http://www.prudentbear.com/articles/show/2004
Martin Hutchinson is the author of "Great Conservatives" (Academica Press, 2005) -- details can be found on the Web site www.greatconservatives.com
Japan and China, the world’s largest holders of foreign exchange reserves with $2 trillion between them are considering investing those reserves in the stock market. Russia has announced it will invest its $108 billion oil stabilization fund in foreign stocks. If you try to remember the last time major government money pools were punted in the stock market (other than for a bailout) you won’t be able to – it was in 1720. That episode didn’t end happily, but it is I suppose encouraging to see that government can avoid such an egregious mistake for as long as 287 years!
Modest propping up of depressed domestic stock markets by government is fairly common. Dubai did it last year, Hong Kong did it notoriously in 1998, Malaysia does it regularly and Japan has done it on numerous occasions in the past. Even the BP rescue of Burmah Oil in 1975 in Britain can be thought of as a similar activity. Here the motivation is clear and the activity generally limited.
Purist economists bleat about this being a grotesque interference in the free market but since the free market is prone to bouts of irrational depression, it may well produce useful liquidity if government props it up at the bottom. It certainly appeared to work in Hong Kong, not a hotbed of government interference.
Indeed, there’s an argument to be made that if Herbert Hoover had done this in 1931-32, instead of raising taxes and making loans to politically connected companies, he might have caused an economic “bounce” a year earlier than it occurred, filled in the trough of the Great Depression’s darkest period and prevented thousands of bank failures.
Then there are the “heritage funds” invested by governments that are exploiting natural resources and wish to provide some of their benefits to future generations. Alaska has one of these, so does Norway; they appear to fulfill their purpose without excessive market distortions, although both Alaska and Norway are small jurisdictions.
The most spectacular example of a heritage fund was Nauru, a Pacific island statelet that nearly mined itself out of existence in phosphates, setting up a trust fund that peaked at $800 million in 1991 and for a time gave the Nauruans the highest living standards in the world. Regrettably, the Nauru Phosphate Royalties Trust was mismanaged and embezzled, the phosphates ran out in 2000 and Nauru now exists on handouts from the Australian government, in return for which it operates a penal colony for illegal immigrants.
Given Russian standards of governance, one would expect the Russian oil stabilization fund to follow approximately the unhappy Nauru trajectory. However, Russia is hugely bigger than Nauru (even a Russian government can’t physically wipe the place off the map, as nearly happened to Nauru) and its $108 billion, plus its foreign exchange reserves of $356 billion make it nearly comparable in size to the Chinese foreign exchange reserves piggybank of $1.2 trillion, though not to the combined Japanese piggybanks of the reserves ($909 billion), the Postal Savings Bank ($1.6 trillion) and the Government Pension Investment Fund ($1.3 trillion).
Even if you ignore smaller copycats like South Korea, with $240 billion of reserves, that’s $5.4 trillion, more than any Gross Domestic product other then the U.S., that over time is likely to be moved into the world’s stock markets (assuming the governments don’t operate with Nauruan levels of self-preservation and give it all to hedge funds to manage.) That’s a lot of dosh. What effect do we think it will have on world stock markets?
It will make them go through the roof! Doh!
For some idea of what this may do to the world economy we need to travel back past the Derivatives Era, past the Industrial Revolution, past Adam Smith, past the Enlightenment, to Paris and London in 1718-1720, when the world was young and stock markets had just been invented.
Once stock markets had got going, the well-connected and unscrupulous realized that they could be used to make a great deal of money, provided money from an outside source was poured into an actively traded stock – the obvious such source being the government. To be fair to those involved, it was not initially clear that such a practice would inevitably end in financial disaster – the only real prior example was eighty years earlier in Dutch tulips, which they probably didn’t know about. To them, it was possible that stock prices would continue trending steadily upwards, avoiding disaster and making everybody rich. Promoters of later bubbles (admittedly not themselves fuelled by government money) in 1825, 1929 and 1999 did not have the same excuse that it had never happened before!
Two schemes were devised within eighteen months of each other, in Paris and London, although British chauvinists can be proud of the fact that the promoter of the Paris scheme, John Law was a Scotsman. Both relied on typical tech-stock stories involving unimaginable wealth, the French Mississippi Company through exploiting Louisiana and the British South Sea Company through exploiting the trade in slaves and gold with Spanish America. In both cases, the source of liquidity that drove the stocks higher was the government, through schemes to swap the shares in the companies concerned for government debt, and assorted manipulations in the government debt market and through an in-house bank to support the shares.
In the French case, the scheme succeeded in its objective; the entire French government debt was exchanged for Mississippi stock. In the British case, the South Sea stock price cracked before the contemplated exchanges could be completed. In both cases, speculators made out like bandits and the stocks concerned rose more than 10-fold, giving market capitalizations for a single stock well in excess of the country’s GDP, before the crash came.
In neither case was the outcome a happy one, even for the promoters, who were mostly jailed on trumped-up charges (charges directly relating to the activities concerned were impossible, since laws hadn’t yet been devised to regulate them.) For the markets, the outcome was even less happy. In Britain, the Bubble Act of 1720 prohibited the establishment of companies without a Royal charter, obtainable only through Parliament. The results were quiescence in the financial markets until 1825 but also, as some commentators have argued, delay by 50 years or more in the arrival of the Industrial Revolution.
In France, the outcome was even more disastrous. French state finances never really recovered, leading to the loss of the country’s North American colonies forty years later and the Revolution 30 years later still. In addition, France acquired a deep suspicion of commercial and financial activities that it has retained to this day.
Today, the numbers are bigger and the available instruments more complex, but the principle is the same and the outcome will be the same. It makes no sense to accumulate large pools of public money and drop them into the stock market. By doing so, policymakers cause a temporary upsurge in the stock market, but reduce the long term return on investments and depress the national savings rate. As we have seen in the United States since 1995, investors will react to higher stock prices by spending their new found wealth, possibly incurring new debt in order to do so.
Devoting government-controlled capital to other people’s stock markets is even more perverse, because it produces cheaper capital for foreign companies while raising interest rates on domestic government bonds. And it’s not as if bureaucrats are likely to make good investment managers, or good choosers of third party investment managers.
However the principal reason why government should not devote pools of money to stock market investment is its potential destabilizing effect on the market itself. At the bottom of a market trough, the government can provide liquidity and prop up confidence, thus providing a market benefit – it doesn’t hurt, either that the government buying in a trough is acquiring stocks at an exceptionally good price. At the top of a bull market when liquidity has been excessive for several years, as at present, the government is simply supplying further air to the bubble.
Since, contrary to John Law’s optimistic expectations in 1720, the bubble cannot go on inflating forever, the government is pouring its foreign exchange reserves, pension money, oil trust fund money or postal savings into investments that are almost certain to drop sharply in price in the fairly near future. By doing so, the government enriches speculators in the short term and impoverishes its people in the longer term.
The bottom year of the Great Depression imposed huge costs on the American people, by making the trough deeper than it need have been, as well as weakening the public’s faith in the free market system. In the same way, a bubble that is blown bigger than it would be in the free market destroys more value than it needs to in the collapse, causes more wasted investment in assets that turn out to have no value, enriches more unworthy shysters and impoverishes more innocent unwary folk who are foolish enough to buy at the top.
Governments that choose this point in the market cycle to devote their national resources to the stock market are failing their people and doing immense long term damage to the world economy. It’s as simple as that.
Of course, I doubt if Vladimir Putin cares. But Shinzo Abe presumably does, and his is the largest pool of money-- Putin, when it comes down to it, is relatively a small-time operator.