The fate of the US economy, like that of Japan, the euro zone, and the rest of the world will rest on an important fact: unless private investors or another government counteract central bank asset purchases 100%, central banks can drive asset prices up and interest rates down by buying any asset that has an interest rate above zero. The Fed has committed to continue buying $45 billion of longer-term Treasurys every month and $40 billion a month of mortgage-backed securities until the economy recovers.
But what if longer-term Treasurys and mortgage-backed securities are the wrong assets for the Fed to buy? Most of those rates are already below 3%, so it’s not that easy to push the rates down further. What is worse, when long-term assets already have low interest rates, pushing down those interest rates pushes the prices of those assets up dramatically. So the Fed ends up paying a lot for those assets, and when it later has to turn around and sell them—as it ultimately will need to, to raise interest rates and avoid inflation, it will lose money. Avoiding buying high and selling low is tough when the Fed has to move interest rates to do the job it needs to do. At least economic recovery reduces mortgage defaults and so helps raise the prices of mortgage-backed securities through that channel. But the effects of interest rates on long-term assets cut against the Fed’s bottom line in a way that is never an issue when the Fed buys and sells 3-month Treasury bills in garden-variety monetary policy.
From a technical point of view, once 3-month Treasury bill rates (and overnight federal funds rates) are near zero, the ideal types of assets for “quantitative easing” to work with are assets that (a) have interest rates far above zero and (b) are buoyed up in price when the economy does well. That means the ideal assets for quantitative easing are stock index funds or junk bond funds!
Yet, is the Federal Reserve even the right institution to be making investment decisions like this? University of Chicago finance professor John Cochrane writes in his Wall Street Journal editorial “The Federal Reserve: From Central Bank to Central Planner.”
In his speech Friday in Jackson Hole, Wyo., Mr. Bernanke made it clear that “we should not rule out the further use of such [nontraditional] policies if economic conditions warrant.”
But the Fed has crossed a bright line. Open-market operations do not have direct fiscal consequences, or directly allocate credit. That was the price of the Fed’s independence, allowing it to do one thing—conduct monetary policy—without short-term political pressure. But an agency that allocates credit to specific markets and institutions, or buys assets that expose taxpayers to risks, cannot stay independent of elected, and accountable, officials.
This is not a criticism of personalities. It is the inevitable result of investing vast discretionary power in a single institution, expecting it to guide the economy, determine the price level, regulate banks and direct the financial system.
As Cochrane points out, isn’t it a bit much to expect the Fed to both choose the right amount of stimulus for the economy and decide which financial investments are the most likely to turn a profit for a government that faces remarkably low borrowing costs?
Why not create a separate government agency to run a US sovereign wealth fund? Then the Fed can stick to what it does best—keeping the economy on track—while the sovereign wealth fund takes the political heat, gives the Fed running room, and concentrates on making a profit that can reduce our national debt.
Sovereign wealth funds are already standard for governments that have paid off their national debt and gone into the black. And some countries have both debt and sovereign wealth funds on their balance sheet. In order of holdings, the Monitor Group’s Sovereign Wealth Fund Assets Under Management Table shows that Norway, China, United Arab Emirates, Singapore, and Kuwait have the top sovereign wealth funds. Markets today are so hungry for assets as safe as US Treasurys, and so frightened of risk (pdf), that a US sovereign wealth fund would be paid handsomely to provide safe assets and shoulder some of the risk. But those financial returns are a bonus over and above the primary aim: fostering full economic recovery.
As an adjunct to monetary policy, the details of what a US Sovereign Wealth Fund buys don’t matter. As long as the fund focuses on assets with high rates of return, the effect on the economy will be stimulative, and the Fed can use its normal tools to keep the economy from getting too much stimulus. So there can be a division of labor: the US Sovereign Wealth Fund can focus on making as high a return as possible for the US taxpayer, and hire accordingly, as other sovereign wealth funds do, while the Federal Reserve focuses on getting the amount of stimulus right, which is where its expertise lies. The US Sovereign Wealth Fund needs the same level of independence as the Fed, and a single mandate to earn high returns, given the level of risk it is taking on. Above some minimum, the US Treasury can be given the authority to determine the amount the US Sovereign Wealth Fund is allowed to borrow so that no one institution would have too much power or too much responsibility.
Since it would horn in on their turf, big investment banks on Wall Street are likely to offer a chorus of complaints about a US Sovereign Wealth Fund. But after many years of playing a “heads I win, tails you lose” game with the US Government and the US taxpayers, the big investment banks have no moral standing to object to the US government and the US taxpayers finally getting some of the return that should go along with the risks that they have always had to bear.