Government Investment In Equities: It’s Not As Simple As It Looks

Brad DeLong writes writes in favor of federal investment in equity markets in the context of various Social Security privatization proposals. After demolishing some really bad ideas, he says,

I would rather see this forced equity savings done not through private accounts but through allowing the Secretary of the Treasury to invest the Trust Fund in equities. I would rather see this done by the Treasury Secretary for three reasons: (1) if I'm wrong, then there's no great harm, while there is great harm if you cut people's benefits assuming expected stock returns will be high and they aren't; (2) there's still a lot of risk out there, and the government is better-positioned to bear that risk than individuals; (3) offer individuals the opportunity to do so and they will churn their investments, buying high and selling low. The only reason to use private accounts for this forced equity savings is the fear that having the Secretary of the Treasury control a lot of equities will magnify our corporate oversight and control problems, and I don't see this is a first-order problem.

Although attractive in the abstract, the idea that the government might try to invest in equities and thus directly enjoy some of the fruits of the very capitalism it creates a safe environment for (rather than just benefitting indirectly via taxes) is, I think, much more fraught than the economic mind instinctively recognizes. While I'd be happy if we could make it work, I don't think we are up to it in practice (and I'm certain the Bush administration is not up to it!): the problems that need surmounting are much worse than Brad suspects, and are much worse then just “magnify[ing] our corporate oversight and control problems,” although who votes the government's shares and according to what policy is no small problem.

No, the first-order problem isn't that having the feds control a lot of equities will magnify existing corporate oversight and control problems. It's that the way in which the feds choose what to hold and sell will create huge new problems.

Start with the buying end. Buying will either be mechanistic, delegated, or discretionary. If it is mechanistic, we have the wrangle over the formula, which then distorts markets unless the formula is to buy a basket consisting of the entire stock market (even this, arguably, has secondary effects on the bond market, but let's not go there).

In fact, this is the only buy/sell formula that doesn't create huge problems right off: have the feds buy a basket that represents all the shares in a multiplicity of exchanges (not just the big ones). But this isn't easy to do, especially for small-cap stocks, without distorting markets. Even here, though, a mechanistic sell policy may have some undesirable depressive effects at inconvenient times driven by demography. And while it's arguable that similar selling would be happening anyway if the funds had been in private pension funds, that may be the wrong comparison, since the funds might otherwise come out of general tax revenue, and thus spread the effects beyond the stock market.

If the feds use any formula other than whole-market, it becomes very distortionary given the sums involved. For example, if the feds just buy the S&P 500, or even just a NYSE basket, the effect of being listed in that group or that one among competing exchanges (or, worse, de-listed) is substantially magnified because it comes with an investor who can be relied upon not to sell based on market shifts, and whose buying and selling generally is predictable. Not to mention that the biggest equity gains may well be in the stocks that are not in the S&P 500 or the NYSE (think, for example, NASDAC).

If buying is delegated to fund managers, they become incredibly powerful and lack the sort of checks on performance that would be needed since the government is highly unlikely to exit an under-performing fund. I suppose one could in theory create some performance-related pay for the managers that might substitute for market discipline, but there is no real chance that politics would allow the feds to create a performance pay scheme that would have the right sort of long-term incentives. (Again, imagine the Bush administration writing the rules here…)

If the feds themselves have any discretion as to what to buy, we're in for even worse crony capitalism than we have now, with a dash of 'lemon socialism'. Imagine if campaign contributions might, or even are thought to maybe, have a chance of turning the feds into a buyer of your shares. At this point, having the Bush administration in charge is just a nightmare. And imagine the pressure to have the government buy into 'critical industries' or key local employers to prop them up or protect them from foreign takeover. (It may be that the new TRIPS and GATT regimes protect against this somewhat; it's been a very long time since I looked.) And try re-telling the Lockhead or Chrysler stories if the government has an equity buying scheme.

It's even worse on the sell side. If the formula for selling shares is anything but mechanistic, then a government sell decision will be seen as a massive vote of no-confidence. [Side issue: can the government use its information about the economy to decide what to buy and sell? Or rather, what information is it allowed to use generally?]

Then there are the macro issues: just imagine the times when Congress and local pols will be pressing the feds to buy or sell as an aspect of counter-cyclical policy…

So while it makes sense in the abstract to have the government be a direct holder of equities, the details are just swarming with devils, demons, pitfalls, and mixed metaphors.

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12 Responses to Government Investment In Equities: It’s Not As Simple As It Looks

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  5. hmmmm…I think delong does you a disservice by suggesting that your comments reflected support for individual private accounts—-to my ear, you were merely cataloguing why the “one big fat federal account” idea is unacceptable.

  6. Iang says:

    There is another option which is to invest in foreign markets. For example, the Kuwait Investment Office (KIO) in London manages the Kuwait treasury by purchasing equity through the London markets, which by dint of some trick also means they can invest anywhere.

    The sovereign generally enjoys special status when investing in another soveriegn’s territory. For example, tax exemption. This came to the fore when KIO was trying to move the market in a particular share (BP?) back in the 80s, in order to make a profit; they were told that they could lose their status if they speculated and played the market. Since then they’ve gone back to more passive investing.

    I don’t think this changes your argument in principle; that the US government might make a pretty bad hash at being an investor in the markets, but it does represent a way to reduce the more eggregious opportunities.

  7. Michael says:

    Yes, I think Brad slyly chose to misread me. As I commented on his blog,

    Actually, no, it doesn’t follow that we should have individual accounts for other reasons well explained elsewhere, not least that the endgame is either destitute old people (whether spendthrift, unlucky, or unwise) and/or new aid programs to help them which end up with us paying twice, once now and once later.

    The answer, rather, is that the social security program we have remains superior to any of the forms of private account alternatives. (If we want to supplement it, that might be a different story.)

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  9. JollyBuddah says:

    Conservatives are confusing two distinct issues of Social Security Insurance and retirement investment programs. Liberals are making it way too complicated. The only “reform” Social Security requires is implementing Al Gore’s lock box, which Daniel Gross discussed in a Jan., ’04 Slate article linked text. Step one is complete. Social Security is fixed. We have just rescued one trillion dollars for the S.S. Trust Fund from the sticky hands of grubby Republican politicians.

    Step two is implementing a separate Thrift Savings Plan linked text exactly like the one available to Federal Employees and members of the Uniformed Armed Services, that is commonly known as Social Security Plus. The matching agency contributions from the federal government would fit in quite nicely with our good President’s goal of making saving easier and more financially rewarding. A version of this suggestion has been proposed both by AARP and by the NCPA linked text TSP has three basic funds its participants can invest in. For some reason the NCPA proposal has five. Either plan is simple, manageable and has low administrative costs.

    As far as whether Social Security Plus would be affordable, this is a simple choice between tax cuts for the top 10% or a genuine retirement plan for the bottom 90%. A nice bonus is that by introducing a Social Security Plus plan, anything Bush proposes becomes Social Security Minus, because any Bush plan diverts FICA payments from the S.S. trust fund to a different purpose. For what it’s worth, I have a few details in a Social Security Plus diary at Daily Kos linked text

  10. JollyBuddah says:

    It appears I didn’t read the NCPA proposal carefully enough. I had never heard of the TSP for federal employees until recently. The NCPA proposal stated that the board selects asset managers for the F, C & S funds and one of the charts at the TSP website seems to indicate three separate funds federal employees can invest in. After more careful scrutiny, I believe the G and I funds are additional choices, but they are investment funds that do not require oversight by asset managers.

    I’ve posted this suggestion on several left and right wing sites and have not had any substantive criticism. If there is a problem I am overlooking it has not been pointed out to me. The primary “conservative” objection is the free market utopian idea that any government “interference” in the lives of private citizens is bad/immoral by definition.

  11. Deb Hendrickson says:

    The Federal Thrift Savings program has five funds, all of which are index funds:

    The G Fund invests in short-term government securities specifically issued to the Plan. The maturities on these securities are 1 to 4 days.

    The F Fund is a bond fund that tracks the Lehmann Brothers U.S. Aggregate (LBA) index. The monies are (currently) invested in the Barclays US Debt Index Fund.

    The C Fund tracks the performance of the S&P 500 through the Barclays Equity Index Fund.

    The S Fund tracks the Wilshire 4500 Index through investment in the Barclays Extended Market Index Fund

    The I Fund tracks the Morgan Stanley Capital International EAFE (Europe, Australasia, Far East) Index through investment in Barclays EAFE Index Fund.

    So, with the exception of the Government bond fund, these are all index funds. There is only a handful, but together they provide good diversification.

    They have a lot of assets under management, I should think, as the Fed is a large employer and all career employees have at least 1% of their base pay contributed to the fund automatically, whether they choose to put their own money in or not. Don’t know that anyone’s complained about market distortions as a result of them.

    It would be very simple to open this program up to the general public, and easy for employers to administer, much more so than the plethora of private options out there.

    But I don’t think getting ordinary citizens invested in the market is really the point of the Social Security privatization exercise.


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