John Law rides again

There was some excitement last week at press reports that the Her Majesty’s Treasury was considering the establishment of a United Kingdom sovereign wealth fund to support public sector pensions. Naturally, custodians shared the excitement. Though not yet as large as pension funds, insurers, mutual funds or even central bank reserves, sovereign wealth funds are nevertheless highly desirable custodial clients. Their collective means greatly exceed the much-vaunted hedge fund industry, and they are conspicuous participants in major transactions. Indeed, they were among the earliest targets of ailing banks seeking a capital uplift in the early stages of the banking crisis of 2007-09. A Congressional report estimated that foreign sovereign wealth funds and other large investors sunk $37.9 billion into US financial institutions in 2007.

If sovereign wealth funds could rescue banks, perhaps they could also rescue pensioners. A funded solution will always appeal to the natural fondness of the Anglo-Saxon bourgeoisie for property ownership. What has become known as “asset-based welfare” has been a popular topic of political discussion in the United States and the United Kingdom since the 1980s. This belief in property ownership translates, on the question of retirement, into a strong preference for pensions that are funded rather than unfunded. In 1996 Marsh Carter, then chairman and CEO of State Street, co-authored a book entitled Promises to Keep, which advocated the investment of social security contributions in the equity markets. Though this kind of thinking is economically illiterate – whether pensions are paid out of taxes or dividends, they must still be afforded out of a single national income - it is always politically popular.

So it was not surprising to find the British government, which is struggling to slow down the rate of growth of public expenditure without bringing economic growth to a halt, taking seriously the idea of backing pension promises with a portfolio of growth-boosting, job-producing infrastructural assets. But if Treasury officials are even half-alert, the enthusiasm of their political masters will be deservedly short-lived. Unlike most sovereign wealth funds, which really provide an alternative home to the foreign exchange reserves for vast surpluses accumulated from the sale of high priced commodities (such as oil and gas) or a positive balance of trade (such as that of China), the proposed United Kingdom fund is not funded with pre-existing wealth at all. Instead, the government will borrow the sums required. In other words, the United Kingdom fund would actually start life not as a sovereign wealth fund, but as a sovereign debt fund.  Nor would it be free to invest where the fund managers chose. Instead, the funds would be directed to the acquisition of infrastructural capital assets, in the shape of road and rail links, power stations, schools, hospitals and housing.

This is worrying. Any sovereign wealth fund is by definition owned and managed by a national government, whose priorities cannot be confined to securing the highest investment returns for pensioners. What will have appealed to politicians is the political capital infrastructural investment can create, not the real capital. Though most sovereign wealth funds were set up to secure an income for future generations, they have not proved immune to the risk of being diverted to grandiose schemes with a strong political narrative or wider geopolitical purposes. Yet the entire scheme depends upon the income from the infrastructural assets being used to secure the interest payments, and then the pension promises, which successive British governments have made to public sector workers.

It is a combination which makes the fund less akin to a genuine sovereign wealth fund than the national investment bank advocated by the British Labour Party in the early 1980s. This was to be charged with putting capital from private institutions and the government “on a large scale into our industrial priorities.” Such ideas have a perennial appeal on the left – the idea of a national investment bank, to invest in infrastructure without regard to return, surfaced in the US Congress in 2007 – but It is curious to find something not wholly dissimilar now being put to a Conservative-dominated government by (of all people) an individual who has made his career in the private equity industry.  According to press reports, the fund is the brainchild of Edmund Truell, a 22-year veteran of the private equity industry in London. In 2006, he entered the pension business through the foundation of the Pension Corporation.

Owned by two private equity firms (Coller Capital and J.C. Flowers), two State-controlled banks (RBS and Lloyds TSB), a State-run investment firm based in Dubai (Istithmar) and a pair of insurance companies (Swiss Re and Sampo), the Pension Corporation is one of several insurance companies that have insured defined benefit pension plan sponsors (including at least one public sector agency) against the risk that they will not be able to meet their pension obligations. The company has also funded the Pensions Tomorrow research unit at the London School of Economics, which has in turn spawned the Pensionomics.com web site, much of which is written by a former senior economist at the Pensions Corporation.

If Edmund Truell and the Pension Corporation are not uninterested parties, they do have direct experience of calculating the net present value of pension liabilities, and assembling a portfolio of assets to secure them. Indeed, a number of pension plan sponsors have already agreed to sell their pension liabilities through buy-outs by insurance companies, which terminate the scheme, and then look to profit from running off the liabilities. It is a more limited approach than trying to continue to provide a pension scheme, which suggests the buy-out providers have neither the appetite nor the skills to do that. They make the numbers add up by charging the sponsor a premium, typically of 130-150 per cent of the liabilities being insured. They then terminate the provision of new pensions, fixing the scale of the risk. Next, the assets of the fund are converted into cash and government bonds. This limits the exposure of the fund to the volatility of the equity markets.

The pension buy-out is not a failsafe solution. It transforms a financing problem into an insurance risk whose likelihood of materialising still depends to some extent on the performance of financial markets. Though private equity has acquired an unfortunate reputation for ripping out costs and widening profit margins, in order to leverage assets before jobbing them on as soon as possible - making its denizens unlikely custodians of long term liabilities such as pension promises – its default mode is actually reassuringly naïve. It is to believe that any problem is susceptible to financial engineering.

Whether the numbers can be made to work in this case seems doubtful. Though a United Kingdom sovereign wealth fund invested in infrastructural assets, and funded from the issue of a mass of interest-bearing securities, would give the managers of the fund control of projects consuming a material proportion of the total United Kingdom tax take, the material need is dauntingly large. The estimated size of the shortfall in public sector pensions is £1.3 trillion. Bonds equivalent to that amount and paying, say, 3 per cent, would require payments of £39 billion a year.

One question is whether that represents a sensible transaction for the government, as custodian of the interests of the British public. The £39 billion of interest payments will be transferred from taxpayers to investors. Those same taxpayers, in their guise as consumers, will also be paying the housing rents, road tolls and power bills that generate the returns on the infrastructural assets that meet the public sector pension liabilities (net of interest and operating costs). In other words, the infrastructural assets will be funded by deferred rather than immediate taxation, and the pension payments by dividends rather than taxes, and the whole enterprise will be intermediated by an expensive sovereign wealth fund manager.

It is not obvious that this makes sense to either taxpayers or public sector pensioners. Economically speaking, it makes no difference whether pension payments are funded out of dividends or taxes. Both are claims on a single national income. Contrary to popular perceptions, funded pensions are not paid out of “savings,” but out of dividends paid from real assets or from outright disposals of real assets. But relying on financial intermediation to fund pensions may be worse than economically pointless.

Over a cycle, the earnings of taxpaying individuals, families and industrial and commercial companies are bound to be higher than those of purely financial investments. If they were not, capitalism would collapse, since it would be more remunerative to leave surplus capital in the bank.  They are also less volatile, so the returns provide exactly the steady stream of revenue that can insulate pensions from the volatility of the financial markets. In other words, long run liabilities met out of the long run earnings of the real economy must in principle be cheaper to sustain than any supported by the prospective earnings of the financial economy. Fretting about the scale of the “deficit” at a particular point in time misses this reality.

In fact, a pension fund can operate soundly while in deficit, which is a notional calculation driven by prevailing rates of interest. The market developed the classical defined benefit pension scheme backed by a corporate or local authority of state agency plan sponsor not because it made immediate financial sense but because it made long term business sense, not least in terms of retaining staff loyalty. The modern tendency to view pensions purely as a financial liability, and the assets of a pension fund as a way of collateralizing a constantly changing level of financial risk, is yet another measure of the excessive financialization of Anglo-Saxon economies – of which private equity fund managers, incidentally, which have profited mightily from the amplitude of the credit cycle, are one of the more conspicuous epiphenomena.

Yet the sheer scale of the liabilities might, in this case at least, defeat even the ingenuity of the financial engineers of the private equity industry anyway. Selling £1.3 trillion of government debt to domestic insurance companies and pension funds, if it could be achieved at all, would crowd out private sector investment. Selling them to the banks, on the other hand, would put quantitative easing into reverse. Given the general paucity of savings in the United Kingdom, especially of the non-equity kind, retail investors anticipating higher rates of inflation are also unlikely to be ready buyers of fixed income bonds issued by a government whose larger troubles virtually ordain the monetisation of its debts.

So if anyone is to buy the securities issued by the United Kingdom sovereign wealth fund, it is likely to be foreign investors, including the genuine sovereign wealth funds of Asia, Russia and the Middle East. They will need to be compensated for the counterparty risk (and especially the anti-inflationary credentials) of Her Majesty’s Government, and the additional exchange rate risk of holding sterling investments. In other words, their assessment of these risks will be reflected in an interest rate premium, further reducing the profit available to make pension payments. In addition, the investment in sterling assets would drive up the exchange rate, making imports cheaper and exports more expensive, further undermining the value of domestic savings by increasing consumption, reducing profits and deterring investment. This would contradict much of the purpose of the scheme.

Of course, borrowing abroad to finance investment at home is not self-evidently stupid. If a country has many profitable investment opportunities but no domestic savings to fund them – and the current infrastructure of the United Kingdom is certainly in need of improvement – it is perfectly reasonable to borrow abroad to build up capital assets at home. It is easy to forget that running down your capital is as good a way of spending money as going on a shopping spree. The public sector, whose financial rhythm is so governed by the political cycle that proper information on the national balance sheet is not even collected, is particularly good at spending money in this way indeed, the shocking states of the infrastructure of the United States as well as the United Kingdom are classic symptom of countries that have carried on consuming even when current public spending appeared to be under control.

So funding infrastructural investment in a ring-fenced manner may make political sense even if it is economic nonsense. To the extent that assets in which foreign borrowings are invested increase the national wealth, and a more efficient infrastructure could certainly have that effect, it could even make long term economic sense. However, borrowing abroad nevertheless represents a subtraction from the national wealth of the United Kingdom. Foreign investors would have claims on British capital, which when they are extinguished have to be re-paid out of the income or capital of some part of the national wealth.

But even with lavish foreign support, it is hard to believe the United Kingdom sovereign wealth fund could make the numbers add up. With the shortfall in the public sector pension schemes of the United Kingdom put at £1.3 trillion, the sum required is not far short of an estimated total national income of £1.4 trillion last year. The usual rule of thumb is that an investment of 2½ per cent of the national income will increase the national income by 1 per cent. On that basis, a sovereign wealth fund investing £1.3 trillion will lift the national income by 40 per cent, which is a material contribution, but still some way short of the large sum required.

It is a reminder that the proposed United Kingdom sovereign wealth fund is nothing of the kind. Indeed, it is really an attempt to create wealth through the issue of paper backed by real assets. It has that character in common with the scheme hatched by John Law in seventeenth century France. His Mississippi Company, a government debt purchase scheme ostensibly backed by income-producing French interests in North America and Asia as well as the domestic tobacco monopoly and the tax take, proved beneficial only to the government. The inflation he unleashed devalued the debt of the French government by two thirds, effectively transferring wealth from the people who had it to the people who had spent it already. No new wealth was created by an elaborate scheme of financial engineering. But it is not hard to see why it made sense for a badly indebted government of the kind in plentiful supply today.