Governments should be run more like businesses (Klein)

Governments hide what they owe and ignore what they own. Current practice “misses large swaths of government activity” and encourages “illusory fiscal practices,” the International Monetary Fund notes in its latest Fiscal Monitor report, which was released this week.

Rather than use accrual accounting and double-entry bookkeeping, most governments focus on cash deficits and gross debt. One consequence is that many governments borrow extensively “off balance sheet.” The most common hidden obligation is the employee pension: promises of future income in exchange for labor provided today. According to the IMF, pensions alone are worth more than the face value of government bonds in Finland, Korea, Norway, Portugal, and the United Kingdom.

Even though those promises are economically equivalent to debt, they are not counted as debt in standard government accounts, if they are counted at all. Unscrupulous politicians can exploit the opaque accounting to hide the cost of their policies. Promising public servants more money when they retire is easier than raising taxes or cutting spending today.

Ironically, the IMF itself seems to have been misled about the dire state of American public pension plans, thanks to the low quality of U.S. government accounting standards. The Fiscal Monitor database shows that U.S. state and local government employee pension plans are a little more than 70% funded. The actual funding ratio is less than 50%.

The difference can be explained by the Governmental Accounting Standards Board’s absurd guidance on how to estimate the size of pension liabilities. Normally, the present value of any defined-benefit pension is the sum of the promised payments discounted by the yield on a government bond with the same duration. Any other discount rate implies the promise could be broken. Yet the GASB suggests discounting promised payments by “the long-term expected rate of return on pension plan investments.”

The result is that the typical U.S. public pension plan estimates its liabilities using a discount rate of 7.4%, compared with a 30-year Treasury yield that has spent most of the past decade at 3% to 4%. According to Stanford University economist Joshua Rauh, using the correct discount rate raises the U.S.’s public employee pension obligations by about 50%.

Liabilities are only one side of the balance sheet. Governments also have assets including sovereign-wealth funds, state-owned enterprises, infrastructure, land, and office space. For the most part, these assets are not properly counted, if they are counted at all.

In the U.S., for example, most public assets are valued at historical cost no matter how long ago they were acquired, supposedly because it is too difficult to do anything more sophisticated. (Perhaps to demonstrate the challenge of proper measurement, the Fiscal Monitor seems to have double counted the U.S. public sector’s natural-resource assets.)

Ignoring net worth discourages investment because the additional assets are not credited against the debt issued to pay for them. The myopic focus on debt also discourages maintenance. While corporations recognize that depreciation is a cost, and budget their capital spending accordingly, most governments do not. The IMF notes that this “reduces the deficit and lowers debt, but also reduces the value of infrastructure assets.” Disinvestment has been a particularly severe problem in Germany, where cumulative public investment after depreciation has been negative since the late 1990s, thanks to its politicians’ obsession with balanced budgets.

Without proper financial information to guide them, governments offer needlessly generous concessions to the private sector to pay for infrastructure and sell valuable assets to reduce gross debt. The IMF notes that “privatizations increase revenue and lower deficits but also reduce the government’s asset holdings” and are therefore negative for net worth. (Oddly, this insight did not prevent the IMF from pushing the Greek government to engage in a massive privatization program a few years ago.)

New Zealand shows how to do things better. After a severe financial and economic crisis in the 1980s, the government embarked on a set of radical reforms, including the adoption of corporate accounting standards for the public sector. Since the early 1990s, the New Zealand Treasury has published a financial statement each month tracking the government’s net worth and how it has evolved. The goal was to make the government accountable in the hope it would improve performance.

Politicians and the public now ignore the cash deficit and instead focus on the government’s operating balance, which properly measures changes in liabilities, depreciation expenses, and the value of investment. The annual financial statement for the 2018 fiscal year, published earlier this week, shows assets worth about 340 billion New Zealand dollars (US$221.3 billion) and liabilities worth about NZ$210 billion.

The point of accounting is to hold institutions accountable. For both the private sector and the public sector, the question is whether managers are creating value. The private sector developed the tools to answer this in the late Middle Ages. The mystery is why democratic governments have resisted adopting these same tools for so long.

Source: Matthew C. Klein,