What's the new capital up to?
Larry Summers has analyzed macroeconomic policies as a top academic economist, and helped form those policies in positions such as secretary of the treasury. He provides his take on the new forms of capital that are likely to affect markets, economies, and lives in the years ahead.
Q: You’ve said in the past that governments are very different from other economic actors and that their investments should be governed by rules designed with that fact in mind. Could you explain what this means for the sovereign wealth funds that governments use to manage investments?
Most investors in a company care about maximizing the value of the company. And insofar as they take more than a passive role with respect to the investment, one can assume that their objectives will be heavily around maximizing the value of the company. Governments are rather different. Governments have political agendas of many kinds.
One can imagine a variety of motivations that governments could have with respect to a given company other than maximizing its value. They might, for example, want to encourage the company to do business with companies in their country. They might want to avoid any controversy in which they could become embroiled, even if management were problematic. They might want the company to share technology with companies in their country. They might have strong views about the location of operations. They might even want the company not to be as effective and successful as it could be, so as to protect the interests of competitors in their country. We’ve made a decision in the United States that the Social Security trust fund should not invest in equities, even through index funds.
We’ve made that decision in part because equities are risky, but we’ve made that decision very substantially out of a judgment and concern about the politicization of the marketplace and the politicization of corporate decision-making. And so that same question arises in a natural way with respect to the decisions of any government entity, including sovereign wealth funds. And the fact that the investment is cross-border may mitigate some of the political risks, but I’m not sure it eliminates them.
Q: One argument I’ve seen is that sovereign wealth funds are mostly passive investors, so these are only hypothetical concerns.
I think that the overwhelming judgment to date would be that sovereign cross-border investments have been benign and have not had these kinds of adverse effects. But I think we’re looking at a wider range of players than we have been in the past, and we’re looking potentially at a very substantial growth in the scale of these investments. And we’re looking at, in some cases, investments coming from countries whose governments have made rather truculent statements vis-à-vis what’s going on in industrial countries that are the targets for their investments.
All of those things suggest to me that it’s natural to have some reconsideration of these issues. In many cases, this international community discussion will strengthen the hand of the experienced financial professionals in countries that have sovereign wealth funds and make it easier for them to explain why it would be extremely unwise to seek to use the sovereign wealth fund as a political tool.
Q: So you can see it going one of two ways: one with the government trying to exert more political influence or one with greater professionalization of the managers.
Right. I think it needs to be understood that sovereign wealth funds and this activity of sovereign investment have very substantial potential to deliver economic benefits.
First, they have the potential to deliver economic benefits for the countries that are making the investments, who for whatever reason have large pools of wealth which have traditionally been invested in ways where they pay a great deal for liquidity that they don’t really need, given the scale of their holdings. By adopting a different point on the risk-return tradeoff they can do much better. It would usually be thought of as malpractice for a university endowment to be invested entirely in state bonds, and in many ways the financial problem of a sovereign wealth fund for a country that’s going to be producing natural resources for a very long time is analogous to the investment problem of a university endowment.
I also think that in a world where there is a huge demand for liquidity, there’s very substantial scope for sovereign wealth investments to make a contribution to the health of the global financial system by virtue of being more patient and more long-term capital. So it certainly should not be the objective of public policy to prevent sovereign wealth funds from making cross-border investments, very much the contrary.
I think it is appropriate that there be some reassurance, and I also think it’s almost necessary, given the degree of public concern that has arisen in many countries.
Q: Part of the interest and the concern around sovereign wealth funds is related to their size and the fact that they’re growing. Can you give a sense of how big a player they are in global capital flows?
Sovereign wealth funds today, depending upon how one counts reserves, how one counts national pension funds, are several trillion dollars. Sometime within the next seven or eight years they’re likely to exceed $10 trillion comfortably. So this is not a dominant fraction of the world capital market, but this certainly makes them substantial players on the scene and much larger relative to other players than they were even five years ago.
Q: Several of them have been willing to step in recently and fund financial institutions, like Citibank.
They’ve been prepared to make investments that others weren’t, and we’ll see how those investments work out on both sides.
For all the instability that we’ve had, we’ve probably had a more stable financial system over the last year than we would have in the absence of sovereign wealth funds.
Q: We’re saying “sovereign wealth funds,” but are there significant differences in how some of the different funds behave — from China to Kuwait to Norway?
I think you have two primary categories here, perhaps three categories.
You have countries that have natural resources that aren’t going to have natural resources forever, and who quite naturally decide that they want to sell their natural resources and maintain the benefits of that for future generations. And so they accumulate large surpluses and then they have to invest those surpluses, and I think that’s a rational view on their part. That’s the story in most of the Middle East.
A second source of sovereign wealth fund money is countries that have accumulated very substantial levels of reserves as part of exchange-rate management strategies. I think there are more questions to be raised about the ultimate sustainability of those exchange-rate arrangements, about the consequences for the global trading system of exchange rates that are managed rather than set by market forces. That doesn’t remove the question of how those funds should be invested, but because foreign exchange funds that have been accumulated with exchange-rate management typically have, on the other side of some national balance sheet, debt that’s issued to the public of the country, there are some rather different issues that arise.
And then there are funds that are accumulated in the context of pension arrangements of one kind or other, where countries quite reasonably seek the benefits of international diversification.
For some purposes, it may be useful to distinguish between those three cases, although for the issues that are of most concern to me, in any of the cases, you have the governments making the investment, and so you have questions as to what the motive of the investment is.
Q: Are there other sources of capital that run into the problem of multiple motives or where a government could influence decision-making?
There are some difficult cases. Think about an entity like Gazprom, which is fundamentally state-controlled, and think about its activities in, for example, the energy-distribution sector in Europe. It seems to me that the fact Gazprom is state-controlled is a legitimate reason for considering those investments in a different way than one might have in the absence of that state control.
Q: Are you nervous about governments getting too much control over the private sector, in part, just because they might do a bad job?
Sort of. Part of the reason why the market system has triumphed and why privatization has been a pervasive phenomenon in the world is there’s a sense that private owners tend to be more successful than public owners in encouraging companies towards efficiency and encouraging them to be attentive to customers. And so it’s an irony at the moment that after all these years of privatization, we’re seeing a certain kind of cross-border re-nationalization, and I think that’s something we need to watch carefully.
Q: In watching that activity, is there — you might be uniquely qualified to answer this question — is there a difference in how a government regulator should think about those kinds of cross-border movements of capital from how a macroeconomist thinks of it?
I think there’s a macro dimension and there’s a micro dimension. From a macro dimension, as long as these flows are reasonably stable, they are unlikely to upset the balances in the global economy. The concerns are of a more micro nature, having to do with what the involvement of governments with corporate entities will bring. As I said, I think those concerns have some place. But I think government has to tread with very, very great care.
To say there is a potential problem is not to say that government regulatory solutions will have consequences that will be better than leaving the problem unattended. I think that those of us who address these issues have to be extremely careful not to fuel the kind of economic nationalism that leads to excessive resistance to desirable investments that come from abroad.
So it’s really a question of engaging in dialog; having some rules of the road; when the regulation of particularly sensitive industries is involved, making sure that regulators are attentive to the plans and intentions of owners; ensuring that review processes are carried out in careful ways. But I think it would be very costly for any country or for industrial countries generally to establish a posture of resisting capital investment by very large pools of patient capital in a world that’s rather short of pools of patient capital.
Q: Sovereign wealth funds are so much being discussed right now, and that raises the question, why now? Is it because of the volume of the capital that’s being invested? Is it because of the ways in which the investments are being made? Or is there an element of racism or xenophobia? If Norway had invested in Citibank, would it have generated the same kind of discussion? Is there some anxiety that is based more on politics than on economics?
It’s complicated. The Norwegian sovereign wealth fund some time ago divested its holdings from Wal-Mart because it disapproved of Wal-Mart’s labor practices. Without at all trying to evaluate Wal-Mart’s labor practices, it’s an interesting question what role that transaction should have had in Norwegian economic relations.
Commercial diplomacy has always been part of diplomacy. The heads of one country hope to get orders for airplanes or orders for other products for their major companies and take up those issues with senior officials in other countries.
When cross-border investments become pervasive, is the tax treatment of corporations now going to be a subject of diplomacy with the foreign governments that own those companies? Is the question going to arise, “Well, you’re interested in selling us airplanes; we’re concerned about the regulatory treatment of this company that our private equity arm owns”? If there is more of that politicization, is that healthy for the economic system? And I don’t think those issues are confined to any one group of countries. Countries that have been governed in ways that are more aligned with our traditions are likely to have investment operations that feel like another state pension fund. With countries whose traditions have been more different from ours, it’s understandable that more concerns arise. I think we need to be extremely careful to avoid projecting any sense of xenophobia or concern about the source of capital, except insofar as that concern derives from something about the structure of the way in which the fund is governed. That provides legitimate ground for concern.
Q: There seems to be a stronger populist response to some investments than to others, whereas a more rational approach might look at how the fund is structured.
I think that’s fair.
Q: And that can lead to political resistance to cross-border investments. You mentioned the cost of resisting this kind of capital flow. What would be the results of too strong a regulatory reaction?
The capital would flow elsewhere. Our cost of capital would be higher. American companies would be less able to invest. The economy would ultimately be less productive.
Q: Given that you want to tread carefully, are there any principles you have in mind for sensible regulation?
I think it’s a balance that has to be struck, and I think the broad concept is that one wants ownership by government to be as passive as possible, and as uninfluenced by any kind of political consideration as possible. That will often involve the investment through intermediaries, rather than direct investment.
It goes to what kinds of control interests are sought. It goes to the size of investments relative to the company that’s being invested in. I don’t have a hard-and-fast set of rules to urge, and I’m not sure that it would be a good idea to have a hard-and-fast set of rules. But I think we do need to have some greater awareness of the fact that this is new and uncharted territory.
Q: Do you have a gut reaction to what’s too much government meddling?
I don’t think I’m in a position to produce guidelines that could be reduced to slogans.
Q: Fair enough. Do you have concern about other multiple motives in investing, like environmental funds? Is that really different from the kinds of multiple motives a sovereign wealth fund might have?
I think investors should be free to invest as they wish, and if people wish to confine their investment to companies that they regard as environmentally sound, I don’t have any quarrel with their making that choice.
In general, at Harvard, as at most other universities, we tended to be very careful before making decisions to let non-economic aspects influence our investment decisions. It’s hard to believe that it wouldn’t have been moral in the 1930s to try to avoid investing in Krupp as it was making munitions for Hitler. And we at Harvard during my time made a decision to divest a couple of companies that were very active in Sudan and were perhaps complicit in the tragic events in Darfur. I was comfortable with those decisions, but I was much more comfortable with the particulars than I was with the principle. Prudent institutions need to be very careful regarding their investment policies and not seek overly to use the tool of investment to achieve influence, both because institutions may be best off staying out of political struggles that don’t go to their mission, and because what’s efficacious may be very much in doubt — whether it’s better for companies to maintain investments in troubled places than for them to abandon investments in troubled places — and because of what it means for the capacity to invest wisely if one’s not using value maximization as a benchmark.
I think this general notion that the investment process should be separate from the pursuit of other objectives is valid. Early in my time at Harvard, there were what looked to me to be a set of attractive investments to make in Harvard Square real estate, and I sought to discuss them with the head of our management company. He rather firmly informed me that if the university was to make those investments because it had an objective of doing things in Harvard Square, that was fine and they would be very happy to provide advice. But their mission was to maximize the return, adjusting for risk, on the endowment, and that was all they looked at. They thought it would be quite corrosive of their process to factor in university strategic objectives. I think that was a reasonable policy for them to pursue, and I think the principle has some broader applicability.
Q: When you divested from the companies involved in Sudan, were you trying to project Harvard’s values in some way, or more to say this rises to some level that we don’t want to own a piece of it?
What was going on seemed sufficiently immoral and seemed sufficiently wrong that it was just best for our institution not to be part of it, even in a small way. In general, I would be reluctant to be part of divestitures that were part of sending a signal, because I think that would represent a kind of politicization of the investment process.
Q: Do you have concerns about other forms of new capital, such as hedge funds and private equity?
The issues raised by sovereign wealth funds, by private equity, and by hedge funds are rather different. I think the crucial issues raised by hedge funds, which in many cases trade in very liquid instruments and use substantial leverage, go to their possible implications for financial stability and the degree to which they’re regulated. I think the questions with respect to private equity go to their impact on corporate performance and how the private equity governance model compares with the public markets governance model, and the extent to which the changes the private equity firms bring about in corporations reflect efficiency gains and the extent to which they come from more problematic sources such as the tax benefits associated with leverage. None of this is to recommend new regulation with respect to private equity or with respect to hedge funds.
Q: One of the issues we’ve heard about is the perception that private equity investors have a short-term horizon. The sovereign wealth funds seem to have the potential to bring a much longer-term—
It’s complicated to think about the horizon of private equity investors. When a private equity firm buys a company, they typically think of themselves as being in it for a number of years. When an institutional shareholder buys a share of stock, they typically think of themselves as being in it for a number of months.
Private equity investors focus on the exit — the exit as a share price. That share price is going to reflect the go-forward prospects of the company at the moment when the exit takes place. So I’m not sure that it’s right to say that private equity somehow has a shorter horizon than the public markets. And you can even argue that because private equity investors are able to get under the hood of the company more than the public markets, companies are able to maintain more long-run expenditure, because they’ve got somebody they can talk to and explain why it’s really valuable in a way that’s more difficult for a public company disciplined by quarterly earnings. I think it’s a great subject for study.
Q: We have one more question related to sovereign wealth. There seems to be a rush on the part of Western institutions — universities and museums — to establish new campuses in places where there’s a lot of money to invest. Given your experience as a university president, what do you make of this? Is the new capital affecting higher education?
I don’t know that it’s really about new investment capital. Universities respond to financial incentives, and there are substantial financial incentives being offered to universities with highly respected brands to affiliate those brands with parts of the world that don’t have the same traditions of universities.
Universities have difficult sets of strategic choices. On the one hand, their mission is to disseminate knowledge, to create new knowledge, to have that knowledge make the world a better place. And by spreading their wings, they may in very important ways be able to do that.
On the other hand, what’s very special about a place like Yale is the kind of faculty Yale is able to gather and the kind of students Yale is able to gather. And if you simply attach the Yale name to an educational institution in another part of the world, unless you’re very careful, you may be attaching the Yale name to something that doesn’t really have Yale’s tradition of excellence, and ultimately that’s not going to favor the Yale name. So there’s a balance that needs to be struck.
Universities have different approaches to these questions, and I think it’s fair to say that Harvard and Yale, perhaps reflecting the strength of their reputations and perhaps reflecting their good fortune manifest in their endowments, have been less aggressive about taking advantage of some of these opportunities than a number of other universities have been.
Q: Do you see a form of trade where capital is flowing from, say, Abu Dhabi to the United States in return for intellectual capital?
I think what my previous answer suggests is that it may be naïve to think about this as purchasing intellectual capital, rather than purchasing the university’s reputation.
Interview conducted by Elizabeth Stauderman and Jonathan T. F. Weisberg;
edited by Jonathan T. F. Weisberg