Economics

Public accounting

Consider the book value

THE ratio of a country’s public debt to its annual income is an undeservedly popular indicator. Presumably, we care about this ratio because we want to determine whether today’s policies burden future generations. But the government’s debt is just a collection of income-generating assets owned and serviced by people in the private sector—often the same people. Thus, for countries that have their own currency, and can therefore always service their nominal debt obligations, the interesting question about the public debt ratio ought to be how government policies affect the distribution of real resources among various segments of the population. For example, one common assumption is that higher debt levels mean higher real interest rates and bigger transfers to bondholders. But even here, the public debt ratio fails to tell us much. America’s government currently pays less to its creditors, in absolute terms, than it did in the mid-1990s even though the budget was balanced back then and the national debt was far smaller. The public debt ratio also has a poor track record of predicting sovereign debt crises among countries that lack their own currency. This suggests that the conventional measure of public indebtedness is not very helpful at telling us what we really want to know: how the government affects our standard of living now and in the future. The stock of public debt is not irrelevant, but it is only one part of what matters.

My modest suggestion is that we start calculating the public sector’s “book value” by taking the difference between its actual assets and liabilities. (Since governments have the power to tax their productive citizens, the asset side of the public sector’s balance sheet should be thought of as a share of the country’s total asset holdings.) This approach would probably be more useful than the simple public debt to national income ratio, even if it comes with its own (significant) complications. One virtue is that it might help explain why the government debt/GDP ratio does such a bad job of predicting undesirable outcomes, even after adjusting for things like debt duration and foreign vs. domestic debt ownership. Countries with more assets than others may be able to bear additional liabilities without danger. The treatment of hidden liabilities can alter the observed debt ratio without changing the real burden to the citizenry. Another benefit of this approach is that the existing budget tests that bedevil the policymaking process could be replaced with a simple principle: maximise shareholder value for the citizenry. In practice, this would mean that the government would try to grow the nation’s assets while hedging its liabilities.

Under this framework, all government spending could be divided into three basic categories: investment to increase the future standard of living, hedging that reduces the nation’s risk exposure, and resource redistribution. Most governments already try to divide their spending into investment and consumption, but ignore the possibility of hedging. America’s Bureau of Economic Analysis produced a handy guide explaining the difference, although I believe their methodology sacrifices accuracy for the sake of precision. For example, this opening passage strikes me as deeply misleading:

Government consumption expenditures consists of spending by government to produce and provide services to the public, such as public school education. Gross investment consists of spending by government for fixed assets that directly benefit the public, such as highway construction, or that assist government agencies in their production activities, such as purchases of military hardware.

An educated public is a huge asset on the national balance sheet,* which suggests that effective education spending should be thought of as an investment in the future standard of living, rather than resource redistribution. James Heckman, the Nobel laureate, has written extensively on the value of what he calls “early interventions” in education and healthcare that create value and save money in the long run. Considering how long people live and the fact they can pass on some of their health and education gains to their descendants, these investments ought to have very long depreciation schedules.** But, as shown in the quote above, most governments only count things like gold and foreign exchange reserves, physical infrastructure, and military hardware. This severely understates a nation’s wealth.

A country’s greatest asset, by far, is its people, who work, innovate, pay taxes, and, generally, reproduce. How well they do these things depends on their legal, cultural, and natural environments, which can be affected, for good and for ill, by the government. Daron Acemoglu and James Robinson persuasively argued that nations thrive when they respect the rule of law and avoid establishing “extractive” relationships. Deirdre McCloskey has shown that northwestern Europe’s embrace of the “bourgeois virtues” can help explain the industrial revolution. Most obviously, the air, water, soil, and indigenous life on this planet provide us with everything we need—as long as we do not abuse them. I have no idea how to properly value these assets (nor does anyone else), but surely they are worth orders of magnitude more than the outstanding debt of any government. Researchers sponsored by the United Nations made some rough estimates for twenty large countries that confirm this basic hunch. We wrote about their efforts and the potential drawbacks with their methodology last summer.

Governments also understate their liabilities. Some of these are imposed on the general citizenry when states make promises to certain segments of the population. From the perspective of the programme beneficiaries, of course, the government’s promises are assets. This means that the important issues with these schemes are the distribution of resources and how that distribution affects incentives, rather than solvency. The best-known examples are pension and healthcare schemes. Most governments’ off-balance-sheet liabilities are less obvious, however. Instead, they are “contingent” in that they only materialise under certain circumstances. Moreover, the size of the exposure is usually a mystery until the contingency actually occurs. Until then, these liabilities remain largely hidden off of the government’s balance sheet.

Contingent liabilities exist because governments provide insurance. States cause trouble for everyone when they write insurance contracts that cannot be supported by their underlying assets. The most obvious example of this phenomenon is when governments decide to peg their nation’s currency to that of another country, or, even worse, abolish their own currency. Governments can usually count on falling interest rates to help offset the pain of recessions because guaranteed nominal cash flows become increasingly appealing to investors as an economy weakens. However, if governments borrow in a currency they are unable to print, the nominal cash flows cannot be guaranteed. As a result, investors are prone to flee, which causes real interest rates to rise and crushes the economy. Despite this large downside, governments sometime choose to borrow in foreign currencies because, when times are good, it depresses their cost of borrowing. But while the lower interest rates observed during good times may flatter the nation’s official public debt ratio, the citizenry’s actual liability becomes far larger. The euro area’s recent experience is only the latest example of this phenomenon. (For a longer treatment of this subject, I highly recommend The Volatility Machine, by Michael Pettis.)

Most of the time, however, the state’s provision of insurance is both affordable and valuable—at least to whoever is “covered.” The problem is that some of these insurance schemes effectively redistribute resources by subsidising certain risky behaviours, as when governments help pay the cost of rebuilding after a recurring natural disaster. Most governments also guarantee certain types of private debt. These guarantees can either be explicit or implicit. Explicit guarantees can include everything from bank deposits to export loans. Most of the time, governments do not need to worry about paying for these guarantees because they often demand upfront fees, collateral, and regulatory oversight. But that does not mean that the state’s exposure does not exist. Governments also make implicit guarantees on many other forms of debt, particularly debt issued by financial firms deemed too “systemic” to fail. Combined, these explicitly and implicitly guaranteed debts are at least as big as the debt formally issued by the world’s Treasuries and Finance Ministries. How much bigger is impossible to say, since we only find out for certain during a crisis.

Some forms of insurance provision, like the “automatic stabilisers” that moderate the downside of the business cycle, are generally beneficial. Tax collections decline because fewer people are working even as the safety net catches people from falling into penury. The problem is that these stabilisers are not consistently symmetrical, in part because the business cycle is rarely symmetrical. A single downturn can have such a large impact on the budget deficit that it can often wipe out any accumulated “insurance premiums” paid by citizens. This does not mean that the government suddenly became “irresponsible” or that the resulting change in the ratio of public debt to national income will soon cause trouble. It just means that the state’s already existing contingent liability was transformed into observable government debt. Since we will probably continue to suffer from infrequent but severe financial crises and frequent but manageable recessions, it would be worth finding policies that could either prevent them or limit their devastation. After all, this asymmetric policy response must produce unintended distributional consequences, even if we do not know exactly what they are.

The last category of contingent liability is the risk of rare, devastating events like wars, terrorist attacks, pandemics, and unusual natural disasters. Strictly speaking, these are not uniquely liabilities of the government but of the citizenry as a whole. In most cases, however, the private sector tells the state to hedge these risks on its behalf by saying that the government is responsible for peace and security within its borders. Policies that successfully reduced the frequency and the magnitude of these rare events would help shrink the size of these off-balance-sheet liabilities—even if those policies caused the observed budget deficit and public debt/GDP ratio to increase.

To take a somewhat controversial example, consider America’s defence and intelligence budget. According to the Centre for Arms Control and Non-Proliferation, the United States spends more on its military than all other NATO countries, China, Russia, India, Japan, and South Korea combined. Many observers conclude that this is a sign America spends too much. They may be right, but it is entirely possible that America’s military preponderance has helped limit the frequency and magnitude of great power conflicts. We can never observe the counterfactual, but the large defence establishment, by reducing the risk of devastating war, could actually be saving the American people much blood and treasure. (Of course, the possibility that the national security state could be beneficial does not mean that all of its manifestations are desirable.) According to this logic, it also helps other countries even more, since they get to “free ride” on the security America provides.

This exercise in national accounting may have been confusing, but hopefully it provided a different, and valuable, perspective on how to think about what governments do, should do, and should stop doing.

*In my imagining of things, the citizenry is an asset on its own balance sheet. This is less weird than it seems. The most valuable income-producing assets a single person owns, by far, are his mind and body, thus making him an asset on his own balance sheet.

**I am arguing that some of what we call consumption could be thought of as investment. Some have said that this logic could apply to individuals as well. By contrast, a colleague got into an argument with other bloggers back in October on the subject of whether some investment spending in China should be reclassified as consumption. Go figure.

I find this discussion a bit odd. All the rich countries have very high % of their GDP as External Debt. Infact some of the countries that rank very high in social equality and other indicators have more than 100% of GDP as external debt. So even if it is indicated as an essential parameter to understand the performance of the economy, the measuring of such a parameter seems to be of only academic interest. The actual policy makers seem to think otherwise! Review this blog that I made and the references are included in it:

Public sector accounting is definitely a worthy topic for discussion. However, a balance sheet approach would lead to even more bamboozling than we have now. Is a newborn child an asset or a liability in the public accounts? Does it increase in value as it becomes educated or decrease in value as its future retirement and medical costs accrue? How are natural resources on public lands valued? What are the values of intellectual property which are in the public domain? Pharmaceutical patents for erectile dysfunction? Rap music? Do Einstein’s theories still have value or are they fully depreciated?
There is no valid way to value these assets and liabilities, which is not to say that they shouldn’t be examined as an academic exercise but their validity, at this time, for analysis and decision making purposes is totally inappropriate. And how much of an individual’s human capital is for public use and private use. The discussion in the essay implies that an individual’s human capital as developed at public expense would be an asset of the public sector. Some people might quibble about that.
To properly construct accounting statements, the preparer must be cognizant of the purpose that these accounts will serve. For public sector investment purposes, it is federal law that a benefit/cost analysis be done. How that justifies most of the Pentagon’s procurement programs illustrates the absurdity of that provision’s implementation, among many other ‘investments’ undertaken by entities which are not constrained by the bankruptcy boundary condition.
The flow of funds approach serves many purposes with some degree of validity, such as liquidity ratios (Greece and Illinois now being insolvent) and the trend line in the national debt which can be used to estimate future liquidity ratios. That is about all that we can expect out of public sector accounts.

Until the government uses GAAP accounting, this is a useless exercise. At the moment, future obligations do not appear on the books anyplace. The CBO has made some attempts at estimating them, but those estimates are not widely distributed. The result is that you have a pile of off balance sheet obligations that makes Enron look like a piker. If you clean up the books, perhaps the "public company" approach might have merit. But I do not think people are quite prepared for the shock of what such a thing would reveal. Bloomberg has published one CBO estimate here: http://www.bloomberg.com/news/2012-08-08/blink-u-s-debt-just-grew-by-11-... The estimate of the present value of future liabilities is $220 Tn and growing by $11 Tn a year. The concept that folks would be forced to reserve against that $11 Tn a year the way an insurance company would is not going to fly well. The emperor is naked and the blizzard approaches.

My modest suggestion is that we start calculating the public sector’s “book value” by taking the difference between its actual assets and liabilities.

In the wake of a crisis brought on by the massive misvaluation of non-productive assets, you want to value assets rather than production. Apparently, you don't want to look at what the return on the assets is, because we don't yet know what the return on an asset is going to be, only what its market value is.

The public debt ratio also has a poor track record of predicting sovereign debt crises among countries that lack their own currency.

Source? If this is a rejection of Reichman and Rogoff, this is pretty casual. It just sounds like "This Time Is Different" to me.

Most obviously, the air, water, soil, and indigenous life on this planet provide us with everything we need—as long as we do not abuse them.

Natural Resources are one of the factors of production. Necessary does not imply sufficient.

As far as I can figure, you seem intent on breaking apart the factors of production, since you seem to break apart capital, then natural resources, then enterprise and labor (citizens), and technology like good governance, and then think that you can assign absolute values to these, as if they weren't related, which is presumably how they contribute to production, rather than just looking at what production is.

In practice, this would mean that the government would try to grow the nation’s assets while hedging its liabilities.

This is a pretty common problem of trying to understand the free market by treating it as if it were a command economy. The government should do what it can do. The government should reduce its liabilities to what the return on the nation's assets can service.

"modest suggestion" meant you were taking us for a ride in Jonathan Swift fashion, right. How much should we value very little citizens, like babies?

My modest suggestion is that we start calculating the public sector’s “book value” by taking the difference between its actual assets and liabilities.

How soon we have forgotten lessons learned during the financial crisis of 2008.

Liabilities on balance sheets remain the same.
Assets on balance sheets can and do fluctuate.

Look what occurred from August 2008 to March 2009 when many people sold assets at the same time. We had too much supply, little demand and so the prices dropped.

Assets are only worth what someone else is willing to pay for them, not what some accounting rule says they are worth.

Do we sell off the Lincoln Memorial, the Washington Memorial, the Grand Canyon, rivers, mountains, etc?

(Since governments have the power to tax their productive citizens, the asset side of the public sector’s balance sheet should be thought of as a share of the country’s total asset holdings.)

But when a gov't raises taxes during a downturn, economist scream that it is austerity. When a gov't cuts taxes to stimulate a demand in the areas where politicians have been "told" to cut, liabilities increase.

Finally, raising taxes may not be an option because a country may have political party in gov't that believes the dreams of a prepubescent boy.

It may have been a joke, but Norquist said in an interview on the Daily Show that he came up with the pledge when he was 12 years old — in seventh grade.

It is past time when government debt be discussed using ordinary concepts of finance with one goal being a rough matching of the maturities of assets to the liabilities that finance it.

As a consequence, the balanced budget fetishists have not been required to explain by government ought to pay cash for an asset, such as a highway or aircraft carrier, that has a lifespan of 20 or more years. A possible result of insistence on balanced budgets is that fewer than optimal assets are purchased due to this entirely artificial constraint.

On the other hand using debt to finance current expenditure -pension and welfare payments for example- for more than a short period of time is fiscal suicide vide Greece.

As things stand this kind of information either isn't available or isn't discussed.

TY!
The definition of Current Assets in particular has driven me crazy for years: the should be listed as a range of values with a % probability next to them. This single figure balance sheet stuff is meaningless.

- a range of possible growth rates in life expectancy (small shifts transform long term dependency ratios, tax revenue & spending obligations on pensions & healthcare). The only ways for government to properly hedge this are (1) to shift the social security age on a year-to-year basis in response to life expectancy gains or (2) to give citizens discretion over when to actuarially annuitize a pension (where the "pot" may be some mix of prior individual contributions, prior government contributions & government promise for limited amount of future contribution on a defined schedule).

- (especially in America) a wide range in possible future rates of healthcare inflation and corresponding government liabilities.

- possibility of deep financial crises, where governments must assume bank liabilities in order to preserve the value & liquidity of the money created by banks (which comprises the vast majority of currency-denominated stakes in the nation's wealth - liquid or otherwise). To properly hedge this, governments should require proper equity buffers; should restrict asset leverage; should require bond buffers where bond yields indicate low default probability (low spread); should require high levels of transparency; should seek to constrain leverage within tight bounds over time (without much increase or decrease).

- possibility for different rates of future GDP growth. Only small shifts in rates of compound GDP growth have enormous implications for the real value of tax revenue streams which governments can raise in future. (May occur because of shifting migration rates, shifting birth rates, productivity developments, terms of trade adjustments or many other potential changes.) This is inherently unpredictable - which suggests that government today should avoid promising where (too much of) future revenues will be spent. So to properly hedge for risk of different plausible growth rates, it is necessary that promised future debt interest, promised future pension obligations & promised future payroll must all be kept at a modest proportion of expected future tax revenue.

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A note on currency: if we believe in central bank independence (on target inflation), it doesn't matter so much whether a country has its own currency. All current deficits (& debt refinancing) must be funded by domestic saving & international borrowing. Where there is not enough demand for a government's debt, central banks cannot manufacture that demand synthetically while still pursuing an inflation target (see Hungary & Iceland today, Greece, Turkey & Italy in the 1980s-90s, Russia, ex-Yugoslav countries, the East Asian crisis, Zimbabwe, half of Africa, etc) - rather, countries are condemned to accelerating sovereign bond yields or accelerating inflation (normally both, with real interest rates rising).

In the end, if a country doesn't have the real revenue stream to finance its real spending promises, it won't keep its real spending promises (and that often means double digit decline in GDP - there are countless such examples in recent history). Having an own-country currency is does not provide an extra asset with which to meet government liabilities - it just provides a politically *unacceptable* way to default on liabilities which should never have been promised.

In Nikolai Gogol's novel Dead Souls, the protagonist travels around rural Russia buying up serfs who have died but still exist officially due to time lag between censuses. If I recall correctly, he plans to use these "assets" as colateral for a bank loan. That's a strategy we can perhaps employ. Lets just create a bunch of fictitious Americans and use them to justify a higher debt level. I mean, who's going to actually go out and count?

WS: Yes, hedging does not reduce risk. The only thing that reduces risk is actual action, of which hedging is not. To reduce the risk of a natural disaster, for example, one must either build to prevent damage, or build in a location where the natural disaster will not likely occur.

The government cannot do much about this-- it can incentivize moving to another location, but I doubt there is political will to block building in disaster-prone areas entirely.