somebody be given the boot.