Sovereign funds have been very much in the news lately. Purchases of stakes in large financial institutions, such as Citigroup and UBS, have sometimes raised concerns about the influence of these giant funds. Today Gary Becker and Richard Posner take a look at the operations of these funds and reach some surprising conclusions: the funds may be beneficial for the United States but bad for the nations that operate them.
The board members of Citigroup and managers of Blackstone will probably not be surprised by Posner's assertion that the rise of sovereign funds is a benefit to the US. Both received large investments from such funds at critical junctures. Posner's argument is that the investment in US companies gives foreign governments a stake in US prosperity.
"It does not undermine our national security just because the purchaser is a foreign government, but on the contrary enhances our security because the investment is a hostage," Posner writes. "It's as if to guarantee China's good behavior the president of China sent his family to live in the United States."
Becker, for his part, argues that having taxpayers as a source of funding coupled with the lack of transparency sets up poor performance incentives. Taxpayers cannot refuse to invest or send in redemption notifications, and it is often hard to tell what exactly they are getting for their investment. "Lack of transparency is a major obstacle to citizens of countries with secretive sovereign funds in determining whether the money that automatically flows to the funds is being well spent," Becker writes.
What's more, the incentive structure of the funds seems guaranteed to produce an overly conservative strategy.
Compounding the adverse effects of the extreme secrecy is that managers of these funds, being government employees on fixed salaries, have only limited financial incentives to try to achieve higher returns for given risk. Even when those in charge of sovereign funds hire private managers for some of their capital, there is still what economists call a principal-agent problem because government officials choose the managers. As a result, one would expect that the management of these funds would be excessively conservative to avoid investment blunders and bad publicity, or that managers would be tempted toward corruption by companies that want to attract investments from these funds.