9  Downside efficiency risks

Economic objective

The economic objective is to minimise the risk of exacerbating existing inefficiencies or creating new sources of inefficiency in the private sector.

The motivation is that, although a market failure may exist, the limitations of government may mean that policy action would not improve economic welfare. In essence, contrary to Sections 7 and 8, government provision of new or additional market maker and risk management services may not be justified because of the risk of making matters worse. Nevertheless, if Ricardian Equivalence fails, it would remain the case that the size and structure of the Crown balance sheet would impact on economic welfare. Therefore, a relevant economic objective is to avoid exacerbating any existing inefficiencies or creating any new ones.

Key insights for policy[29]

A number of cases may be identified where Crown financial policy potentially should target the minimum-variance portfolio:

• Bounded rationality. Bounded rationality implies that citizens would not take full account of the probability distribution of future tax rates (and government spending and transfers). In the extreme, bounded rationality may lead to naïve forecasting of the tax rate, i.e. citizens assume the future tax rate will be the same as the current rate until the government announces otherwise. A Crown financial policy aimed at minimising the variance of tax rates would validate such forecasts.

  More generally, even if citizens’ forecasts are somewhat more sophisticated than naïve forecasting, intuition suggests that a minimum-variance policy would help to minimise citizens’ forecast errors, thereby minimising the risk that Crown financial policy exacerbates inefficiencies arising from bounded rationality.

• Costly information. To the extent that information is costly to acquire and interpret, the principles of policy transparency discussed in Section 3 would apply. Transparency would at least allow financial intermediaries (as delegated agents) to acquire and interpret information on behalf of citizens.

  However, citizens would still be faced with making decisions with inadequate information. If these conditions lead citizens to make naïve forecasts, a Crown financial policy aimed at minimising the variance of tax rates would minimise the risk of citizens making decision errors, thereby minimising the risk of inefficiency.

• Capital taxation. Coleman (1997b) shows, in the presence of capital taxation, that a Crown financial policy of investing in risky assets creates an incentive for citizens to exacerbate risk exposures. The incentive arises because good returns on the Crown portfolio lead to reduced tax rate on returns on individual portfolios, while bad returns on the Crown portfolio would lead to higher tax rates on individual portfolios. Citizens’ therefore have an incentive to replicate the Crown portfolio so that their individual returns are correlated inversely with the tax rate. A Crown financial policy aimed at minimising the variance of tax rates would minimise the incentive for citizens to exacerbate risk exposures.

• Liquidity constraints. In Section 8 it was noted that liquidity constraints prevent some citizens from creating desired exposures by borrowing to invest in risky assets. Binding liquidity constraints would also prevent citizens from smoothing consumption in the face of variability in income and wealth. In this case, the Crown’s objective could be to avoid being a cause of variability in citizen’s income and wealth. Consistent with Davis (2001) and Grimes (2001a), Crown financial policy would be aimed at minimising the variance of tax rates as a means to avoid exacerbating inefficiencies arising from liquidity constraints.

Conflicting implications arising from short-selling restrictions

In contrast to the arguments above in favour of targeting the minimum variance portfolio, other considerations suggest the Crown should be cautious in accumulating risky assets for tax smoothing purposes. In the case where citizens face short-selling restrictions, a Crown investment strategy that placed too much weight on some assets relative to that desired by citizens would leave those citizens over-exposed to particular risks. An objective of minimising downside risks would suggest placing upper bounds on the accumulation of assets that are not widely held by citizens, to avoid the risk of creating exposures that citizens would be unable to unwind.

“Large player” issues

If the Crown’s financial asset portfolio became large relative to the New Zealand capital market the risk would arise that the Crown’s investment strategy could substantially alter domestic asset prices. Distorted prices would reduce the allocative efficiency of capital markets. Similarly, the Crown, as a large player, may acquire dominant shareholding positions in listed companies (as noted in Section 6). The Crown could effectively convert a wide range of private sector companies into state-owned entities, with the attendant risk that public choice considerations have an adverse impact on corporate governance. The policy conclusion is that the Crown should be restricted in its holdings of some asset classes (e.g. local shares) and some particular assets.

Market maker services

The discussion on market maker services in Section 7 concluded that issue of nominal government debt and various indexed securities may enhance economic welfare. The objective in this section (of avoiding exacerbating any existing inefficiencies or creating any new ones) suggests a distinction be made between existing debt securities and financial innovations to issue securities with entirely new characteristics, e.g. country-indexed securities. The objective suggests that policy should ensure that existing benchmark securities continue to be maintained so as to avoid the risk of creating new missing markets that would occur if private sector financial innovation did not replace any government security withdrawn from the market place. This would protect against downside risks relative to the status quo.

A similar argument applies in terms of avoiding the risk of increasing liquidity premia. To the extent that a liquid secondary market has already developed on the basis of the current debt structure, reducing key debt instruments below threshold levels carries the risk of increasing liquidity premia. At a minimum, even if private sector instruments would eventually fill the gap, higher liquidity premia would apply during a transition period during which public debt is being run down but the secondary market in private market instruments had yet to become fully liquid.

Summary for downside efficiency risk

Economic objective

Minimise the risk of exacerbating existing inefficiencies or creating new sources of inefficiency in the private sector

CFP objectives

Portfolio policy

1. minimise the risk of materially affecting asset prices;
2. minimise the risk of materially affecting corporate governance;
3. minimise the risk of creating exposures that citizens cannot unwind (e.g. due to short-selling restrictions);
4. minimise the risk of creating new missing markets or causing an increase in liquidity premia; and
5. possibly aim for minimum-variance portfolio (depending on source of market imperfection)

Targets

1. upper bound on portfolio weights on assets consistent with (a) – (c) above;
2. lower bound on portfolio weights on benchmark debt instruments consistent with (d) above; and
3. minimum-variance portfolio (possibly)

Instruments

Portfolio weights