Joe McConnell
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Accounting matters, not least because it changes behavior. In a year of elections and political change, it is worth taking stock because conventional accounting is sending some exceptionally misleading signals to policy.
Consider, first, central bank finances. Central banks are suffering losses on assets purchased through so-called quantitative easing aVsceker the 2007-09 financial crisis and during the pandemic. On a mark-to-market basis, many have negative equity and are therefore technically insolvent.
It sounds scary. Yet central bank balance sheets are curious because they exclude the most valuable asset of central banks: seigniorage, or the profit derived from money creation. Only if the contraction of equity is greater than the net present value of future income from seigniorage is a central bank insolvent.
This seems unlikely in advanced countries today. Note that we are talking about public institutions with a monopoly right to create money, government support, and protection from bankruptcy proceedings. In some cases, most obviously the Bank of England, there is full government compensation against losses on QE purchases.
Economists at the Bank for International Settlements have found little evidence of a systematic relationship between central bank capital buffers and subsequent inflation. Indeed, central banks in Mexico, Chile, Israel, and the Czech Republic have operated for long periods with negative capital without policy going awry.
The only caveat is perception. Milton Friedman and Anna Schwartz, in their renowned monetary history of the United States, have shown that the Federal Reserve’s preoccupation with its own net worth helped prevent a more aggressive response to the Depression of the 1930s.
The equivalent today would be to allow short-term central bank losses to influence judgments about the sustainability of long-term government debt, forgetting that those losses were incurred to raise income for the entire economy, thus broadening the tax base, something the new British Labour government should think about. That said, if fiscal support for a central bank is lacking, market participants may fear that it will issue additional reserves to finance its liabilities, thereby eroding confidence in money and putting price stability at risk. And if governments exploit the perceived need to recapitalize central banks and seek to influence policy, the independence of central bankers could be threatened.
However, the fact remains that central bank accounting capital will generally be a poor guide to assessing the effectiveness and solvency of policies.
Now we turn to pensions, which offer an extreme example of how a change in accounting can damage the structure of an entire industry to the detriment of the economy. In the 1990s, accounting standards bodies in the UK decided that pension fund surpluses and deficits should be recorded on company balance sheets. Chief financial officers responded by closing defined benefit pension schemes to new entrants, while trustees sought to de-risk their funds by turning to liability-based investments. These LDI funds invested in assets, mainly government bonds, that produced scheduled cash flows to match pension outflows.
This risk aversion was compounded by the fact that a major asset, the sponsor company’s guarantee to cover pension scheme deficits, was not recorded in pension fund accounts. This in turn influenced regulators who sought to prevent employer failure at all costs and to protect the country’s Pension Protection Fund reserve fund from employer insolvencies. They pressured trustees to adopt LDI when government bonds offered low yields.
Companies were then forced to pour money into pension funds that could otherwise have been used, among other things, for investments in the real economy. Their pension fund equity holdings were reduced to almost zero. And since government bond yields were low, the funds borrowed to increase yields. Pension funds thus became a systemic risk, resulting in the 2022 government bond market crisis, when rising interest rates and collateral demands caught over-leveraged funds by surprise.
Perhaps the biggest gap between accounting and the real world concerns externalities such as environmental pollution. Market prices and corporate accounts do not fully reflect the associated social costs.
As we decarbonize, these externalities need to be internalized. The lives of fossil-fuel-intensive assets need to be shortened, increasing depreciation charges and bringing asset write-downs in line with emissions reduction targets, which is difficult when much of the information for sustainability reporting comes from companies’ value chains over which they have limited control. In a fragmented framework of reporting standards, most investors believe that stock market prices inadequately reflect the realities of climate change.
The benign verdict is that sustainability reporting is a work in progress. The broader lesson is that policymakers, regulators and investors need to be acutely aware of the gaps between conventional accounting and economic reality. Likewise, the risk that radical accounting changes could generate unintended consequences.
john.plender@Vscek.com
