As U.S. approaches the fiscal cliff, will it jump?

October 4, 2012

In many ways, we’ve already fallen off the cliff. The focus by government and market analysts on the potential medium-term impact on GDP has obscured some themes that deserve far greater attention.

Entitlement reform is no longer something that can be pushed aside. If the government had used GAAP accounting (generally accepted accounting principles), as do practically all private-sector companies (and even local governments), the deficit in 2011 would have been $3.7 trillion higher. This would have been on top of the $1.3 trillion official deficit that was recorded by the Congressional Budget Office and the president’s Office of Management and Budget.

While John Williams of Shadow Stats has been writing about this theme for years, mainstream outlets like USA Today are starting to cover how the government basically exempts itself from including the costs of promised retirement and healthcare costs in its deficit calculation. Including the growing costs of future Social Security and Medicare liabilities, the deficit in 2011 was $5 trillion.

Despite an accumulated “Trust Fund” of nearly $3 trillion, Social Security is already losing $165 billion in cash annually. This is partly due to the recent payroll tax cut. But the financial capacity of the Trust Fund also peaked in 2008 and is set to decline steadily for the next 30 years. At the same time, Medicare expenses are shown to exceed dedicated payroll tax receipts by $255 billion per year. The current accounting conventions distract us from the obviously perilous situation of spending $400 billion more per year on these programs than the U.S. is taking in – even before considering the much larger annual cash flow imbalances of future liabilities.

For the government to meet its future Social Security promises, it would have to set aside more than $20 trillion and find a place to park these reserves to earn some interest. USA Today notes that this figure is almost double what would have been required as recently as 2004.

What makes the government so special that it can model its accounting rules so differently from private business? Simple: Congress can always change what it owes by raising taxes or cutting benefits. But who really believes that Congress will ever talk straight about its accounting?

The looming fiscal cliff has tax rates climbing back up to their pre-2001 levels (from 25 percent to 28 percent in the lowest bracket). A payroll tax holiday is set to expire, and there are the across-the-board spending cuts that will come from the “sequestration” – the result of last year’s failed shot at budget reform. Add in a handful of other expiring benefits, and the total tab for the “cliff” amounts to more than $600 billion, or about four percent of next year’s GDP. The consensus opinion is that Congress will, yet again, punt on these tough decisions.

Fannie Mae and Freddie Mac have run up a taxpayer tab of $150 billion since the crisis, but their roughly $5 trillion in assets and liabilities are kept “off balance sheet”.

It’s time to link budget reform to government accounting reform so that the true cost of federal credit guarantees and liabilities is recorded honestly and fairly.

For some perspective, we can look to big banks and large financial institutions, a world apart from government, but one where accounting practices present the same sorts of problems. The largest financial institutions have balance sheets that are opaque and largely impenetrable.

Andrew Haldane, the UK’s head of financial stability, has perhaps been the sharpest critic and advocate for change when it comes to the reports and disclosures of large financial institutions. Haldane explains that the financial reports of banks differ over the course of the business cycle, and the current risk management tools often fail to accurately price or account for risk.

This column has argued that too many assets are deemed “safe” by regulators. Yet the principal indicator of how much leverage there is in the U.S. financial system concerns derivatives. GAAP accounting allows U.S. firms to net their derivative exposures. JPMorgan, for example, reports that it has $1.7 trillion in total derivative exposure. But when you net out all the longs and shorts, only $85.5 billion appears on its balance sheet.

Imagine if a bank issued $100 billion in debt to purchase $100 billion in corporate bonds that later declined in value to $96 billion. If this were a short credit derivatives position, the bank would only account for $4 billion in “net” liabilities. The $100 billion would remain off the balance sheet as long as the price of the corporate bonds remains unchanged. This is the sort of example that has many market watchers, including the Wall Street Journal, wondering whether JPMorgan is a bank with $2.3 trillion in assets or one with roughly $4 trillion.

These issues are exacerbated when viewed through a global lens. Europe is applying a different set of rules on netting derivatives, which leads to an apples-to-oranges comparison of banks across the pond. If Deutsche Bank fell under U.S. accounting rules, its leverage ratio would be almost half of the 40 times it shows under European accounting rules. Claims that European banks are “insolvent” relative to their U.S. peers depend, in many cases, on discrepant accounting treatments.

The scale of this issue is also enormous. On a notional basis, the total amount of derivatives today is greater than global GDP – 10 times over. This is why the answers to seemingly obscure questions can have such profound impacts on our understanding of how much leverage exists in our financial system. Do the derivatives that are supposedly matched account for counterparty risk? Are they of the relative-value variety, and if so, how sensitive are they to changes in interest rates or currencies? Amazingly, the current public disclosure regime doesn’t effectively cover these issues.

What’s particularly terrifying is that the solvency of many financial institutions – and the U.S. federal government – can be called into question even when they are evaluated using rules that are almost purposely crafted to overstate their financial positions. In short, it is not possible to measure the ultimate cost of public and private-sector indebtedness when there is no transparent accounting method available; one that measures the cost of spending commitments in excess of income and parses non-trivial questions about derivatives.

If the fiscal cliff gets “solved” at the end of the year by Congress committing to start yet another budget process in the middle of 2013 (i.e., kicking the can even further down the road), one of the binding objectives ought to be accomplishing some overdue accounting and disclosure reforms. The questions of how to accurately measure public and private debt and leverage have never been more important.


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Our government is rather like the reverse of a lunatic asylum. Taxpayers are on the outside looking in but neither they, their economists or their journalists are allowed the necessary information to comprehend the chaos each observes because of “privacy”.

The “tipping point was probably reached years ago. We are trapped with no exit on a roller coaster ride with poorly maintained equipment, all the safeties disabled or non-functioning and no knowledge that the track ahead has ever been traveled before or even completed. What could possibly go wrong?

If all “we, the people” can do is dial 911 on our cell phone, what’s your point, Christopher?

Posted by OneOfTheSheep | Report as abusive

American Spring?

Posted by philbrabe | Report as abusive

We are (in general) all eating, have roofs over our heads and enjoy the basic necessities. What is it that is providing those basics? Is it money or simply the world’s resources? On the face of it global resources seem sufficient to allow for all to live with dignity.

When the financial system in respected then no, things are not working. When dollar or euro or other monetary icons are included then that we going (or have gone) off a fiscal cliff.

Maybe some day the whole world will fall off the fiscal cliff and find that the landing was soft and that people are still eating and living with dignity.

Posted by anthropisces | Report as abusive

No, it will not jump. It will just print more money.

Posted by tmc | Report as abusive

It’s impossible to address our fiscal problems in any meaningful way until we first address the trade deficit. It’s impossible to avoid recession in an economy that is being drained of its assets by a trade deficit without an equal infusion of deficit spending.

The U.S. economy isn’t approaching a “fiscal cliff.” We drove off that cliff in 1947 with the signing of the Global Agreement on Tariffs and Trade, forerunner of today’s World Trade Organization. The only question now is whether congress will call off the team feverishly digging a hole at the bottom of the canyon to delay the inevitable crash.

Pete Murphy
Author, “Five Short Blasts”

Posted by Pete_Murphy | Report as abusive

Printing money only makes the problem worse. The US and the Global Economy is the likeness of a small child not wanting to take its medicine because it tastes so bad! This is coming, no matter how much we kick and scream. It is time to let the cuts expire, and see where we land. We can no longer believe that war creates profit and prosperity for this country. We can no longer believe that Corporate Welfare is a good model for success.

As a nation, yes the necessities are all we really need. Work is now akin to slavery. We work for money, when in relaity we could have enough resources for all. Capitalism is a pissng contest between people who want to acquire as much CRAP as they can. We will be ok without it, as we have been before. But the time is NOW to make that change. Kicking it down the road only further detaches the American public from the reality we face. I am ready to jump… I have a Plan B, and C and D if we collapse. It is time we all prepare for some pain. And this is not Obama’s fault. Blame yourself, Bernays, Big Government, Big Business, and the Central Banking Cartel. We are all liable here. You can’t live in fantasy land forever. Time to get to work and un-do what we have done. And for Logic’s sake, get the HELL out of the Middle East!

Posted by cmoses0971 | Report as abusive