Sunday 18 July 2010

Government debt? Out-of-sight, Out-of-mind

It’s been clear for a while now that the UK’s public finances are in a mess, but this week’s ONS report on “off-balance sheet” liabilities really rubs it in. Although it made the front page of the Independent, and a small article in the FT, it hasn’t yet had the attention it deserves.

The Office for National Statistics has attempted to quantify some of the future payments the government is locked into, but that are not accounted for in the figure quoted as “the national debt.” Some of the liabilities it has included, related to guarantees on financial instruments and the government’s stake in the banks, are not likely to materialise into real losses. In that sense, the upper estimate of the liabilities of £3,000,000,000,000 (Three trillion) pounds is a bit alarmist.

However some of the future payments are inescapable – most notably the Private Finance Initiative (PFI) obligations. PFI is a mechanism almost solely designed to allow governments to put off expenditure. Instead of paying up front for buildings and infrastructure, such as new roads, hospitals or landfill sites, the government signs a contract to pay a fixed fee at a future point in time for the services delivered in that infrastructure. The private sector then finances the capital investment in property and equipment, and aims to get a reasonable return on its capital when the services are delivered.

In the private sector it is akin to a “leasing” model where you are replacing a capital cost with an operational cost. However in the private sector, the assets being leased are generally being used to generate revenue. The cost of one year’s lease can be straightforwardly compared to one year’s revenue. In this context, then, the lease makes the accounting simpler. When applied to the public sector, however, there is no income to offset the cost, and the effect of the PFI is often to complicate the accounting. Furthermore, the need to draw up large, long-term contracts is a costly process. And flaws in the contract can leave the government with major costs incurred, without seeing the benefit expected (as happened with the London Underground expenditure, which used the related “PPP” mechanism).

Fundamentally, the move towards PFI has allowed the government to hide its liabilities. It is similar to the “Off-balance sheet liabilities” that contributed to the bankruptcy of Enron, and to the 2008 financial crisis (most of the CDOs held by banks were off-balance sheet).

On the bright side, the fact that the ONS is beginning to pay more attention to the obligations that will fall on future generations is most certainly a good thing.

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