The world is governed more by appearance than realities so that it is fully as necessary to seem to know something as to know it.

~Daniel Webster

Update: This article was featured in the Carnival of Wealth #13 posted at Personal Dividends. Thanks!

I used to think that accounting principles were sort of set in stone like 2 + 2 = 4. You take account of how much you have and how much you owe. End of story. Dealing with my own finances and watching some of the voodoo accounting to which we’ve borne witness over the past few decades has caused me to realize that there is more art than science to accounting practices.

What is my net worth? That depends on the value I assign to my assets. I might say my house is worth $300 000, but if I can’t find anyone to pay any more than $250 000 for it, that changes everything. The value of any asset is always somewhat subjective and definitely subject to change over time. Fair value can be more elusive than you might think.

What Is the Real Value of Ottawa’s Pension Obligations?

A recent report by the C.D. Howe Institute suggested that we have a Public-Sector Pension Bubble on our hands, and that we need to take action to prevent taxpayers from footing the bill in the event that it bursts. If you don’t have time to read the report in full, here’s a quick rundown of their findings quoted directly from the report by Alexandre Laurin and William Robson:

• Fair-value accounting reveals Ottawa’s employee pension obligations to be larger and more volatile than they appear, a problem shared by European and US state governments.
• The federal government’s net pension obligation under the fair-value approach stands at almost $208 billion – some $65 billion larger than reported in the Public Accounts; to keep pace with benefit accruals and stop the gap from growing, contributions in the latest fiscal year would have had to be almost double what was actually paid in.
• Taxpayers risk finding that responsibility to back-fill the funding hole falls to them – and potentially finding that fears of sovereign defaults by governments with opaque balance sheets and big exposure to public employee pensions drive up the cost of borrowing.

As mentioned in the report, this situation is not unique to Canadian public-sector pension plans, or even to North American systems. This is a global issue. The good thing about it is that we know about it now. The not-so-good thing is that we’re not doing anything to nip it in the bud.

Black Swans and Running with Scissors

We’ve had similar problems before with the mispricing of assets and liabilities. Of course, it is the subprime CDOs and other real estate derivatives that are fresh in our minds because we’re still recovering from the economic carnage they wrought. Many believe that the problems with the foreclosure process in the United States are a canary in the coal mine for more trouble around the corner.

For years many people warned that the build-up of unregulated derivatives posed a serious threat to the financial system. They were universally dismissed by regulators, politicians, and investors who were making a killing on exponentially rising housing prices. Average consumers loved to see the value of their homes inflating and the extra things they could buy when they borrowed against their home equity.

We all know that bubble did not end well. There is increasing evidence that it was filled with more than air. It was likely helped along by complacency at best and outright fraud at worst. And yet very few people have been prosecuted 2 years after the crash. The whole ordeal has been whitewashed painted as a “black swan” event: a hundred year flood that no one could have predicted.

Most folks with common sense and a reasonable grasp of basic economics could have seen this thing coming miles away. The lax regulation, excessive monetary tinkering and collective obliviousness to the inherent dangers of the policies at the time were the financial equivalent of running with scissors. Someone was inevitably going to lose an eye.

In fact, we all did. But this was no black swan. It was just sold to us that way. Now, with the black paint wearing off the housing-related crash, we’re starting to see those white feathers showing through. And yet another fake fowl is heading our way.

Will We Buy the Black Swan Again?

The C.D. Howe study shows that we will have more trouble ahead if we continue to pretend assets are worth more (and liabilities less) than their fair value. The consequences of this game of financial dress-up are far from innocuous. According to the report, there are plenty of domino effects to go around:

“Taxpayers face two types of risks. One is obvious: responsibility to back-fill the funding hole will fall to them. The other risk is more speculative: as debt levels rise, fears of sovereign defaults will likely drive up the cost of borrowing – for all governments, but particularly for those with opaque balance sheets and big exposure to public employee pensions. Europe’s less fiscally healthy governments now face double-digit borrowing costs and painful budgetary consolidations. US state governments may be next.

They recommend the following to Canadian politicians:

Fair-value reporting of Ottawa’s pension obligations, ideally in conjunction with supporting change in Canada’s public- sector accounting standards, plus a credible plan to manage the costs revealed by a proper measurement of pension liabilities, would help keep Canada off that list.”

A great deal of material information has been withheld from the public, both leading up to and during the response to the financial crisis. The easy monetary policy that helped create the successive bubbles of this young millennium is supposed to inspire confidence in market participants. But perhaps a simple dose of transparency would do the trick. It wouldn’t cost as much as spending trillions of dollars to buy bonds or rescue failed institutions and it might be just what we need to restore the concept of fair value to our alleged free market system.

As much as I would like our leaders to come clean on the true state of balance sheets in the financial industry, pension plans, and sovereign nations, I don’t have a whole lot of faith that anything of the sort is on the agenda. Rather, I think they’re just putting the final touches of black paint on the next “unforeseeable” swan. Or maybe they’ll save a couple of bucks on the paint by using one of the oil-soaked variety that is now prevalent in the Gulf of Mexico.

I wonder how many people will buy the black swan idea again if public sector pension shortfalls really start to cost taxpayers. Would you?