Keywords: Macroeconomics & Money; Statistics;
Balance sheets are integrally involved in the greatest economic crisis in our lifetime. So while my remit is to provide the conference with an economic context to its deliberations, I have to engage with accountancy. What I am going to do then, is describe briefly the state of the world economy and how it got into the current muddle. Then I shall explain how it affects New Zealand, and the New Zealand public sector. Part of the story involves accounting conventions. All the previous great economic crises have involved these issues, but this is the first time that we have had such comprehensive balance sheets that we can systematically include their effects. Keynes’ General Theory, written in response to the Great Depression, only alludes to balance sheets. A modern day Keynes could not avoid making them central to the analysis.
As I began, the world economy is facing the greatest economic crisis for 80 years; perhaps ever, because globalisation has intensified the linkages between economies, industries, and financial systems. Its causes go back a long time – perhaps even to the Bretton Woods settlement in 1944. For our purposes in 2002 the Bush administration increased the US fiscal injection. As a consequence of the US government spending much more than its revenue there was an increase in the dollar denominated assets available to the world’s financial system. Fortunately, at about same time a number of other countries – especially China – ran fiscal surpluses which they chose to invest in these dollar denominated assets, thereby temporally obscuring the rise in the liquidity of the financial system.
However the increased liquidity was not all mopped up by the sovereign funds. A share of the additional assets reached the balance sheets of financial institutions which used them to increase their lending. A lack of prudential supervision and new ways of financial leveraging led to balance sheets which with hindsight proved to be highly vulnerable to a downturn. In particular there were widespread investment in assets at prices which were unsustainable.
The best-known of these unsustainable assets were the sub-prime mortgages to ‘Ninjas’ – people with no income, no jobs and no assets – and with no ability repay their debts. Instead they hoped the house prices would rise, and cover their debt servicing. This required ongoing increases in housing prices.
Prices for assets do not rise for ever (unless product prices do too). When their inflation stopped the underlying weaknesses in the balance sheets of the financial institutions became evident. Borrowers who had relied on the inflation to service their debts found they were exposed.
Because today’s story is a balance sheet one I pass over the poor alignment of incentives where those who made decisions – such as sell mortgages to Ninjas – did not take on the risk on the debt they issued. This was a major contributor to the boom and no doubt will lead to major changes in the regulatory framework, including better measurement of risk in balance sheets.
Whatever the details, the outcome was that a whole range of assets which had been put into balance sheets at one particular price, proved to be less valuable. Writing down the value of over-priced assets is routine, but a group has proved particularly difficult because there is no agreement as to the level to which they should be written down. Typically these are assets where there is considerable uncertainty as to the revenue stream they generate. The valuation of these so called ‘troubled assets’ can differ by a factor of three. ‘Troubled’ is a transferred epithet. It is the holders who are troubled, not the assets; a more common expression is ‘toxic’ assets.
Toxic assets in a balance sheet mean that the value of aggregate assets is uncertain and so, therefore, is the value of the ownership equity. This severely limits the ability of a prudent financial institution to make advances or other investments. If that applies to enough financial institutions then there will be a shortage in the system of the credit which is necessary for trade, business investment, house purchase, consumer durables and so on. Production in the economy contracts too, with resulting reductions in investment and consumer purchasers and layoffs; the economy sinks into recession or even depression.
Toxic assets mean that monetary policy cannot effectively moderate the downswing. Normally lower interest rates induce more investment and spending. But financial institutions, uncertain about the true state of their balance sheets, will be reluctant to make the required credit available even if, as applies now, world interest rates are near zero in the short term. Instead public policy turns to fiscal reflation, that is adding to aggregate demand by increasing government spending relative to revenue.
Let us elaborate the balance sheet story with a homely example. Although toxic debt is at the centre of the current crisis, I shall assume none in this example.
Suppose you are the owner of a house worth $300,000. Your investment rule is to maintain a fifth in equity and borrow four times as much. Your statement of financial position might look like this:
ASSETS (house) $300,000
DEBT (mortgage) $240,000
EQUITY $ 60,000
Suppose that the price of your house was to increase by a half (above the equilibrium level of house prices) – which, incidentally, is my estimate of what happened between 2002 and 2007.
Your balance sheet would now look like
ASSETS (house) $450,000
DEBT (mortgage) $240,000
At this point there are a number of options. You might think that nothing has really changed and do nothing. Or you might borrow to fund – say – a holiday. But we’ll look at the situation where you decide to use the capital gain to purchase an additional house or houses.
As a result of the additional asset purchase(s), after maintaining the gearing ratio of equity to debt of one to four your balance sheet looks like
ASSETS (houses) $1,050,000
DEBT (mortgages) $ 840,000
EQUITY $ 210,000
Now suppose the value of the houses you own returns to its old level – a half up, a third down.
Perhaps I should add – I dont want to panic you – that for various reasons I dont think house prices will quickly fall back to their long-run equilibrium. However, let’s assume they do. In which case your balance sheet will look like
ASSETS (houses) $700,000
DEBT (mortgages) $840,000
EQUITY Negative $140,000
The effect of the house price decline is to wipe out the original equity converting the positive $60,000 into a negative $140,000 , and leave the home owner severely in debt.
(As an exercise lets look at what happens if you use a higher gearing – say double, or one to eight. Your balance sheet sequence would look like
$300,000 $450,000 $1,650,000 $1,100,000
$266,667 $266,667 $1,466,667 $1,466,667
$ 33,333 $ 183,333 $ 183,333 -$ 366,667
Doubling your gearing doubles your equity loss. The higher the gearing the more vulnerable to the downswing.)
More generally, the higher the gearing, the more an investor is vulnerable if prices turn down. In particular, a bank which is typically geared at ten and more to one, will have to contract its advances (i.e. its assets) if there is fall in its asset prices. This is a key mechanism in the credit contraction during a financial crisis.
Few home owners would as highly leveraged in assets with such price collapses. But many financial institutions, particularly hedge funds, were even more highly geared with very volatile assets.
The point of this illustration is that the gearing associated with an apparently rational investment on the upswing based on ever increasing prices can be disastrous on the downswing. Its effect is to exaggerate the boom. The higher house prices generated the capital gain which leverages additional house purchases; this raises higher house prices further, there are higher capital gains and so the market spirals up.
Stein’s law says if it cant go on forever, it wont. What halted the house price boom was the difficulties of servicing the debt. The rents tenants were willing to pay did not rise as quickly – they are connected to their ability to pay and so their actual incomes and the price of products. Landlords found they did not have sufficient revenue to cover their loan commitments. They gave up further purchases of houses, individuals speculating on rising house prices found they were not rising fast enough, at which point house prices steadied or began to fall.
Once the boom was over, the weakness of individual and institutional balance sheets became exposed. Market sentiment turned, financial institutions tried to remedy their balance sheet deficiencies, and the credit contraction began which, ironically, intensified the weaknesses in the balance sheets.
This illustration of the boom bust process used housing. However the same could be told about financial institutions – how rising asset prices give them the leverage to increase their advances. And how, when reality breaks through, they also suffer losses of asset values which compromises their ownership activity. Some went bankrupt; others had to be taken over by other private institutions or the government.
It is at this point the toxic assets become critical. It is not just their value decreases; we dont know by how much, so we do not know to what extent the financial institutions are insolvent or potentially insolvent. As a consequence other financial institutions are reluctant to lend to them. Interbank and other inter-financial lending stalls, at which point the money markets gum up, and credit becomes difficult to obtain. That is the point we have reached today.
Getting proper values for assets becomes vital. The Obama administration has had a number of initiatives, including stress-testing the big banks, that is independently assessing their balance sheets.
In addition the financial institutions have criticised mark-to-market valuations, the approach implicit in my story of the house owner who geared up on capital gains. They argue that markets are so illiquid that the true value of the assets in their balance sheet is understated.
There is an irony here. There was no complaint about mark-to-market valuation from the same institutions when it favoured them during the boom; now they point to its deficiencies when it becomes a drag during the bust. Mark-to-market is pro-cyclical. accelerating the economic upswing but also reinforcing the economic downswing. This is not to blame the entire boom and bust on the accounting standards. Mark-to-market was only a contributor to the boom and the unsustainabilty which generated the bust. Other factors contributed too.
American financial institutions have recently got America’s Financial Accounting Standards Board to agree to a mark-to-model approach; European and International standards may well follow. That means that during a bust assets may be valued in the balance sheet based on some assessment of their medium term worth, above their current market value. We saw mark-to-model misused in the case of Enron – it seems possible that it were also misused during the more recent boom. – so I have reservations. On occasions one mutters GIGO – garbage in, garbage out. One hopes the accounting profession will set out a very clear set of standards, and the auditors will enforce them. Otherwise we face the possibility of the corruption of the system as we saw happen with Enron.
It is not my purpose here to judge whether mark-to-market, market-to-model, mark-to-maturity or some other valuation approach is appropriate. That is something for the accountancy profession to work out, and in any case I have no proposals for an alternative. I do note however, that economics only provides a rigorous justification for mark-to-market under certain conditions, which have obviously not been pertaining during the boom. At best mark-to-market is a heuristic rule, perhaps the best available, but far from perfect. Whatever the accountancy measurement conventions regulators could use a different measure of the value of assets when they are setting their prudential ratios.
Are these issues relevant to New Zealand public sector accounts except in a background sense? As far as we know, New Zealand’s banks do not own substantial quantities of toxic assets. Our problem is different. The trading banks have substantial offshore borrowings – around $90b – which have to be rolled over because they are on-lent to New Zealand house owners and businesses. As a consequence of the gumming up of international markets, the funds can be borrowed only for very short periods. That is not a good way to run a bank. It is like having all one’s domestic deposits on call with the possibility they could all move rapidly offshore.
Additionally, the public sector has moved from being a net lender to a net borrower. In order to reduce the rise in unemployment the New Zealand government is attempting to maintain aggregate demand by spending more and lowering taxation. Even if the New Zealand private sector does not require any additional overseas borrowings, the country as a whole has to increase its overseas debt.
This places a restraint on the size of the government deficit – the excess of spending over revenue. The difference has to be borrowed, and that requires willing lenders. As best can be judged, were the New Zealand public deficit to get any larger, there would be a credit downgrade. The least damaging outcome would be that the offshore debt would be more costly to service with higher effective interest rates – not just the new debt but the over-rolling debt. But as painful as that would be, we cannot rule out that the overseas lending could dry up all together. New Zealand (with Australia) is unusual in the world financial system; we are an affluent debtor with no patron: Iceland was bailed out by the Nordics, the emerging economies in Europe have the European Union, the Latin American countries – our closest comparators – have the US.
The restrictions on the government borrowing mean that the fiscal injection is constrained, so unemployment will rise to levels which a couple of quarters ago would have been judged unacceptable. I’m afraid that cannot be avoided. But there is a second problem.
The current fiscal forecast is that when New Zealand gets through the recession the fiscal position will still require heavy borrowing. The fiscal deficit is not just a temporary measure to deal with the international global crisis; we now have a structural one. The Minister of Finance warned us of this when he talked about the prospect of ‘decades of deficits’. He has rightly said that such a situation is unsustainable.
To what extent reducing the deficit will involve cutting spending or raising taxes will be seen when the 2009 budget is announced on May 28. I hope there will be no tricks with mirrors. The public may be fooled, but potential overseas lenders will not.
It will be obvious to this conference that the quality of the government accounts is crucial. In the 1970s there were plenty of opportunities for smoke and mirrors, while there were not the forward projections displaying the structural problem which short term measures can obscure. Over the last three decades there has been considerable work done improving the transparency of the government accounts. Additionally there will be projections out to 2014.
The projections involve economic forecasts. The interaction between the public accounts and economic analysis is not ideal. The biggest problem has been that the headline statistic, OBEGAL – the operating balance before gains and losses – is not a good indicator of the overall impact of the fiscal stance on the economy. It has led to calls for tax cuts which were not economically sustainable. It has been a terrible example of Gillings Law – the way the game is scored affects the way it is played. Popular commentators took OBEGAL (and its predecessor OBERAC) as the score and their commentary was dreadful and misleading.
Let us be clear that OBEGAL is a better measure for some purposes than the (more volatile) operating balance including gains and losses. But OBEGAL does not give the full impact of the government on the economy. Government decisions are properly political rather than commercial, and are subject to different analysis. Some of the less commercial decisions occur outside the core accounts, while public investment is not included in OBEGAL (but depreciation is).
Again I am not criticising the accountants’ definition. My purpose is to remind everyone that accountancy and economics are different professions with different concerns; their concepts do not always interface well. We need to work together while respecting each’s perspective – and even more important we need to get these different perspectives across to the public.
A particular area where this is going to be problematic is in the asset valuations of balance sheets – the statement of financial position – which cover the gains and losses not included in OBEGAl. My understanding is that there is little problem with the assets in the core government accounts, but there are likely to be major write-downs in a number of accounts which sit outside it but are of great interest to the public. These include those of the ACC, the Government Superannuation Fund which provides for the retirement incomes of public servants, and the New Zealand Superannuation Fund, (the ‘Cullen fund’) which is intended to pre-fund the rising requirements of an aging population. All these funds will being writing down the value of their assets, reflecting the general fall in the price of some financial assets in the last few months.
In part the assets were overvalued in the past because of the boom conditions and their values are being scaled down to more realistic levels in the long term. But as I explained the mark-to-market valuation over-reacts on the downswing as well as the upswing, and it seems likely that many assets will be valued at below the realistic long-term levels.
No doubt there will be much consternation when the public (that is the media) becomes aware of the apparent losses. It will be very easy to panic and assume that ACC, say, is in some deep trouble that it was not in a year ago. Undoubtedly there are some problems with its costs, and they need to be addressed. However the weaknesses in its statement of financial position reflect the deep problems which face the whole of the world economy. Just as with OBEGAL, the politicians and pundits are likely to go off half cocked. It is important that at this point accountants and economists stand shoulder to shoulder and try to quell the hysteria, while giving to the genuinely concerned a clearer understanding of the real issues.
This paper is a reflection of this approach insofar as it has tried to set out for a general audience – this time of accountants in the public sector – issues which face the economy as a consequence of the Global Financial Crisis. It will be evident that there are issues of deep complexity, which we must try to get across to the public as well as ourselves. The same problem applies to the government accounts, which are not, I’m afraid, transparent even to this economist, and will be even more opaque and misrepresented on budget day. It is of little benefit if we get a particular matter conceptually right, but fail to get its implications across to the polity. Gillings Law Rules – and it is not always OK. I hope the remaining papers at this conference properly pursuing these technical issues will keep in mind the needs of a wider audience.