Friday, January 19, 2007

How Bad is the Federal Deficit Really?

There seems to be an extremely important issue surrounding the federal deficit - beyond the facts that there is one, it continues to increase, and that it is measured in the billions of dollars. The issue is exactly how big it is. You'd think this would be a fairly simple matter - after all, periodically the deficit comes up as a political issue and is widely reported as being a specific number. The problem is that the federal deficit is a function of the federal budget and the federal budget is a matter of accounting - like all budgets, personal, corporate, etc.


For example, I keep detailed records of all of my expenditures throughout the month. At the end of the month, I enter them all into a spreadsheet and assign them to one of many pre-defined categories, e.g., "groceries", "gas", "medical", etc.

I then analyze that data to determine a) whether my family "operated" in the black or in the red last month, b) where did the money go?, c) how are we trending in general?, d) how is each expense trending on a monthly basis?, e) what are potential areas of improvement?, f) how much are we projected to spend next month?, g)are there any red flags in the way we spend our money or how we expect to have to spend out money in the future.

Often times, an expenditure does not fit neatly into one expense category. For example, we spent a lot of money on gas to drive to Florida for a special event. If I record that expenditure as a gas expense, however, it creates a much higher number of monthly gas expenses than normal. Should I expect to have to spend that much again next month? Not unless I plan on going to Florida again. Likewise, there were others expenditures associated with the trip that could have fallen into other categories. Instead, I chose to create a new category, "trips", into which all such expenditures would fall. This has the effects of a) more accurately representing "where the money went", b) resulting in a more accurate run rate for the expenses concerned, c) allowing me to make more accurate projections about how much those expenses will be next month, and d) allowing me to project how much future trips might cost when they come around.

Now, when I sit down and look at the data and ask "how did we do last month? Is there anything we should try to improve?", the answer inevitably is "well, it's a matter of how you look at it - a matter of accounting. How did we classify those expenditures?"

Thus, you can see how, even with small family budgets, you can fiddle with numbers in many ways and effectively make the data say many different things. For instance, I could have classified all of those things as "recreation" and told my wife to stop having so much fun because it is breaking the bank. Obviously, though, that would not have helped anything - even if our expenses were much less the following month, I couldn't reasonably attribute it to the imposed boredom of my wife.


Just because a predicted effect happens does not mean that it can be attributed to the supposed cause.


Anyway! The point is, you can cook the books.


Now, for a little bit of an accounting lesson:

There are two general types of accounting: cash accounting and accrual accounting. The basic difference between the two is that cash accounting records expenses and income only when money actually changes hands. Accrual accounting records transactions when they are agreed upon. For example, if a company has an employee to whom they promise a signing bonus of $1,000 payable after one year (regardless of whether or not he stays with the company that long), when that $1,000 expense is recorded depends on the type of accounting the company is using. If the company is using cash accounting, the expense would be recorded as occurring at the time when the company actually wrote him the check. If, however, the company is using accrual accounting, it will record the expense as occurring the day the employee is hired because it is then that the $1,000 is promised to be transferred. Likewise when someone buys something at a store but puts it on a payment plan.

In the US, by law, all publicly traded companies and all companies or institutions that have more than $1 million in annual revenue must use accrual accounting.

Finally, we arrive back at the point of the post, the federal deficit, which, as I said,
is a matter of the federal budget, which, as I endeavored to explain, "is all a matter of accounting."

Specifically at issue currently, as reported in this USA Today article, is the matter of exactly how the federal government records certain expenses. As the article explains, this is part of a much bigger issue, namely, how the government practices accounting in general. That's for another time, though. What the article and this post are primarily concerned with is how large is the actual federal deficit. It seems that the number that is generally touted is not entirely accurate. (BTW, I know you're shocked, SHOCKED to find out that the government of all institutions is cooking the books).

It seems that the government insists on using cash accounting procedures when recording things like Social Security and Medicare benefits. To fill in the blanks: that means that all of the future obligations that the government is racking up vis-a-vis US citizens are not being recorded when they are incurred. Thus, even if the government has promised $1 trillion in benefits, it's not reporting that as an expense because it hasn't actually made good on the obligation yet. The "best" part of this is that the government is justifying this practice by pointing out that Congress can cancel those obligations at any time, i.e., simply pass legislation voiding all previously "promised" Social Security and Medicare benefits.

Digest that for a minute. Both parties are swearing up and down that they're going to save Social Security, etc., while at the same time using the fact that they could, in theory, completely renege on all of those obligations as justification for not including them in accounting records of the federal government.

Now, to be fair, there would be big problems with trying to apply the methods of accrual accounting to the federal government in this way. As Social Security chief actuary Stephen Goss says “A country doesn't record a liability every time a kid is born to reflect the cost of providing that baby with a K-12 education one day.”

On the other hand, as you can see from, Social Security makes up an enormous part of the federal budget. As such, I can see reasonable people wanting it to be factored into the annual federal expenses in some way.

BTW, if the government were to record these types of expenses using accrual accounting methods, the deficit in 2004 would have been $11 trillion. Now, just to be clear, this is not the national debt (which is currently $8.6 trillion) - the total amount "in the hole" the federal government is. The $11 trillion deficit is how much farther in the hole the government went in just one year (granted, 2004 was an unusual year because of new legislation that was passed)
. Can you imagine what the national debt would look like if this type of accounting were used?


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