Listener: 1 October, 2011.

Keywords: Macroeconomics & Money;

The world’s economic difficulties arise because so many balance sheets are badly balanced. A balance sheet – of a person, a business, a financial institution, a government or a country – consists of the entity’s assets on the left and its liabilities on the right. (Accountants are such a conservative profession, I doubt they are making an implicit political statement.)

Assets and liabilities are rarely equal. If the assets exceed liabilities, an item called equity appears in the balance sheet. If it’s the other way around, the item is negative equity. A business with negative equity is likely to fail – people won’t want to do business with it since there’s a good chance they won’t get their money back.

Because all businesses need a cushion against contingencies, they need some (positive) equity. This is the shareholders’ funds – which are not the same as the valuation provided by the sharemarket.

For financial institutions, the cushion for contingencies is particularly important. Depositors may be unable to get their money back if the cushion is inadequate. Following the global financial crisis, the desirable size of the cushion required for prudent management has increased. Where do these institutions get the additional reserves from? Many have had to “write down” the value of their assets because of bad debts (including worries that some sovereign debts won’t be repaid in full).

Households can have negative equity from student loans, credit-card debts and excessive mortgages. Lenders may be more tolerant if they think the debt can be serviced from income – that is, that the interest can be paid and the debt eventually repaid. If it cannot, the lender may, say, sell the debtor’s house to pay off a mortgage. This outcome will not be widespread as long as unemployment is low.

One source of negative equity is houses whose prices have fallen. This is a more serious problem in the US than here, because house prices have fallen more dramatically; households may be “underwater”.

Just as conventional household balance sheets omit human capital, government balance sheets omit the sovereign right to tax. So a government’s negative equity is covered by tax receipts. Some governments – including New Zealand’s – have modest levels of debt; others – most notoriously Greece’s – have debt levels so high that all may not be repaid. Lenders are reluctant even to roll over (relend) such debt, which compounds the country’s financial distress.

Lenders recently realised that governments may be less able to raise taxes to service their debt. The concern, evident during the recent near-stalemate in the US Congress, may also apply to many more nations. Taxpayers pay taxes in return for public spending. For them, debt servicing is not a priority. If public spending is cut back to pay debt, taxpayers on the left of the political spectrum may revolt. If that is combined with the current discontent from those on the right (who just object to taxation), things will be very messy.

Consolidating all the balance sheets of a nation (many liabilities will be offset by others’ assets) gives the national balance sheet, which is more than just the government sheet. New Zealand’s shows we owe a lot offshore. Those who lend to us may be uneasy about the borrowing. Perhaps there is a problem somewhere in all the balance sheets that combine to make the aggregated national one.

This problem is not in the balance sheets of the Government, businesses (we think), or the finance sector (now the most incompetent finance companies have collapsed, also destroying household assets/deposits). It’s probably in the household sector’s. Some households are strongly placed; others are, if not underwater, barely floating. We could shift their liabilities elsewhere – most obviously to the Government, although that would worsen its balance sheet. Even were it fair to do this, things may well get much worse, so we need a strong Government balance sheet. Alternatively, households could save more, but that reduced expenditure would contract the economy and create unemployment.

The dilemma is not just New Zealand’s. Many other countries face the same challenge. The intricate interdependence of all the world’s balance sheets (my liabilities are someone else’s assets) means we cannot be sure what will happen, or when it will happen.