Christopher Papagianis

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.