Western governments are even more indebted than you might think

The way governments account for their finances means we aren't getting a true picture of the scale of public debt, says Matthew Partridge.

We've heard a lot in recent years about the large levels of public debt harboured by many nations around the world. The fight between Brussels and Madrid over the rescue of Spain's banks shows that to get the true picture, you sometimes need to consider private debt too, especially if it is in reality backed by the state.

However, some experts fear that the problem of public sector debt goes even deeper than this. More to the point, they also believe that this problem isn't just limited to countries like Greece and Spain.

Ian Ball of the International Federation of Accountants (IFAC) has some very strong views on this. He thinks that public sector accounting is flawed. Indeed, he points out that while the Enron debacle forced wide-ranging changes to private sector accounting, the public sector remains unreformed.

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What does this mean for government finances and for investors? I recently asked him to outline his views in more depth to find out.

Cash versus accrual accounting

Ball points out that most countries around the world still use what is termed "cash-based" accounting for public finances. This means that cost of a policy is only assessed when payment is made ie when the bill comes due. However, under "accrual" accounting, which is used by the private sector, costs are counted at the time the obligation is incurred ie when you commit to something.

The distinction may sound minor. However, Ball argues that the former system can lead to long-term obligations being overlooked. In the worst case, it may actually encourage dodgy schemes to massage the figures. For example, David Cameron and George Osborne have been criticised for taking over the Royal Mail pension system in order to temporarily 'cut' the deficit. Meanwhile, 'public private partnerships' (PPP) may have helped the last government to hide the true cost of new public projects.

A subtler problem is that of large unfunded public sector pensions. It makes sense for some state-funded professions, for example teaching, to have good benefits relative to salaries. This is because such a structure rewards loyalty. However, for others there is little such business need. But a lack of focus on the long-term costs - driven partly by accounting methods - means that governments have ignored these issues and are now facing a huge bill.

Of course, Ball concedes that it is possible for governments to change the terms of the schemes, even to existing members. Indeed, he accepts that future liabilities related to old-age pensions paid to the general public should not be counted for this very reason.

However, he thinks that the employee pension schemes should be included because they are much harder to modify. Even if you think that pensions are too high, most of us would agree that there's something not entirely fair about agreeing to one set of terms when people start a career, only to change the terms a decade or two down the line once they are locked in.

In contrast, accrual accounting should reduce this problem. It should stop the number-fudging shenanigans of PPP, for example. And it also forces the government to think about the long-term costs of its commitments, or at least to make sure that they are properly funded.

In theory, this should lead to greater control of costs. Ball cites the case of New Zealand, which moved to accrual accounting in the early 1990s. This forced it to properly fund public pensions. As a 2006 study points out, gross public liabilities fell from two-thirds of GDP in 1993 to a quarter of GDP twelve years later, while those of other OECD countries increased.

The implications for Europe

So what implications does this have for investors? It makes it very clear that the traditional measures of public debt do not tell the whole story. Even for the UK, adding in public sector pension liabilities adds another 90% of GDP to debt.

Yet Britain is in a relatively secure position compared to other eurozone countries. As the Wall Street Journal reports, Spain, Greece and Portugal's liabilities are 204%, 231% and 298% respectively. And even these are not the worst countries: Germany and France top the table, with 330% and 360% of GDP respectively.

France's problems are made worse by the fact that it can't reform the general state pension system. Indeed, the Hollande government has just cut the retirement age for some French workers to 60.

Supporters of this move point out that the French government will also be raising taxes to try to pay for this. However, there are limits to how far this 'tax and spend' strategy can go, given that French taxes are already high. Overall, it further reduces the chances of France being able to make inroads into the deficit.

It also shows that the political will, even (or perhaps we should say particularly) outside the peripheral' countries, for balanced budgets is very low. As we've said before, if Paris is unwilling to go along with austerity and get its house in order, it will be very hard to make the likes of Spain and Greece cut further. Meanwhile, the high levels of liabilities also suggest that Germany may be over-rated as a safe haven.

In short, Ball's view of how governments fiddle their accounts makes us even less happy about the idea of holding developed world government debt. Tim Price, who writes The Price Report newsletter, is similarly unimpressed with bonds in the developed world. But he does have a suggestion for a fund that might suit those who are looking for bonds issued by more solvent sovereigns the Wealthy Nations Bond fund. You can learn more about from Tim's colleague Killian Connolly, who was at our most recent Roundtable: Nine investments our experts would buy into now.

Dr Matthew Partridge

Matthew graduated from the University of Durham in 2004; he then gained an MSc, followed by a PhD at the London School of Economics.

He has previously written for a wide range of publications, including the Guardian and the Economist, and also helped to run a newsletter on terrorism. He has spent time at Lehman Brothers, Citigroup and the consultancy Lombard Street Research.

Matthew is the author of Superinvestors: Lessons from the greatest investors in history, published by Harriman House, which has been translated into several languages. His second book, Investing Explained: The Accessible Guide to Building an Investment Portfolio, is published by Kogan Page.

As senior writer, he writes the shares and politics & economics pages, as well as weekly Blowing It and Great Frauds in History columns He also writes a fortnightly reviews page and trading tips, as well as regular cover stories and multi-page investment focus features.

Follow Matthew on Twitter: @DrMatthewPartri