Ignore the wisdom of accounting at your own risk


Optimism is rife in financial affairs, and so is the claim that today’s losses represent an investment in the future. Keeping this in mind, John takes a look at what determines when deficits really matter and when they do not – double-entry bookkeeping.

It was – rather surprisingly – Goethe who declared that double entry bookkeeping was the loveliest invention of the human mind. I doubt if the great German intellectual was thinking of his country’s trading relationships with the US or the fiscal policy of the newly founded American republic. But double-entry bookkeeping is the key to understanding when deficits matter and when they do not.

The double-entry principle is that whenever there is a debt there is a credit. If there is a deficit, there is a corresponding surplus in the same column of someone else’s books, and a corresponding surplus in a different column of your own books. America’s trade deficit is, necessarily, a trade surplus for the rest of the world. The deficit that attracts attention is a deficit on current account: Americans buying more goods than they sell. There is therefore a matching surplus on capital account: the corollary of the current account deficit is that the rest of the world buys more dollar assets than it sells. These principles are as relevant to the public sector as to the books of private companies.

A good system of management accounts defines its categories so that deficits signal when management action is required. If a shop makes a profit on men’s clothing and a loss on women’s clothing, it needs to do something about the women’s clothing division. But accounting expertise requires business judgment. An airline may lose money on its short-haul routes and make profits on long-haul operations, but only by understanding the business will you learn whether this is bad management or good strategy. Whether deficits matter depends on the context.

Three distinctions are particularly important to national accounts – those between capital and income items, those between public and private activities and those between domestic and foreign transactions. The capital-income balance indicates whether you are building for the future, the private-public balance spells out the implications for future levels of taxation and the domestic-foreign balance is a guide to the future course of your currency.

What is capital and what is income, what is public and what is private, even what is foreign and what is domestic is always a matter of judgment. Optimism is endemic in financial affairs, and so is the claim that today’s losses represent an investment in the future. That assertion is common to dotcom expenditures and George W. Bush’s tax cuts. And it is not as easy as you might think to say what is public and private. The discovery that you can create private sector assets that are not treated as public sector liabilities has been extremely profitable for consultants and bankers in the past two decades: it offers much of the rationale for privatisation and public-private partnerships.

Even the domestic to foreign distinction can be blurred. “Who are ‘us’?â€? is an increasingly apposite question as corporations and markets become more global. Economic or commercial intention must always be translated into practical rules. And these rules can never cover every contingency or match the ingenuity of the endlessly inventive human mind. You need not look beyond Enron to see the scope for gaming against precisely formulated rules.

Sometimes deficits really do not matter: the German current account deficit after reunification didn’t matter because it was the result of foreign investors taking a share in the investment required to rebuild the infrastructure of the east. But the accounting concepts in common use are employed because experience has shown that looking at figures in these ways is the best way to anticipate trouble ahead. The most influential writer on the relationship between economics and accounting, Sir John Hicks, recognised how difficult it all was. He came to the conclusion that “we should eschew concepts of capital and income to economic analysis: they are bad tools that break in our handsâ€?. But the comment of Dennis Robertson, his contemporary, was perhaps wiser: “The jails and workhouses of the world are filled with those who gave up as a bad job the admittedly difficult task of distinguishing between capital and income.â€? The private sector is helping to fill the jails: perhaps the public sector will help to fill the workhouses.

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