Frightening Update

I recently wrote about how frightening the financial situation of the United States was. How could it be that an entity as complex as the United States economy could employ cash based accounting, the same method used by hot dog stands?

After posting that blog I had breakfast with one of my oldest and best friends. I met him early in my engineering career. We branched in graduate school after both of us completed Masters degrees. I went on with mechanical engineering, while he pursued an MBA. We branched again when I abandoned engineering and ran down the software track.

We've managed to stay in contact in spite of the fact that we no longer work together. We'd meet for lunch until the noon hour stopped being considered a sacred "meeting free" time. Then we switched to monthly breakfasts before work. These are coffee-fueled discussions about all our favorite topics - engineering, politics, religion, movies, sports. I can't think of many people in my life with whom I could spend an hour this way. I look forward to them like nothing else.

My friend is a dyed-in-the-wool leftie who's against all things Republican. I tend to be left of center as well, but it's easier for me to slip into "a pox on both your houses" mode when I think that Democrats aren't living up to their ideals. It's a position that's easy to assume these days. Except for the change in tone I don't see much difference between the current administration and the Republican regimes of the last eight years, with two wars in progress and being funded by "off budget" expenditures, the Treasury taken over by Goldman Sachs, the Patriot Act in place, Glass-Steagall rolled back, and Guantanamo in operation.

During our last breakfast I relayed the essence of my distress: Why doesn't the US government use GAAP? I thought myself very clever when I said that cash based accounting made us no better than a hot dog vendor.

My friend drew on the wellspring of knowledge he accumulated during his MBA and shot me down: "Cash-based accounting is the most honest form there is. You look into the till and report on how much cash you see!" He pointed out that GAAP is loaded with loopholes and tricks. Depreciation makes all kinds of shenanigans possible.

My argument was shot down. I was an easy target, because I've never studied accounting.

I'd appreciate it if someone could explain to me where I went wrong. I realize that it won't be possible to relate or absorb such a vast subject in the space of a web comment, but I could use a nudge in the right direction.

Perhaps the real answer is that no accounting system is a guarantee of honesty and transparency. Scandals too numerous to list, such as Baan, Enron, etc., have taught us that outright lying can be done using any accounting system. GAAP won't stop you from booking loans as income, or moving sales back from one quarter to another to make a bad quarter look better, or shipping product to a warehouse you own and treating them as sales, or ignoring an IOU to Social Security and Medicare because you spent the cash accumulated within back in the Vietnam days.

The real problem isn't the way the Congressional Budget Office is tallying the numbers. It's the way we're misled about what the numbers are in the first place.

One reason for the housing boom is people taking on debts beyond their means, assuming that the value of the house would always appreciate at a rate that would make it possible to flip the house at a profit before paying for it became a problem.

I think our current fiscal situation is based on an equally flawed assumption: that the United States will always be the world's pre-eminent economic power, that the rest of the world will never catch up, that our economy will always continue to grow fast enough to make it possible to pay off the obligations we're piling up.

I keep waiting for the Obama administration to start telling us the truth, but it's like waiting for Godot.

Frightening

Articles like "Risk Free Is Not Without Risk" at Rude Awakening scare the living hell out of me. I've included their image of the US government's outstanding liabilities, calculated using cash accounting and GAAP, to lead off this entry.

One paragraph from that column says it all:

The fiscal condition of the United Sates has deteriorated dramatically during the last several years. On the basis of current obligations, U.S. indebtedness totals “only” about $12 trillion. But when utilizing traditional GAAP accounting – the kind of accounting that every public company in the United States MUST use – U.S. indebtedness soars to $74 trillion. This astounding sum is more than six times U.S. GDP. (GAAP accounting includes things like the present value of the Social Security liability and the Medicare liability – i.e. real liabilities.)

The $12T figure is scary enough. It's the basis for all the rationalizations that our politicians are using for their monetary policies: "We can afford this deficit, because it's still a small percentage of our GDP. America is still the mightiest economy in the world." Our overall debt is roughly one year's GDP now.

But with a true debt that's six times our GDP it feels we're in an airplane that's nosediving and in gravity's grip. Pulling out will take all of our strength.

Does it bother anyone else that our government can hector industries about their poor practices - deservedly so - yet continue to use cash based accounting? Isn't that the style that one would use to run a small, cash-based business like a hot dog stand? I suppose that would be fine, as long as we were talking about the world's mightiest hot dog stand.

There's a fight going on between "fresh water" and "salt water" economists about the wisdom of continuing to run a large and growing deficit to stimulate the American economy. The Keynesian school says that massive deficits are the only way to restore our prosperity.

This argument is based on the kind of wishful thinking that brought about the recent collapse of the real estate market. It assumes that deficits are a temporary condition and that the economy will always grow. What politician has ever shut down a program once it was put in place? What if the economy collapses under the weight of all that debt?

The only time I can recall running a surplus was at the end of the Clinton years. Even that was suspect, because it was fueled by an unanticipated windfall from capital gains taxes that were based on "irrational exuberance". Remember Al Gore and his "Social Security lockbox"? How did that work out? How much of our debt was retired after that adventure in creative finance?

I fear that our situation has become so unmanageable that the economy will never be able to grow its way out of debt. Neither our people nor our government show any inclination to cut back on consumption and retire our debts. We continue to hear about new rights (e.g., good jobs, universal health care, retirement with dignity, etc.), but no one wants to pay for them or face up to the obligations we've already incurred.

The only alternative we have is inflation. If we continue to debase our currency, perhaps all those dollars that the Chinese and Japanese are sitting on will become worthless. That'll teach them a lesson! Too bad that the dollars in my 401(k) will be suffering the same fate. The joke will be on us.

I'm glad that the Republicans are out of office after an eight-year nightmare. I like Mr. Obama and wish him well.

But the Democrats have done nothing with their filibuster-proof majority to date. And neither political party is telling us the truth or doing anything significant about the real problems that we all face. Our news media would rather tell us about Jon and Kate and their unholy brood rather than let us know how dire our finances have become. We're encouraged to continue to spend, as if it was our patriotic duty.

I fret about how right-leaning religious nut cases who believe that our wealth and happiness are mandated by divine right will react if the tide turns.

We're all going to have to learn to live within our means; our means will be declining. If we can't do it ourselves, perhaps the Chinese and Japanese will force the lesson on us. If they decide to stop buying our bonds we're going to see interest rates rise whether we like it or not.

We won't be a great economy if we don't make things that the rest of the world wants to buy. Contrary to what a lot of people think, God didn't make the United States the greatest economic power of the 20th century.

I think it's misguided to think that a service-based economy can allow us to maintain our pre-eminent position in the world. If we continue to see industries collapse, without something new coming along to take their place, things could get very ugly here in the coming years.