How to Make Government Honest Again
Both the Tories and Labour are gaslighting the public over Britain's fiscal challenges because both are committed to flawed fiscal rules. What's needed is honest accounting and a focus on net worth
Rachel Reeves this week accused the government of “gaslighting” voters with claims that the economy has turned the corner. But the real deception is not the Rishi Sunak and Jeremy Hunt’s predictable but harmless attempts to put a positive spin on a slight improvement in the economic data and the likelihood of imminent rate cuts. It is the prime minister and chancellor’s claims that they can revive growth, repair broken public services, spend more on defence, invest in future technologies and reduce public debt without raising taxes. Yet Reeves doesn’t mention this bit of gaslighting because the shadow chancellor is guilty of it too.
The point is not to accuse Sunak and Hunt or or Reeves of dishonesty. It is note that the entire political class has become prisoner of a fiscal regime that pretty much every reputable economist regards as deeply flawed. That’s not just because the fiscal rules that both major political parties are committed can so obviously gamed: by setting a five year moving target to put debt on a downward trajectory, the government never has to reach its goal and can claim to be acting responsibly by sticking whatever fantasy plans it likes into the forecast, as Hunt is doing with fiscal plans described by the Office for Budget Responsibility as “worse than fiction”.
The real problem with the fiscal rules is that they create perverse incentives. That is because they make no distinction between debt incurred to fund investment to boost productivity growth and borrowing for current spending with the inevitable result that governments prioritise on what is politically expedient in the short-term over what is most likely to boost long-term fiscal sustainability. This arises because the fiscal regime in Britain, in common with almost all other advanced economies, is based on cash accounting. The only two metrics that matter is the stock of public debt and the budget deficit, which is the difference between income and expenditure.
Ponzi Economics
Cash in versus cash out: this is of course how Ponzi schemes work - until the cash dries up and unfortunate investors discover that the venture doesn’t have any assets. That is why, in the corporate world, investors insist on a full set of financial statements, including crucially a balance sheet. It may not be enough to prevent all fraud, but without a full assessment of a company’s assets and liabilities, how on earth can one assess its solvency or whether it is being managed prudently?
The same should be true of nation states, yet governments are under no obligation to produce a balance sheet and very few do. The rationale is that all that matters for debt sustainability is a government’s capacity to collect taxes. The International Monetary Fund has long urged its members to produce complete financial statements, but only 23 produce consolidated balance sheets and much of that information is incomplete and published too late to be useful. Even so, the most recent statements, based on 2021 data, do not paint a pretty picture: all but two G7 members had total liabilities greater than their total assets. Italy was worst with a negative net worth of 168 per cent, followed by Britain on minus 96 per cent, according to the authors of Public Net Worth, a compelling new book on the case for proper financial accounting.
For decades, western government’s have been running down the asset side of their balance sheets, whether by selling off public assets at below market value to fund fiscal giveaways, or by failing to invest in or maintain infrastructure. They have been consuming the nation’s wealth rather than creating wealth to pass on to the next generation. Not only is that unfair, it is also reckless at a time when governments are under pressure to spend more in response to demographic changes, geopolitical tensions and climate change. The markets have already sounded the alarm about long-term debt sustainability, not least during the eurozone debt crisis and the Liz Truss debacle in Britain. Meanwhile the IMF last month warned about the risks of current high debt levels in advanced economies to global financial stability.
There’s no serious solution to the challenges facing western societies that does not involve far greater focus on the asset side of the balance sheet - or at least no politically sustainable solution. Governments typically own real estate alone worth at least 100 per cent of GDP, note the authors of Public Net Worth. That is before one includes real estate owned by the wider public sector including local councils, and other public sector assets such as infrastructure, utilities, public services such as transport and intangible assets such as data, which can be several multiples of GDP more. Yet because governments are not required to maintain a balance sheet, most have no complete record of what they own and what it is worth, and thus no incentive to increase its value. After all, what is not measured cannot be improved.
Kiwi Rules
But there is one country that has taken a different approach. Faced with an economic crisis in the late 1980s, New Zealand adopted two radical reforms. The first, which has since been widely copied, was to make its central bank operationally independent and give it control over monetary policy. The second was to adopt accrual accounting for the whole of its public sector and put the balance sheet and net worth at heart of its fiscal framework. For three decades, New Zealand governments have been obliged to produce a three and ten-year forecast balance sheet alongside its annual budget setting out the likely trajectory for net worth as well as a 40 year Statement of the Long-Term Fiscal Position every four years and within 30 days of a general election.
The result has been astonishing. Perhaps uniquely among advanced economies, New Zealand has delivered primary budget surpluses and increased net worth every year, except for the four years in the aftermath of the global financial crisis and a devastating earthquake in 2011. It has been able to do this because the financial rigour derived from robust accounting has led to an intense focus on the management of public assets to maximise their economic value and any income associated with them. What’s more, net worth is now firmly embedded in political culture. The transparency provided by timely, robust accounts is now a focus for public debate.
No wonder the IMF has been urging other governments towards adopting this approach for 20 years. The upside for public finances and long-term debt sustainability could be huge. The IMF estimates that the loss to the global economy caused by the inefficient use of government-owned assets is about 1.5% of the total value of those assets per year. Using the IMF’s estimate that such assets total 200% of global GDP implies an annual efficiency loss of 3% of global GDP, or around $3.4 trillion per annum, say the authors of Public Net Worth. That could pay for a lot of extra defence, or new infrastructure or investment in green technologies. What’s more, it could allow governments to borrow more, if debt was being raised against commercially-managed public assets or to finance productive investment.
Yet governments continue to resist. That’s partly because switching the entire public sector to accrual accounting will be a large and expensive exercise. Its also because there is no pressure to switch to accrual accounting from rating agencies and the financial markets, who continue to assess debt sustainability on the basis of cash accounting - though in fairness, they currently have no choice. But it’s also because switching to a focus on public net worth would force governments to confront trade-offs between spending and investment that they would far rather avoid. It would force politicians to be be honest about the long-term consequences of their policies.
In fairness to Reeves, she is one of the few politicians to have shown an interest in such an approach. She has previously flirted with the idea of introducing a public net worth component to the fiscal rules. As I previously noted, one of the most encouraging aspects of her recent Mais Lecture was a commitment “to report on wider measures of public sector assets and liabilities at fiscal events, showing how the health of the public balance sheet is bolstered by good investment decisions”. But she should go further. Just as Gordon Brown stunned the markets by announcing on his first day as chancellor that he would copy New Zealand’s switch to an independent central bank, Reeves should announce that she will copy New Zealand’s adoption of accrual accounting and incorporating public net worth into the fiscal rules.
Domesday Book
For my part, I am convinced that public net worth is an idea whose time has come. Indeed, it is hard to see how else western governments can meet their fiscal challenges other than to improve the efficiency of the public sector, which typically accounts for up to half of a country’s GDP. A transformation in the way states manage their assets is required. That should start with a comprehensive asset map of what the state owns, a Domesday Book for the 21st century, and the creation of public wealth funds to manage them professionally. For Britain, the benefits for parts of the economy neglected under the current flawed fiscal regime could be enormous. That includes local councils, schools, hospitals, infrastructure providers and public service providers. It will also mobilise the real estate and financial sectors whose skills will be needed to deliver improved management of public wealth.
That is why I am delighted to be partnering with Colligo Labs, an innovative new consultancy focused on improving public service delivery, and the authors of Public Net Worth in a series of events, starting with a webinar today to discuss how to convince the British government to take these ideas forward. Subscribers to Wealth of Nations can expect to hear more from me on this over the coming months and on how a commitment to rigorous financial statements and a proper focus on balance sheets could help other countries too. I would urge you to share this post with anyone who may have an interest in driving this agenda and encourage them to sign up. No more gaslighting. Time to Make Governments Honest Again!
A very interesting read and a massive opportunity for Reeves to make her mark early on in her new role as Gordon Brown did in 1997 with a decosove and positive step.
I only hope she doesn't then follow his example and sell a key financial asset on the nations balance sheet, its gold reserves, at a knock down price. But I digress.
Just bought the book. Please keep it coming. 👍🏼