Feel the force
Many worry that with the collapse in commodity prices, sovereign wealth funds will destabilise markets as they sell off assets. In the short run, SWFs may indeed cause volatility, as the International Monetary Fund warned in October. But in the long run, they should be seen as a force for good — and be used as such much more than they have been.
In corporate capitalism, the bulk of economic activity is carried out through a system that involves two dimensions of decentralised decision making. Goods and services are made and sold out by the dispersed, impersonal production units we call corporations. Those corporations are in turn financed and owned — but largely not controlled — by dispersed investors who are mostly very, very small relative to the capital market as a whole and even their own companies.
This twin decentralisation — of production and of capital allocation — is the most productive system of economic organisation humanity has ever known. Yet it is a distant second best from what we should aim for. While the shortcomings of decentralised production are well known — it runs into problems with externalities, market power, and falling production costs — those of decentralised ownership are much less so. To understand the importance of owners is to appreciate the enormous, but unfulfilled role to be played by investors able to counter the inertia of dispersion, SWFs chief among them.
The public corporation’s separation of ownership from management always carries the risk of misaligned incentives: what is known as the principal-agent problem. But this becomes a lot worse when there are many shareholders, each of which only has a very small degree of influence.
One consequence of this misalignment is the short-termism bemoaned by, for example, the Kay Review into UK equity markets. To the extent a manager’s tenure is shorter than the horizon of shareholders’ (let alone society’s) interests, corporate decision making will be inefficiently focused on the short term. That exacerbates externalities that work over the long term — such as greenhouse-effect pollution or the unwillingness of companies to invest (which shrinks future wealth in the economy).
The impotence of dispersed investors is also likely to have given management free rein to let executive pay gallop into insanity. And it is wage inequality that accounts for the bulk of increased income inequality in the rich world. So from climate change through investment droughts to income inequality we can tie the biggest economic issues facing us to dissipated corporate control.
SWFs are in a unique position to address these failures of capitalism because they uniquely combine four characteristics. First, the fact that they are universal investors — they tend to be invested very, very broadly. The Norwegian oil fund owns on average 1.3 per cent of every listed company in the world. Second, the fact that they are typically explicitly long-term investors — mandated to fund future pensions, or even more open-endedly, to benefit (presumably all) future generations.
Third, their size. Before the latest turmoil, SWFs held about $7.3tn in total, rising to $21.3tn if all government-controlled pension savings are included. And fourth, their unity of purpose, given by explicitly specified mandates from a coherent constituency (a state) and a unified direction and management to pursue it.
The latter two characteristics mean that SWFs have the power, more than any other type of investor, to influence corporate behaviour. The Norwegian fund’s experimentation with active ownership — which is exceedingly tentative though far bolder than what any of its peers has tried — proves that the power is there for the taking.
The former two characteristics show that SWFs have the economic incentives to do so — and more importantly, that those incentives are better aligned with society’s broader interests than those of individual corporations. Consider what it means to be a universal investor. If a company you own increases its profits in ways that impose greater costs on other companies (a negative externality), you lose overall. Conversely, because of the universal portfolio, you gain if every company takes greater idiosyncratic business risks, because successes by some outweigh the failure — including to the point of bankruptcy — of others. An established company’s management will be naturally much more conservative than this. But both the shareholder class as a whole and society at large would benefit from behaviour that creates sustained, broad-based growth — since that is what ultimately funds shareholder payouts and material wellbeing. That requires externalities to be internalised, risky expansion of real activity to be undertaken, and decisions to be taken for the long term.
The redeeming feature of capitalism has always been to align private benefits with broad social gains. When it has failed to do that, it has tended to be reformed or overturned. The standard way to align private and public interests when they do not naturally concur is through smart government regulation and tax policy. But the more both economic activity and corporate ownership cross national borders, the harder this becomes. Which is why the alternative — behavioural change driven by investors — becomes that much more important.
As the FT has reported, even private asset managers are discreetly trying to encourage management for the long term. This is welcome. But they lack public investors’ unique combination of characteristics listed above. SWFs and public pension funds should wake up to the powers they have, and recall that with great power comes great responsibility. And the rest of us should encourage them to use that power actively for theirs and our benefit.
- Sir John Vickers calls out the Bank of England for its timidity towards the banks. The BoE’s latest capital requirement rules fall far short of what has been recommended by the Independent Commission on Banking, which Sir John chaired. He has also published a longer VoxEU column which sets out the analysis behind his critique.
- Russia’s trade with the past Soviet satellites in Europe fell by one-third last year.
- Japan’s economy shrank at an annualised pace of 1.4 per cent in the previous quarter.