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Why a sovereign wealth fund won't work

Stephen Kirchner | Business Spectator | 21 February 2012

There has been growing debate as to whether Australia should make greater use of Australia’s sovereign wealth fund, the Future Fund, to manage fluctuations in the federal budget balance due to commodity price cycles and the business cycle.

It has also been argued that Australia needs a sovereign wealth fund to better manage the macroeconomic consequences of the “terms of trade” boom, such as the rising Australian dollar and the so-called “Dutch disease”. A sovereign wealth fund has also been advocated as a mechanism for sharing the revenue from the global commodity price boom with future generations.

A sovereign wealth fund can be defined as a pool of state-owned or controlled financial or other marketable assets designed to finance government activities in either the short or the long term. Sovereign wealth funds can be broadly divided into pension and non-pension funds.

Announced in 2004 and in operation by 2006, the Future Fund was notionally designed to pre-fund what would otherwise be unfunded public sector superannuation liabilities.

However, it was also designed to address the problem of what to do with large budget surpluses after the Commonwealth’s net debt had been repaid in April 2006.

With gross Commonwealth debt issuance having fallen to levels that threatened the future liquidity and viability of the government bond market, the Howard government used the Future Fund to recycle budget surpluses into other financial assets instead of engaging in further gross debt redemption, tax cuts, or additional government spending.

Additional ad hoc funds were created by both the Howard and Rudd governments for capital expenditure in the areas of health, education and other infrastructure, which are also managed by the Future Fund but governed by separate legislation.

The Rudd government initially undertook to place any budget surpluses in the Future Fund, but the financial crisis and fiscal stimulus of 2008-09 saw a return to chronic budget deficits and a positive net debt position. No contributions have been made to the Future Fund out of the budget since August 2007.

The Future Fund remains available as a vehicle to warehouse future budget surpluses, although it is unlikely that future governments will again enjoy the series of positive revenue surprises and persistent budget surpluses of the period between 2003 to 2008.

Making greater use of a sovereign wealth fund has gained support from some politicians and commentators because it sounds fiscally responsible and prudent.

However, the returns on the Future Fund are poor compensation for the alternative uses of these funds, including expenditure on productivity-enhancing infrastructure and the elimination of inefficient taxes that raise little revenue but impose significant costs on the Australian economy.

While the Future Fund seeks to invest in such projects, it is not a source of new saving in the financial system. It disintermediates the private sector from saving and investment decisions and risks politicising the process of capital allocation in the economy.

The fungibility of assets in the Future Fund with other sources of revenue and government borrowing means there are no guarantees as to how these funds will be used in future, even under existing legislation.

The Future Fund eases the federal government’s future revenue and borrowing constraint, weakening incentives for responsible long-run fiscal management. The best solution to this dynamic inconsistency problem is to bind future governments in relation to the stock of physical and other assets and to maximise the long-run growth rate of the Australian economy.

A sovereign wealth fund is of little value in promoting macroeconomic, fiscal and exchange rate stabilisation objectives. The Australian economy is well diversified and not dependent on a single, exhaustible resource for its current or future prosperity.

Greater flexibility on the supply side of the Australian economy, including greater openness to foreign labour and capital, is the best policy approach to addressing the economic consequences of the terms of trade boom.

The government also needs to reduce its call on resources and private saving through reductions in government expenditure.

Many of the desirable objectives of a sovereign wealth fund could be achieved through greater use of enforceable fiscal policy rules that would enable politicians to make long-term commitments to responsible fiscal policy outcomes and tie down expectations in relation to the future path of net debt. This is a fundamental feature of many overseas sovereign wealth funds. For example, the Alaska Permanent Fund operates under constitutionally defined rules than can only be changed by a popular majority vote.

Since 2006, Chile’s sovereign wealth funds have been governed by a new Fiscal Responsibility Law. By contrast, the legislation governing Australia’s Future Fund is completely ad hoc, operating outside any well-defined fiscal policy framework.

Only enforceable fiscal policy rules can solve the fungibility problem inherent in a sovereign wealth fund by creating binding revenue and borrowing constraints to guide future government expenditure decisions. Politicians who are unwilling to support such binding fiscal responsibility legislation cannot be trusted with a sovereign wealth fund.

Stephen Kirchner is a Reserach Fellow at The Centre for Independent Studies. He co-authored Future Funds or Future Eaters with Senior Fellow Robert Carling.