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Accounting is important, not least because it changes behavior. In a year of elections and political upheaval, this point is important because conventional accounting sends some extremely misleading signals to policymakers.
Let us first look at central bank finances. Central banks are suffering losses on assets they bought after the 2007-2009 financial crisis and during the pandemic as part of so-called quantitative easing. On a mark-to-market basis, many of them have negative equity and are thus technically insolvent.
That sounds scary. But the balance sheets of central banks are strange because they ignore the central banks’ most valuable asset: the capital gains tax, i.e. the profit from money creation. A central bank is only insolvent if the decline in equity is greater than the net present value of future income from the capital gains tax.
That seems unlikely in the developed world today. Remember, we are talking about public institutions that have a monopoly on money creation, receive government support, and are protected from bankruptcy proceedings. In some cases, most obviously the Bank of England, there is full government compensation for losses from QE purchases.
Economists at the Bank for International Settlements find little evidence of a systematic link between central banks’ capital buffers and the resulting inflation. In fact, the central banks of Mexico, Chile, Israel and the Czech Republic have operated with negative capital for long periods without their policies going wrong.
The only caveat is one of perception. Milton Friedman and Anna Schwartz, in their famous book on the monetary history of the United States, showed that the Federal Reserve’s concern for its own wealth helped prevent a more aggressive response to the depression of the 1930s.
Today, one would factor central banks’ short-term losses into the assessment of the long-term sustainability of government debt, but forget that these losses were actually incurred to increase overall economic revenues and thus broaden the tax base – something the new British Labour government should think about. However, if a central bank lacks fiscal support, market participants may fear that it will issue additional reserves to finance its liabilities, undermining confidence in money and endangering price stability. And if governments exploit the perceived need to recapitalise central banks and try to influence policy, the independence of central bankers could be threatened.
Nevertheless, the fact remains that central banks’ balance sheet capital is generally not a sufficient measure for assessing the effectiveness and solvency of their policies.
Turning now to pensions, they are 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, UK accounting standards decided that pension fund surpluses and deficits should be reported on company balance sheets. Finance directors responded by closing defined benefit pension funds to new members, while trustees sought to reduce the risk of their funds through liability-focused investments. Such LDI funds invested in assets, mainly government bonds, that generated cash flows that coincided in time with pension expenditure.
This risk aversion was exacerbated by the fact that a key asset – the sponsoring company’s guarantee to cover the pension system’s deficits – was not recorded in the pension funds’ accounts. This in turn influenced regulators, who wanted to prevent employer insolvency at all costs and protect the country’s pension protection fund from employer insolvency, and put pressure on the trustees to introduce LDI when government bonds were yielding meager returns.
So companies were forced to pump money into pension funds that would otherwise have been used to invest in the real economy, among other things. Their pension funds’ equity holdings were reduced to almost zero. And because returns on government bonds were dismal, the funds borrowed to boost returns. This made pension funds a systemic risk, leading to the crisis in the government bond market in 2022, when rising interest rates and demands for collateral caught the over-indebted funds unprepared.
Perhaps the biggest gap between accounting and reality concerns externalities such as pollution. Market prices and corporate balance sheets do not fully reflect the associated social costs.
With decarbonization, these externalities must be internalized. The useful life of fossil fuel-intensive assets must be shortened, increasing depreciation costs and adjusting depreciation to 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. With a patchy framework of reporting standards, most investors believe that stock prices poorly reflect the realities of climate change.
The charitable verdict is that sustainability reporting is a work in progress. The broader lesson is that policymakers, regulators and investors need to be aware of the gaps between traditional accounting and economic reality, and of the risk that radical changes in accounting can have unintended consequences.
