Time for a full accounting for the financial state of the union

“… the federal government faces long-term challenges resulting from large and growing structural deficits that are driven primarily by rising health-care costs and known demographic trends. This unsustainable path must be addressed soon by policymakers. The longer actions are delayed, the more difficult adjustments are likely to become.”

These words in the 2009 Financial Report of the U.S. Government were written by Gene L. Dodaro, acting comptroller general. The report was released Feb. 26 by the Department of the Treasury. His words have many implications for pension funds and other institutional investors.

The federal government's sizable projected economic deficits and highly leveraged balance sheet suggests that managing money in the future will be much more challenging. If the direction the government finances are heading is not addressed soon, there will be dire consequences. The economy's growth rate will decline. Government debt owed to third parties will grow rapidly. Political instability will rise as politicians are unable to maintain social insurance benefit levels. Furthermore, debt and equity market volatility and credit spreads are likely to be well above historic market averages.

To understand the gravity of Mr. Dodaro's comments, one has to estimate the consolidated financial results and financial position of the U.S. government. This is necessary because none of the several sets of books published by the government provides the required consolidated information. The estimate needs to add our social program expenses to the financial report's statement of net costs (the “income statement”) and related obligations to the balance sheet. Currently, no social insurance costs or obligations other than current year expenses are consolidated in these financial report statements.

However, the financial report does include statements of social insurance, disclosing the present values of the off-balance-sheet social insurance obligations, primarily Social Security and Medicare.

The estimated consolidated financial results indicate that the federal government has been running huge economic deficits. Based on figures included in the financial report and statements of social insurance, the federal government had an economic deficit in 2009 of $4.3 trillion. This economic deficit is calculated by adding the increase in the present value of projected revenue and expenditures of social insurance obligations during the next 75 years for current participants as reported in the statements of social insurance to the net operating cost figure included in the financial report.

For some perspective on the size of our likely future economic deficits, it is useful to review recent U.S. government spending. Over the past nine fiscal years, ended Sept. 30, 2009, the federal government has spent at the rate of almost $3 for every $1 collected. Over this period, the government generated a cumulative economic deficit of approximately $38 trillion. For comparison, the cumulative U.S. gross domestic product was $113 trillion. The average annual economic deficit over this time frame was approximately $4.3 trillion, so 2009 was an average year. The cumulative economic deficit exceeds the reported cumulative budget deficit by a factor of 11. Please note that there is no year during this period when the economic deficit was less than $1 trillion, and it ballooned in 2004 to more than $11 trillion because of the creation of Medicare Part D, a federal subsidy of prescription medication, which had an initial-year present-value cost of $6.3 trillion.

The Congressional Budget Office's analysis of the president's proposed budget indicates that the estimated budget deficit for 2010 is expected to be $1.5 trillion and the estimated cumulative budget deficit for 2010 through 2012 will be $3.7 trillion. The economic deficit will remain daunting each year as the $52.1 trillion of present value of social insurance obligations continues to increase by an amount greater than the total tax revenue collected by the federal government in 2009. In order to calculate projected economic deficits for the 2009 to 2012 period, an unknown amount of additional accrued expenses (the average annual cost for these expenses for the last nine years is approximately $277 billion) and an unknown increase in the present value of social insurance obligations (the average annual increase for the last nine years is approximately $2.9 trillion) must be added to the projected budget deficits.

As of Sept. 30, 2009, the federal government's total net obligation, including the present value of social insurance obligations, was $63.6 trillion. There are no existing assets to offset the present value of social insurance obligations because amounts set aside in Social Security and Medicare trust funds are intragovernmental obligations that are eliminated in the consolidation of the financial statements. The total net obligation exceeds $205,000 for every U.S. citizen and represents an amount equal to more than 30 times the 2009 total U.S. government revenue.

One of the difficulties that we collectively face in achieving fiscal responsibility for our government is that often our two political parties talk past one another because they don't have a common basis for discussing the government's finances. The most well-known set of accounts, and the only one that politicians want to discuss, is the budget that is cash based and has little relationship with economic reality. Under budget accounting rules, outlays are recorded only when bills are actually paid. This shortcoming is the primary reason every publicly traded company in the U.S. is required to use accrual accounting.

The federal government has been putting together the accrual-based financial report since 1997. It comes closer to providing an accurate picture of our financial results and financial position. However, it has several enormous flaws. The most serious omission is that it does not include the cost of Social Security, Medicare and Medicaid other than current year expenditures. The adjustment outlined above corrects this issue for Medicare and Social Security, but not for Medicaid. The Medicaid program is another large unfunded obligation. No adjustment is made because government data do not exist to calculate the increase in the present value of its cost. In addition, the financial report does not consolidate the financial results of government-controlled entities, including the entire Federal Reserve System, Federal National Mortgage Association, Federal Home Loan Mortgage Corp., General Motors Co., GMAC Inc. and American International Group Inc.

Joseph H. Marren is president and CEO of KStone Partners LLC, Briarcliff Manor, N.Y.