Annual, cash-based deficits and cumulative public debt have always been the dominant metrics of governmental financial health. The data is usually readily available, and it is certainly relevant. Governments that continually run wide annual budget deficits and build up large amounts of debt are more vulnerable financially than governments that run narrow deficits and accumulate less public debt.
But cash-based assessments of governmental activity don't always tell the whole story. Modern governments are often complex and sophisticated enterprises. They operate business ventures, acquire and sell real estate, have financial investments of various kinds, make and guarantee loans, and own or control vast reserves of natural resources and marketable commodities. They also make financial commitments that extend well beyond the current year. All of these varied activities and commitments can affect a government's financial prospects and viability in ways that aren’t captured in typical budgetary reports.
Public sector balance sheets (PSBSs) can help fill in the pieces missing from cash-based budgeting. High quality PSBSs, which are rare today, are modeled on the financial reporting requirements that are common for private-sector companies. A PSBS is an accrual-based assessment of a government's total assets and liabilities. When a government’s assets exceed its liabilities, the government is said to have a net worth equal to the excess. When liabilities exceed assets, it may signal that a government does not have the wherewithal to meet all of its financial obligations. With a few exceptions, most of the world’s central governments do not compile or release comprehensive PSBSs covering all of their various activities.
The International Monetary Fund (IMF) wants that to change. Last year, the IMF took up the concept of PSBSs in a report that provided a useful analytical framework for understanding how they ought to be constructed. The report also provided preliminary PSBSs for 31 countries by applying a uniform set of accounting rules to the available data. The results demonstrate the real promise of supplementing existing budgetary reports with PSBSs. In particular, PSBSs can bring to the surface risks and opportunities that might otherwise go undetected. For instance, a PSBS can bring attention to accruing governmental liabilities in a failing, government-owned business venture. It can also highlight assets under governmental control that are producing returns below reasonable benchmarks. The IMF argues persuasively that PSBSs can improve governance by providing a perspective that draws attention to better management of both liabilities and assets.
The IMF highlights some of the key issues that need to be addressed when assembling a credible PSBS. In the first instance, the balance sheet needs to reflect all of a government’s assets and liabilities from its basic activities, with the amounts set, if possible, based on market values. For instance, assets should include the funds set aside to pay for accruing public employee retirement benefits, and liabilities should include the present value of the benefits owed to those retirees under these arrangements. In order to get a comprehensive look at the entire public sector, the retirement obligations of subnational governmental units (such as states in the U.S.) should be included in the calculation. Social insurance retirement programs, however, are excluded from PSBS liabilities based on the argument that the "asset" that will be used to meet these claims is the tax base from which revenue can be collected in the future. Consequently, the financial effects of social insurance programs are addressed separately in what are called intertemporal PSBSs (discussed below).
The IMF stresses the importance of assessing a government's financial and non-financial assets separately, to allow for net worth calculations based on total assets as well as just liquid assets. Some non-financial assets (such as historical heritage sites and large national parks) may be highly valuable but nearly impossible to convert into usable financial reserves. Central bank assets and liabilities, such as those of the Federal Reserve in the U.S., are included in the PSBS, as are sovereign wealth funds.
A government's balance sheet should include all government-owned and controlled business enterprises, which are typically excluded from the budgetary reports covering central government activities. In the U.S. context, that means the assets and liabilities of Fannie Mae and Freddie Mac need to be reflected in the federal government’s balance sheet.
A government's non-financial assets will include government-owned reserves of natural resources, which of course means oil. In most cases, when a non-financial asset is sold, the transaction is recorded as swapping one asset, such as real asset, for a financial asset, i.e. cash. However, in the case of oil, the current convention is to allow the recording of sales as governmental receipts. This treatment creates the appearance of on-going returns from oil reserves when, in fact, all sales of oil will necessarily deplete the country's known reserves. The IMF report notes that this treatment might need revision in the future.
The IMF highlights the importance of adding to the PSBS framework a summary measure of expected future cash flows. As noted, the liabilities of programs like Social Security and Medicare are not included in the base PSBS. However, to provide a complete picture of a government's financial viability and future solvency, it is critical to assess its future revenue and spending. The IMF report suggests an intertemporal PSBS as the solution. In an intertemporal PSBS, the present value difference between expected future governmental spending and revenue, including for large pay-as-you-go systems like Social Security and Medicare, would be added to the net worth calculation of the base PSBS. If, under current laws, a government is expected to run large future deficits, as is the case in the U.S., then the present value of those budget deficits would be reflected in a reduction to the net worth assessment included in the base PSBS.
The IMF's initial effort to construct PSBSs for 31 countries includes some fascinating results. One important takeaway is that governments with ownership rights to large oil and natural gas reserves have a significant financial advantage over other nations. Norway has vast oil reserves and has leveraged those reserves into the world's largest sovereign wealth fund, with invested assets of $1 trillion. In the IMF report, Norway has a net worth of 421 percent of GDP — the highest level among the nations included in the analysis. Excluding all of its non-financial assets (including its oil reserves), the government still has a net worth of 155 percent of GDP.
Russia also has vast oil and natural gas reserves but has been less successful in converting those reserves into liquid financial assets. Russia’s PSBS shows a total net worth of 404 percent of GDP, but its net worth falls to -18 percent of GDP when oil, natural gas, and other non-financial assets are left out of the calculation.
The IMF's PSBS for the U.S is, perhaps not surprisingly, rather gloomy given the mismanagement of governmental finances in recent years. According to the IMF, the U.S. has a total public sector net worth of -17 percent of GDP. Excluding non-financial assets, the U.S. public sector net worth falls to -101 percent of GDP. As noted, this assessment doesn’t even take into account the large federal government deficits expected in coming years from growing payments for Social Security and Medicare benefits. Because of data limitations, the IMF has yet to compile intertemporal PSBSs for all of the countries included in this initial report, including the U.S. An intertemporal PSBS is certain to show the U.S. is facing a massive public sector shortfall that will be difficult and painful to address.
The IMF's PSBS framework helps illuminate the unique circumstances of some countries. It is well known that Japan has run large general government deficits to stimulate its economy and to counter deflationary pressures. Those deficits have pushed general government debt up to an astonishing 236 percent of GDP. However, Japan’s government also owns substantial amounts of both financial and non-financial assets. In the IMF analysis, Japan’s PSBS has a total net worth of just -5.8 percent of GDP despite its large amount of governmental debt. Excluding non-financial assets, Japan’s net worth is -170 percent of GDP. Japan’s future solvency may depend on its ability to generate substantial returns from its non-financial holdings.
While the IMF's report makes a convincing case in favor of PSBSs, it is also clear these assessments shouldn’t replace traditional budgetary analyses, and they also need to be read in context. The quality of the data used to construct PSBSs is still uneven, in part because assigning a value to publicly owned assets sometimes requires making highly uncertain assumptions. Further, the role of the public sector is not the same as that of a private-sector business. The public role is to facilitate the achievement of societal goals. That should mean setting the conditions under which the balance sheets of private firms will strengthen over time, even at the expense of the government’s bottom line. It is certainly better to have a strong PSBS as opposed to a weak one, but that doesn’t mean the public sector should assume control of profit-making assets that would be better left in the private sector. It is very possible for a country with low public sector net worth to be strong economically because of a dynamic and prosperous private sector.
Even with these caveats, more use by governments of PSBSs would be a welcome development. It is important to know if a government is running surpluses or deficits, and to know how much debt a government must service with interest payments each year. But it is also important to know what the government owns, and what it owes in the form of liabilities coming due in future years. PSBSs are useful because they fill in these details, and by so doing hold public officials accountable for the stewardship of the public assets under their control.
James C. Capretta is a RealClearPolicy Contributor and a resident fellow at the American Enterprise Institute.
