It is a near-universal rule of time management that the urgent but not necessarily terribly important takes precedence over the important but not terribly urgent. Economic policy making is no exception to this rule. I was therefore pleasantly surprised to read in the papers that Peter Orszag, Director of the Congressional Budget Office (CBO) said on September 9 that “It is the CBO view that Fannie Mae and Freddie Mac should be directly incorporated into the federal budget”. The CBO is the (non-partisan) federal agency within the legislative branch of the US government that acts as a congressional budget watchdog and among whose responsibilities is the projection of the budgetary consequences of proposed legislation.
Why does it matter that the revenues, outlays, assets and liabilities of Fannie and Freddie be put into/onto the budget and balance sheet of the US Treasury? It won’t help or hinder the resolution of the current financial crisis. What is does, is strike a blow for accountability for the use of public funds. It enhances the quality of the information available to the Congress and to the public at large about the federal government’s financial exposure (including its contingent exposures) and about future expected or planned sources and uses of funds. Without high-quality information and without transparency, there can be no accountability for the use of tax payers’ money. Peter Orszag therefore struck a blow for good governance, for better government and for checks and balances.
In the private sector, off-balance sheet vehicles are motivated 99.9 percent of the time by regulatory arbitrage and tax efficiency (aka tax avoidance). The remaining 0.1 percent of the time off-balance sheet vehicles serve their economic function of better aligning incentives in complex organisations. In the public sector, off-balance sheet financing and off-budget revenues and expenditures are used by the executive branch to avoid parliamentary scrutiny and wider public accountability. Sometimes the executive and legislative branches conspire to hide assets, liabilities, expenditures and income streams from public scrutiny.
In countries where the public purse merges seamlessly into the privy purse of the head of government/head of state, the off-balance sheet and off-budget arrangements are blatantly corrupt. More often, politicians use these arrangements to pursue political objectives rather than personal gain. Getting around fiscal-financial constraints (whether self-imposed, as with the Golden Rule and the Sustainable Investment Rule in the UK, or externally imposed, as with the 3 percent of GDP ceiling on the general government financial deficit, and the requirement that, over the cycle, the general government budget be close to balance or in surplus associated with the EU’s Stability and Growth Pact) is often the proximate driver of off-balance sheet and off-budget finance.
The vast majority of the projects financed in the UK through the Private Finance Initiative, for instance, only had this arrangement chosen for them (despite the fact that it increases borrowing costs) because, under the old budgetary accounting rules, the debt incurred through PSI projects was off-balance sheet. Another example is the International Finance Facility through which the UK securitises supposed future development aid commitments, permitting it to spend more on aid today without having to cut other categories of spending today, without raising taxes today and, according to the accounting conventions, without incurring debt or reducing assets. No matter how noble the purpose for which the funds are spent (state schools, state hospitals, prisons, vaccinations in developing countries), the financial shenanigans inherent in their off-budget and off-balance sheet financing are a disgrace.
Even with Fannie and Freddie now on the federal budget and balance sheet for most purposes, the conventional balance sheet and budget are bad measures of the financial constraints faced by the government, now and in the future. Conceptually, the correct measure of the government’s fiscal-financial elbow room is the comprehensive balance sheet or intertemporal budget constraint, which (somehow) capitalises at their fair value, all current and future income and outlays of the government, including uncertain/contingent revenues and outlays.
The only government in the world that gets close to providing all the relevant information to have a go at constructing its comprehensive balance sheet is the government of New Zealand. Since 1989, the Public Finance Act 1989 (PFA) requires the New Zealand government to pursue its policy objectives in accordance with the following principles of responsible fiscal management:
- Maintaining debt at a prudent level by ensuring that, on average, over a reasonable period of time, total operating expenses do not exceed total operating revenue.
- Achieving and maintaining net worth at levels which provide a buffer against factors which may adversely impact on net worth in the future.
- Managing prudently the fiscal risks facing the Government, and;
- Pursuing policies which are consistent with a reasonable degree of predictability about the level and stability of taxes for future years.
That’s rather waffly, but the implementation of these principles is anything but. The PFA requires the government to present, in each financial year, two reports outlining Government’s fiscal policy: the Budget Policy Statement (BPS) and the Fiscal Strategy Report (FSR). The BPS has a short run focus setting out policy goals that will guide the Government’s Budget decisions and priorities. The FSR is presented with the Budget and must state the Government’s long term objectives for fiscal policy over a period of at least 10 years and the Government’s short term intentions for fiscal policy over a period of three years. The FSR must also provide projections of fiscal variables to show progress towards meeting the long term objectives (Progress Outlooks).
In addition, the Treasury is required to publish, at least every four years, a Statement of the Long Term Fiscal Position. This has a horizon of at least 40 years and identifies how demographic and other changes may impact the fiscal position.
Added to this are serious attempts to value such contingent liabilities as guarantees, and to calculate the fair value of such contingent political commitments as social security retirement benefits.
A little dose of fair value accounting would help deflate some of the more extreme figures that are being tossed about concerning the additional debt acquired by the US Treasury through its de-facto nationalisation of F&F. The $5.4 trillion figure bandied about consists of about $1.7 trillion of debt and $3.7 billion of exposure through mortgage or MBS guarantees. Exposure means the maximum amount you can lose if everything you guarantee defaults and has zero recovery value. Using exposure as a measure of fair value, as some commentators appear to do, is like reporting the largest possible prize in a lottery for which I have bought a ticket as the fair value of the ticket. S&P estimate that the maximum loss that can reasonably be expected on the guarantee portfolio is around $325 bn. Even $325 is likely to overestimate the fair value of the guarantees. None of this justifies the current practice of keeping non-traded contingent liabilities like mortgage guarantees off the balance sheet completely.
New Zealand demonstrates that there is a way to present the fiscal-financial constraints faced by the state in a manner that, while imperfect, is infinitely better than the shambles that the US, the UK and most of Europe and the rest of the world are willing to live with. Peter Orszag could do worse than following the Kiwis’ example.