Cooking the Books Is a Bad Recipe to Cool Deficit

By conventional wisdom, the federal budget deficit in 1990 will meet the Gramm-Rudman-Hollings target of $100 billion. Why, then, will the federal debt rise during the same year by about $280 billion?

Because the federal government has cooked the books. The American public is being led to believe that the deficit is falling when it is actually rising.

Specifically, we are using surpluses in federal trust funds (especially Social Security) to mask the federal operating deficit. By paying for current operation with the growing surplus of money collected to assure retirement benefits for future generations, the government creates the illusion that the deficit problem is being solved.

The use of trust-fund surpluses to mask the true size of the deficit is not the only accounting illusion being used to show a lower deficit.

Another gimmick used to meet Gramm-Rudman targets is to shift federal paydays from the next fiscal year to the current year. The economic reality does not change; federal workers must still be paid and we’ve still got to borrow the money. All we’ve done is deceive taxpayers by claiming a “lower” deficit next year.

More onerous is a refusal to recognize the growing burden of unmet costs that we will have to face. If we had dealt with the S&L; crisis two or three years ago when the Federal Savings and Loan Insurance Corp. was plainly going broke, we could have saved billions. Yes, timely action would have made the deficit in those years look worse; so the problem was ignored until it was impossible to postpone.

There are other huge costs which must be dealt with sooner or later:

-- The General Accounting Office estimates as much as $150 billion may be needed to clean up and modernize the nation’s deteriorated nuclear weapons complex.

-- To update antiquated computer systems at the Federal Aviation Administration, the Internal Revenue Service, the Department of Veterans Affairs, the Social Security Administration, the Defense Department and other agencies will cost billions over the next decade.

-- The Department of Transportation estimates $50 billion is needed to repair or replace the nation’s 240,000 deficient bridges and a staggering $300 billion by the year 2000 to maintain highways in their 1983 condition. These costs are shared with state and local governments, but the federal government traditionally provides a large share of the money.

--And more: $20 billion to repair the deteriorating stock of public housing; $2 billion to eliminate a backlog of deferred maintenance at national parks; about $5 billion to build needed prisons; $14 billion to clean up hazardous waste dumps at military installations.

These costs go to the heart of federal obligations. In private industry, many such future expenditures would have to be accounted for as unfunded liabilities; the rest would have shown up in the depreciation of capital assets. In the federal government, we’ve shut our eyes, trying to pretend these costs do not exist or that we can somehow “grow” our way out of the hole we’re in. More illusions.

Using smoke and mirrors is, of course, nothing new. The 20th Century is filled with instances of creative accounting; it’s also replete with failures that can be directly attributed to poor, gimmicky or non-existent accounting standards and practices. A brief look back is instructive.

Before the 1929 stock market crash, many companies used what became known as “appreciation accounting”; they would write up their accounts if they thought their property had increased in value over the previous year. This meant a corporation that suffered a bad year in sales or operations could mask the downside by claiming an “appreciation” in assets. Many companies did that in the late 1920s. In the feverish, wildly optimistic atmosphere of the time, it was easy to fool stockholders and the public.

The Samuel Insull empire was a case in point. Sam Insull had been the secretary and financial adviser to inventor Thomas A. Edison before starting his own ventures in Midwest utilities and holding companies. Before 1932, Insull’s companies had engaged in both appreciation accounting and a form of depreciation accounting that greatly overstated assets. The result was a holding company built on a house of cards. When it collapsed, thousands of creditors and stockholders lost their money. So did Insull.

As a response to such failures, the Securities and Exchange Commission was created and other reforms were instituted to require standard accounting practices.

But some industries were exempt from these reforms, including the railroads. They used what was known as “betterment accounting”; accounting changes for track and roadbed were booked only when improvements were made. This, of course, avoided depreciation and the orderly write-off of assets.

Despite criticism from many quarters, the railroads argued that since they were regulated by the Interstate Commerce Commission, they constituted a special case. The debate ended when the largest railroad, Penn Central, went into bankruptcy in the early 1970s. The Penn Central crisis cost American taxpayers about $7 billion, much of which went into needed improvements in roadbeds and car barns that had needed investment all along. It was an expensive lesson.

The public sector has seen similar shenanigans. New York City, for example, had long been required to show a balanced budget. The city got in trouble when it began moving operating costs to the capital budget and floated bonds to finance the difference. Before its financial crisis in the mid-1970s, 10% to 15% of New York City’s operating budget was being financed through long-term bonds. The “balanced budget” was an illusion.

Finally, only a federal bailout rescued the city. But the crisis might not have happened if New York had used proper accounting and budgeting standards.

A more recent example of creative accounting relates to practices in the savings-and-loan industry. For years, federal regulators allowed many tottering S&Ls; to use “regulatory accounting principles” (RAP) to report their financial condition, as well as the more widely recognized “generally accepted accounting principles” (GAAP). Reduced to essentials, many S&Ls; using RAP were not required to book certain losses when they occurred. The same institutions, meanwhile, were allowed to appreciate the value of certain assets. As conditions in the industry worsened, RAP made it easier to maintain the fiction of solvency.

Relaxed accounting principles can hide truth in the short term, but for an institution on the slippery slope to insolvency, they cannot stop the inevitable. it’s all over when the cash runs out.

The inevitable, of course, has happened. The most recent GAO estimate is that it will cost $257 billion over the next three decades to rescue depositors in failed thrifts holding federal insurance. Of that amount, $139 billion will come from the taxpayers--more than $2,100 for every family in America. The use of overly lenient accounting standards must share the blame for this debacle.

Proper accounting is now required for the budget deficit. Solving the deficit crisis is obviously a matter of resources but in a larger sense the solution must also involve a realistic appraisal of where the government stands financially and what obligations it has assumed. Such an appraisal demands state-of-the-art budget and accounting systems that will give Congress, the Administration--and the public--information untainted by gimmicks. The systems now being used are no longer capable of meeting our growing and complex needs for accurate and timely information.

Installation of modern accounting and financial management systems will require a number of years to implement plus a considerable investment in money and talent. Given the magnitude of the problem, this is an investment long overdue.

A modern budgeting system, for example, would keep the concept of a unified budget (showing total federal income and expenditures). But it would also clearly show ordinary operating costs as distinct from capital expenditures. It would account for surpluses in the trust funds as well as activities by government “enterprises” such as the Postal Service. Such a system would help sort out priorities while providing an honest accounting of how--and where--taxpayers’ money is being spent or not spent.

The history of accounting gimmickry in the 20th Century has one unyielding lesson: It is impossible to repeal the economic facts of life. Ultimately, illusions give way to reality.