Stay informed with free updates
Simply sign up to the Global Economy myFT Digest — delivered directly to your inbox.
Accountancy matters, not least because it changes behaviour. In a year of elections and political shifts, the point is worth making because conventional accounting is sending some exceptionally misleading signals for policy.
Consider, first, central bank finances. Central banks are incurring losses on assets they bought through so-called quantitative easing after the 2007-09 financial crisis and during the pandemic. On a mark-to-market basis, many have negative equity capital and are thus technically insolvent.
This sounds scary. Yet central bank balance sheets are curious because they exclude central banks’ most valuable asset: seigniorage, or the profit made on creating money. Only if the shrinkage in equity capital is greater than the net present value of future income from seigniorage is a central bank insolvent.
That seems implausible today in the advanced countries. Note that we are talking here about public institutions with a monopoly right to create money, government backing and protection from bankruptcy proceedings. In some cases, most obviously the Bank of England, there is full government indemnification against losses on QE purchases.
Economists at the Bank for International Settlements find little evidence of any systematic relationship between central bank equity buffers and subsequent inflation. Indeed, the central banks of Mexico, Chile, Israel and the Czech Republic have operated for long periods with negative equity without policy going awry.
The one caveat relates to perception. Milton Friedman and Anna Schwartz, in their renowned monetary history of the US, showed that the Federal Reserve’s concern for its own net worth helped prevent a more aggressive response to the 1930s Depression.
Today’s equivalent would be to allow short-term central bank losses to affect judgments about long-term public debt sustainability while forgetting those losses were incurred to boost economy-wide income, so broadening the tax base — something Britain’s new Labour government should ponder. That said, if fiscal support for a central bank is lacking, market participants may fear that it will issue additional reserves to finance its liabilities, thus eroding trust in money and putting price stability at risk. And if governments take advantage of a perceived need to recapitalise central banks and seek to influence policy, central bankers’ independence could be threatened.
Yet the fact remains that central bank accounting capital will generally be a deficient guide to assessing policy effectiveness and solvency.
Turn now to pensions, which offer 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, accounting standard setters in the UK decided that pension fund surpluses and deficits should be recorded on company balance sheets. Finance directors responded by closing defined benefit pension schemes to new entrants, while trustees tried to de-risk their funds by resorting to liability-driven investment. Such LDI funds invested in assets, mainly gilts, that produced cash flows timed to match pension outgoings.
This risk aversion was compounded because an important asset — the sponsoring company’s guarantee to meet pension scheme deficits — goes unrecorded in pension fund accounts. That in turn influenced regulators that sought to prevent employer failure at any cost and protect the country’s back-up Pension Protection Fund from employer insolvencies. They applied pressure for trustees to adopt LDI when gilts were offering threadbare returns.
Companies were thus obliged to pour cash into pension funds that might otherwise have been used, inter alia, for investment in the real economy. Their pension funds’ equity holdings were run down to near zero. And because gilt returns were dismal, the funds borrowed to boost returns. Hence pension funds came to pose a systemic risk, resulting in the gilt market crisis of 2022 when surging interest rates and collateral calls caught overborrowed funds off guard.
Perhaps the biggest gap between accountancy and the real world concerns externalities such as environmental pollution. Market prices and company accounts do not fully reflect the related social costs.
With decarbonisation, these externalities have to be internalised. The lives of fossil fuel-intensive assets need to be shortened, raising depreciation charges and bringing asset writedowns to align with emissions reduction targets — difficult when much information for sustainability reporting comes from companies’ value chains over which they have limited control. In a patchy framework of reporting standards, most investors believe that stock market pricing inadequately reflects climate change realities.
The charitable verdict is that sustainability reporting is a work in progress. The wider lesson is that policymakers, regulators and investors need to be acutely aware of the lacunae between conventional accountancy and economic reality. Likewise of the risk that radical accounting changes can spawn unintended consequences.
john.plender@ft.com