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<p>Photo by Mike Bowers.</p>

Photo by Mike Bowers.

Grasshopper Economics

Apart from the question of who should manage it, some question the sense of Australia’s Future Fund. Some fabled wisdom about fabulous wealth might help explain sovereign wealth funds.


Surely everyone knows Aesop's fable about the ant and the grasshopper.

But in case you don't, here it is in a nutshell:

Australians ... suddenly perceived themselves as much richer. And what did they do? They stopped saving, they borrowed and spent and bid up the price of real estate.

The grasshopper has spent all summer singing, while the ant toils to store food for winter. Come winter, the starving grasshopper begs the ant for food, but is denied and rebuked for his laziness.

It's a simple lesson in prudent planning for the future. It's also the rationale behind something which sounds more complex, the sovereign wealth fund.

Dozens of countries, from giants like China to tiny ones like East Timor, have them. They are most in favour among countries which have economies heavily dependent on selling natural resources, particularly energy resources, to the world. Thus almost all the world's big oil producers - Saudi Arabia, Norway, the United Arab Emirates, Qatar, Russia, Kuwait, Libya, et cetera, have very large SWFs.

The rationale is that those resources are finite, and that a share of the proceeds which come from selling them should be reinvested by government to ensure long-term economic security.

Some sovereign wealth funds are established to fund specific purposes, others are used more generally, to even out the economic cycle.

Australia also is a heavily resource-dependent economy, and has lately become much more so - in 2010, according to recent figures cited by the Reserve Bank, iron ore accounted for 17 per cent of the value of Australia's exports, while coal accounted for another 15 per cent, up from three and seven per cent respectively in 2003.

Maybe, then, we should have a SWF, too.

Well, actually, we do. It is one of the special purpose kind. It's called the Future Fund, although until recently, not much was heard about it. Then Peter Costello, the former Treasurer who established it back in 2006, had a public hissy fit because he was denied in his ambition to be the boss of its continuing operation. Instead, the Government appointed a businessman, David Gonski, as chairman. Then the federal Opposition took up Costello's case, and attacked the government - justifiably in the eyes of many commentators - for the messiness of the process of selecting a chairman. The opposition also backed Costello - much less justifiably, in the eyes of many commentators - as the right man for the job.

But we're not going to get into the to-and-fro of that political fight, except inasmuch as it illustrates broader issues relating to sovereign wealth funds, starting with the threshold question of whether they are or are not a good idea.

See, the debate about sovereign wealth funds complicates the simple truth of Aesop in a number of ways. The first question relates to who one defines as the "ant" of the parable and who as the "grasshopper".

Out on the further reaches of the right of economic opinion, governments are always seen as grasshoppers, which inevitably waste resources. The argument goes that they can't be trusted with a big bucket of money, that they will always be tempted to dip into it for wrong purposes, or, alternatively, will feel free to spend recklessly in their other budgets, in the knowledge that the SWF is there.

The real ants, in this right-wing view, are individual taxpayers, and any excess income government receives should always be handed back to them to spend wisely.

And they do have at least half a point. Governments do not always spend money wisely. You could envision a scenario where one responsible government puts money into a fund, which is subsequently raided by a future government.

<p>Photo by Mike Bowers.</p>

Photo by Mike Bowers.

Peter Costello recognized this by setting up the Future Fund in such a way as to be as independent as possible of Government, and as resistant as possible to capricious spending.

And this is why most independent commentators see it as a good thing that Costello was not awarded the chairmanship of the Future Fund. Even the co-architect of the fund, former Finance Minister Nick Minchin argued Costello should not have got the job.

"The fund must be and be seen to be independent, professional, completely above politics and entirely apolitical," he said in a letter to The Australian, in the wake of the Costello complaint. Appointing a former politician - even one of the stature of Costello - as chairman would therefore be most unwise."

Now, there was undoubtedly a political subtext to his intervention, but in a way, that only underlines the point that these things should be kept as distant as possible from politics.

So, one of the major issues with a sovereign wealth fund, then, lies in ensuring it is used for its proper purpose - as a hedge against future economic difficulties, rather than to fund current consumption. The Future Fund actually provides a fine example of this, for it was set up to deal with a specific future economic problem. That was that the federal government had not funded its future liability to pay retiring public sector employees under their defined benefit superannuation scheme.

Fortuitously, the boom economy of the mid 1990s saw the Government rolling in cash. It also had lots of money raised from the privatization of Telstra. To have given it all back in tax cuts would have risked over-stimulating the economy. Better, it determined, to put some away to meet future payouts. The rules governing the Future Fund stipulate that no money can be withdrawn until those liabilities are met, or until after July 1, 2020, whichever is first. Currently, the Future Fund is worth somewhere between $70 and $75 billion.

But that brings us to another problem with SWFs. Where do you invest the money? And what if those investments go bad? The Future Fund, for example, has about 25 per cent of its investments in shares, some Australian, but most offshore.

It is more painful to stop the giveaways than it would have been to never start the giveaways in the first place.

And, as we all know, it's been a rough time for equities in recent years, and the performance of the Future Fund illustrates the point. In its portfolio update, to the end of last December, the fund conceded it had not done so well.

Since the first contribution on May 5, 2006, it has averaged a return of 4.2 per cent per year. But for calendar year 2011, that return was just 1.6 per cent, and for the most recent six months from the start of July, it was minus 3.1 per cent.

Such returns are ammunition for the economic right, and one prominent member of that group, Terry McCrann, was eager to fire off a few rounds.

He fired them, it should be noted, in the context of a most entertaining dispute with Liberal MP, former investment banker and boss of Goldman Sachs Australia Malcolm Turnbull, who is supportive of the idea of a sovereign wealth fund.

McCrann damned the Future Fund as "underperformed and aimless". He went on to argue - citing work by the right-wing think-tank the Centre for Independent Studies - that Australia should not consider the idea of establishing a broader sovereign wealth fund because any such fund "eased the Government's future revenue and borrowing constraints - thereby weakening incentives for responsible long-run budget management".

The argument got quite personal; McCrann suggested the only certain winners from an Australian SWF would be the fund managers who were employed to invest the money.

"Given Turnbull's history at Goldman Sachs, does that demonstrate even more that he doesn't understand the real-world consequences of his proposal? Or that he does?" snarked McCrann.

<p>Photo by Mike Bowers.</p>

Photo by Mike Bowers.

But, personal barbs aside, his real point, made in The Australian on March 17, was that any advocacy of a sovereign wealth fund "presumes you will get a better economic outcome by having governments over-tax their citizens and "better" deploy the money".

He went on to say that "any taxation reduces economic utility; deliberate over-taxation is much worse," and to allege that anyone who believed SWFs were advantageous was either a "representative from collectivist central" or of Wall Street.

Alas, McCrann's case that individuals always spend more wisely than governments is undermined by reality. A case study presents itself. Here in Australia, during the boom of the 1990s, the Howard/Costello Government did not put all that much, proportionately, of its tax windfall into the Future Fund. Far more was distributed in tax cuts and middle-class welfare.

Australians not only had tax cuts. They had cheap credit, and they suddenly perceived themselves as much richer. And what did they do?

They stopped saving, they borrowed and spent and bid up the price of real estate.

Indeed, it was almost as if the people followed the government's lead in profligacy. To quote from an RBA analysis of the period: "In the late 1990s the rate of dwelling price growth accelerated and in the first four years of the 2000s prices increased at an average rate of 14 per cent.

"In 1990 Australia had one of the lowest household debt-to-income ratios in the developed world at 46 per cent. By 2000 it had doubled to 94 per cent and was similar to that in Canada and the United States. By the end of the 2000s, the Australian ratio at around 150 per cent of household disposable income was one of the highest in a group of comparable developed economies."

Phase two of the mining boom is not yet producing the predicted bonanza, tax receipts are down, people are not spending, and the Labor Government is struggling to wind back the over-generous middle-class welfare instituted by its predecessor.

The point here is that it is not only governments that are inclined to imprudent spending when presented with a big bucket of money. So are individuals.

Which brings us to Malcolm Turnbull's side of the argument.

He believes that if Australia set up a SWF it would make government more likely to save than spend. A government presented with a windfall in revenue is always tempted to give tax cuts or direct more to politically-important interest groups, or spend it on its own pet projects, he wrote.

"Now, one of the biggest problems with this temptation is that more often than not with an economy like ours the fat years, the years of surplus, are a consequence of a commodities boom - the revenues are therefore in large part cyclical. But the expenditures Governments are inclined to make, or increase, are more often than not structural - that is they will continue or be expected to continue into the future."

In other words, it is more painful to stop the giveaways than it would have been to never start the giveaways in the first place.

"If, rolling in a big cyclical surplus, a Government were to cut income taxes that may not immediately send the budget into deficit, but when the cycle turns, tax receipts drop, unemployment benefits rise the tax cut will still be there and reversing it will cause much more political pain than delivering the cut derived political joy. "

Indeed, this arguably is what is happening right now. Phase two of the mining boom is not yet producing the predicted bonanza, tax receipts are down, people are not spending, and the Labor Government is struggling to wind back the over-generous middle-class welfare instituted by its predecessor.

As The Global Mail has previously written, the Government remains doggedly determined to produce a budget surplus this year, no matter what. But it is unlikely to be real and it certainly won't be big. So, for the time being at least, talk about a Sovereign Wealth Fund remains an interesting hypothetical.

Until the world economy turns seriously for the better, Australia won't have enough spare money to put away anyway.

1 comment on this story
by Sandy

You wrote "They stopped saving, they borrowed and spent and bid up the price of real estate.

Indeed, it was almost as if the people followed the government's lead in profligacy."

You failed to justify equating bidding 'up the price of real estate' and 'profligacy'.

Gold has no intrinsic value. It does need feed, clothe, educate, shelter, heal or entertain us. But it is a store of value. Why ? Because of the safety in numbers. It's intrinsic characteristics of gold has lead to a large percentage of people trusting it as a safe store of value.

And that's what Australian real estate is. What are the alternative investments? They are all dangerously gamed by hungry sharks including governent, smart money, the rich, etc .
After paying income tax, interest bearing investments pay less than inflation and hence fail as a 'store of value'. Equities are higher risk whereby groups of individuals can have their investments picked off one by one. The World Bank rated Australia embarrassingly low on investor protections. And it looks like The Global Mail will be just another publication that ignores this key failing of Australia..

These are the factors that you seem to have wilfully ignored. Taken in context, Australian's pushing up house prices looks more like the opposite of profligacy. It's more like investment for capital gain and capital preservation.

Australian real estate IS 'safety in numbers' preservation of capital. Australians are actually quite cunning and shrewd. A large % of Australians have done screamingly well from investing in their houses.

March 20, 2012 @ 12:05pm
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