What if public net worth is negative, and worse, if it is not known?

Ball and others have noted that the Governments throughout the globe require every worthwhile organisation to publish financial accounts without applying that cardinal rule to Governments themselves. The problem with Governments is that they wholly focus on outlays ignoring three further important requirements which every public expenditure program should satisfy. In a flow of Government expenditure, outlays should produce outputs, outputs should lead to outcomes, and outcomes should bring in the needed impacts in society 

Parliaments and democratic traditions

Those in the two key branches of Sri Lanka’s polity, the executive, and the legislature, seem to be relishing the fact that the Parliament has the supreme power over the country’s public finances. Hence, it is claimed that the third branch of the polity, the judiciary, has no business with anything approved or unapproved by Parliament relating to the public finances of the country. According to them, this is the highest level of adherence to democratic traditions.

Concerns of the Auditor General

However, behind these optimistic viewpoints, there are contentious issues relating to the public finances, which should be properly termed as government finances. There are two contentious issues relating to the public debt of Sri Lanka, an important ingredient in the government finances, according to the country’s Auditor General (visit: http://www.auditorgeneral.gov.lk/web/images/special_report/Public-Debt-Management-finalEnglish.pdf). One is the underreporting of the public debt. The other is the gross non-reporting of the asset base covered by the borrowing of the Government. 

For instance, as at end of 2016, the total reported public debt of Rs. 8,794 billion had underreported Rs. 826 billion or 9%. Similarly, the total asset base covered by the total borrowing of the Government as at the same date had amounted to Rs. 1,087 billion. This has worsened by end of 2017. Hence, the supreme Parliament, according to the Auditor General, has not been successful monitoring the growth of public debt properly.

Low literacy of government finance is the issue

This is due to low literacy in government finance among the citizens. Politicians and policymakers who are supposed to be knowledgeable of government finance are not an exception. This is not typical only to Sri Lanka. It also applies to many other countries in the world.

To address this issue, five experts on government finance, Ian Ball, William Buiter, John Crompton, Dag Detter, and Jacob Soll, hereafter Ball and others, have compiled a textbook on the subject under the title Public Net Worth. The subtitle of the book, Accounting, Government, and Democracy, tells the whole story.

The book is soon to be out in print form by Palgrave Macmillan Publishing Company. I got an advance e-copy of the book to facilitate this review.

Government Finance Statistics Manual

To compile the government finance statistics uniformly across the globe, IMF has issued a compilation manual to be adopted by member countries. This manual is in conformity with all other macroeconomic statistics handbooks, namely, System of National Accounts or SNA issued by the UN System, Balance of Payments and International Investment Position Manual, Monetary and Financial Statistics Manual, and Public Sector Debt Statistics Manual, all the three issued by IMF.

The currently applicable Government Finance Statistics Manual has been issued in 2014 (available at: https://www.imf.org/external/pubs/ft/gfs/manual/2014/gfsfinal.pdf). All these are technical manuals helping compilers to do the double entry bookkeeping. Though they are based on principles of economics, the economic rationale of the treatment has not been given. There is a gap in the knowledge and that gap will be filled when the Public Net Worth Textbook compiled by Ian Ball and others will be out in print form for use by policymakers.

Governments not conforming to what they require from others

Ball and others have noted that the Governments throughout the globe require every worthwhile organisation to publish financial accounts without applying that cardinal rule to Governments themselves. The problem with Governments is that they wholly focus on outlays ignoring three further important requirements which every public expenditure program should satisfy. In a flow of Government expenditure, outlays should produce outputs, outputs should lead to outcomes, and outcomes should bring in the needed impacts in society.

Ball and others have summarised it as follows: “Today, most governments focus solely on how much they have borrowed and how their revenues compare with their expenditure. They ignore whether money is going on investment or consumption, what assets or (non-debt) liabilities they have and how to manage them.”

But according to them, keeping proper accounts will not solve the problem. It will reveal hidden assets which are otherwise out of the public radar system. To identify how far a Government’s expenditure program financed out of taxes and borrowing, it is essential to measure the public net worth, just like measuring the net worth of a corporate body.

Citizens should be concerned not only about the transactions of the central Government which are normally reported by ministries of finance. They should be concerned about the wide-public sector that encompasses, in addition to the central Government, State owned businesses, State banks, the Central Bank, and transactions done by the private sector on guaranteed issued by the Government. This is known as the wider public sector accounting. Without this wider public sector accounting system, it is not possible to correctly assess the public net worth. Ball and others have recommended the construction of an aggregate public sector balance sheet to make a correct assessment of the state of finance of the public sector

In the case of a corporate body, if the net worth is continuously in the negative range, it is not a ‘going concern’ or not capable of continuing as a business. The same rule should be applicable to a Government which has a negative net worth. To find it, citizens in their own interest should insist that proper accounting should be done by Governments.

This is the issue which the Auditor General of Sri Lanka has brought out when he had reported that the cumulative borrowing of Rs. 9 trillion has created identifiable assets of only Rs. 1 trillion. The rest may be there, but the present accounting system adopted by Sri Lanka Government does not reveal them. Such revelations are alarming, and they are good feed for sensational stories. But Ball and others have noted that by continuing to ignore them, a society is not fair to its posterity which should bear the whole loss. Sri Lanka is going through this situation when its Government has become bankrupt, and all citizens have been called upon to bear the burden.

A comprehensive textbook

The book is divided into four parts containing 20 chapters and a glossary of terms and a full list of references. It, therefore, helps users to understand the complicated matters easily and if they are interested, to do further studies. Though matters are technical, it is written in laymen’s language. For instance, it is full of terms like ‘warfare to welfare’ to describe the evolution of the Government activities over the last 300 years, and ‘owning and owing’ to denote assets and liabilities.

For democracy to prevail, proper accounting is a must

As the subtitle of the book says, it is on how accounting can help Governments to establish and maintain democracy. The popular belief is that if citizens can vote the rulers to power and oust them at free and fair elections, they enjoy the rights of democracy. That is not sufficient if Government accounts are not properly maintained. Ball and others have, throughout the book, brought this view home: “Better government accounting, and better use of that accounting, can make a key contribution to putting democratic states back on the path to fiscal sustainability, by ensuring that the dangers are identified; by providing policy tools that can ensure that government finances stay within safe limits; and by making intergenerational choices about the allocation of benefits and costs more explicit.”

Democracy is not just satisfying the present citizenry. It should also satisfy the future generations as well. If Governments maintain accounts properly and ensure a non-negative net worth in its balance sheet, this requirement can be met. A critical issue here is meeting government finance through money printing. If it is not managed properly, it creates inflation leading to the creation of another risk, namely, credit risk, a situation where markets will not be ready to lend to Governments anymore. Ball and others say that “The problem is that when inflation is the result of printing money because the markets won’t lend it anymore, then there is no such self-correcting mechanism. Inflation is ever-accelerating. When money is seen to be without value, and Government guarantees of no worth, then the impacts on economic activity, and on personal and public wealth, are catastrophic.” Today’s Sri Lanka is the best example for this type of catastrophe.

Central bank accounts should also be analysed

Does this mean that the Government accounts and the central bank accounts should be unified at least for analysis? Central banks create reserve money on behalf of the Governments and that reserve money helps them to make an unusual monopoly profit, known as ‘seigniorage’. This seigniorage is eventually shared with the Government. Hence, from the Government’s point, a bigger seigniorage is a better outcome. But from the point of citizens, it is the opposite.

Ball and others have noted this: “A sudden large increase in seigniorage can provide material additional command over real resources for the State, but only for as long as actual and expected inflation don’t rise significantly and cause the real inflation tax base to shrink. Once actual and expected inflation adjust, the maximum sustainable seigniorage revenue as a share of GDP could be no more than 0.5% for the US – at an inflation rate of 11.9%. Even if we assume a significantly lower responsiveness of real currency demand to its opportunity cost (the short nominal interest rate), the maximum sustainable seigniorage as a share of GDP only rises to 1.2% - and the associated actual and expected constant inflation rate is 32.5%. Simply “printing money” therefore runs rather quickly into the quite tight limits imposed on real seigniorage revenue by the demand for real central bank money balances. Attempts to “outprint” the demand for real central bank money balances will likely result in accelerating inflation and ultimately hyperinflation.”

Therefore, if central banks become a yielding hand to the profligate expenditure programs of Governments, they are also responsible partners of creating a negative net worth. Hence, any analysis of the net worth of the Government, the accounts of the central bank cannot be ignored.

Go for accrual-based accounting

But we do not see the net worth directly. Why? That is because of a peculiar accounting method used by Governments. All other entities in a society record their transactions on an accrual basis. Accordingly, it is not only the earned incomes and incurred expenditures that are recorded. Even the unearned incomes and deferred expenditures pertaining to the period in question are recorded while money received in advance or expenditure incurred pertaining to the future periods are excluded and carried as liabilities and assets in the balance sheets.

Hence, an important requirement for constructing a proper balance sheet adopting accrual-based accounting. Even Governments want their taxpayers to do this when they calculate the taxable income. However, they practice cash-based accounting, and the Sri Lanka Government is not an exception. In cash-based accounting, cash in and cash out are recorded irrespective of the period for which such transactions are conducted. It cannot generate a proper balance sheet. This is why there is no proper balance sheet to be seen.

In the case of Sri Lanka, the Ministry of Finance publishes the Government balance sheet in its annual report. But that balance sheet contains only the financial assets and financial liabilities. Even regarding those assets and liabilities, the Auditor General has questioned their veracity.

Importance of accrual-based accounting

Regarding the importance of accrual-based accounting, Ball and others have reported as follows: “From a decision-making perspective, perhaps the most significant problem associated with cash accounting is that it does not reflect the different economic impacts of investment as opposed to consumption spending. In our personal lives, we understand that money spent on the cruise mentioned earlier (consumption spending) is very different to that spent on purchasing a house (an investment). In the case of the cruise, when it is over, we may be relaxed but our resources are diminished. With the house purchase, you still have a resource, albeit has changed from cash to a property asset. Accrual accounting records the value of the asset acquired, cash accounting does not. The substance of the two transactions is that the holiday results in a lower net worth, the asset purchase does not. Accrual accounting reports this substance, where cash information alone does not.”

Aggregated public sector accounting is the necessity

Citizens should be concerned not only about the transactions of the central Government which are normally reported by ministries of finance. They should be concerned about the wide-public sector that encompasses, in addition to the central Government, State owned businesses, State banks, the Central Bank, and transactions done by the private sector on guarantees issued by the Government. This is known as the wider public sector accounting.

Without this wider public sector accounting system, it is not possible to correctly assess the public net worth. Ball and others have recommended the construction of an aggregate public sector balance sheet to make a correct assessment of the state of finance of the public sector. What is referred to as the public net worth is the net worth arising from this wider public sector. Governments should be persuaded to accept this notion and produce accounts in an aggregate form.

A textbook recommended for all

The public net worth is an essential reading by all those who are concerned about the fairness of the government finance. All we see is half-baked accounts which do not reveal the exact position of the finances of the Government sector. If the net worth is negative, it is a sad state of affairs. Citizens will have to pay for this folly in the short to medium term. This is the message delivered by Ball and others in their exemplary work relating to public net worth.

I recommend this book to all and more specifically to politicians, policymakers, students of government finance, and Treasury officials.   

(The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected].)