The real position of the global economy and of the current global debt bubble is currently hiding behind a mask of accounting and legal trickery…
Editor’s Note: Following John’s article is the embedded YouTube video of John Adams and Martin North discussing this topic.
The real position of the global economy and of the current global debt bubble is currently hiding behind a mask of accounting and legal trickery.
During the course of 2017 and 2018, two shocking stories were revealed by key global institutions that at least $US 20 trillion (or $AUD 28 trillion) of debt were hidden in systemically important countries and economic sectors through the use of ‘off-balance sheet’ accounting and legal classification techniques.
For example, in September 2017, analysis by the Bank of International Settlements (BIS) discovered that non‑bank institutions outside the United States owed up to $US 13 trillion via financial instruments such as foreign exchange swaps and forward contracts which were hidden in the footnotes of the bank’s financial statements.
The BIS reported that this debt was hidden from the plain view of the market and of the public through the use of contemporary accounting conventions that allowed the classification of these debt instruments as off‑balance sheet items.
“For the US dollar alone, contracts worth tens of trillions of dollars stand open and trillion change hands daily. And yet one cannot find these amounts on balance sheets. This debt is, in effect, missing…. The debt remains obscured from view. Accounting conventions leave it mostly off-balance sheet, as a derivative, even though it is in effect a secured loan with principal to be repaid in full at maturity. Only footnotes to the accounts report it.”
Also, in recent weeks S&P Global Ratings reported that at least 40 trillion yuan or $US 5.8 trillion of debt within the Chinese local government sector has been concealed through the use of ‘off-balance sheet’ classifications in order to meet the ‘debt quotas’ set by the Chinese national government. Such quotas have been an important policy measure for officials in Beijing who have sought to rein in total level of debt within the Chinese economy.
Such is the quantum of debt uncovered by S&P credit analysts, that these analysts believe the overall level of Chinese local government debt carries significant systemic risks for the Chinese economy and therefore carries important implications for the global economy.
Alarmingly, S&P analysts stated in their report that “the potential amount of debt is an iceberg with titanic credit risks.”
However, and unfortunately, these case studies of accounting and legal masking techniques are not isolated examples.
At the individual corporate level, examples abound across the world of corporations using a variety of ‘aggressive accounting’ techniques to improve the appearance of the company’s financial performance and financial position.
For example, the former second largest construction company in the UK, Carillion who declared insolvency and collapsed in January 2018, used a variety of accounting techniques to artificially inflate its revenue and therefore its profits, but also to mask significant debts and therefore present a robust balance sheet to the market and to shareholders.
Such accounting techniques were also present prior to the collapse of Lehmann Brothers in September 2008 and the major corporate collapses of Enron and Worldcom in the 2001.
More broadly, these case studies are typical examples of such accounting and legal techniques that are often employed during economic booms and financial bubbles. Indeed, analysis and commentary by UK investigative reporter Richard Brooks in his 2018 book, “Bean Counters – the triumph of the accountants and how they broke capitalism” illustrates that during economic booms and financial bubbles:
auditing standards tend to be watered down, resulting in audits either not identifying or not addressing significant instances of financial risk, financial mismanagement or accounting issues;
accounting and financial fraud increases; and
the deployment of aggressive or creative accounting techniques which are permissible within the accounting standards are used with greater frequency.
This behaviour manifests itself throughout key sectors such as governments, financial institutions and other large corporations as they seek to exaggerate their financial position and performance in order to:
artificially promote economic, business, investor and customer confidence that spurs further economic activity and growth through additional investment and consumption;
meet and even exceed the economic expectations of select stakeholders such as corporate shareholders; and
realise short-term personal gains (e.g. through higher executive compensation and higher share prices).
It is concerning that these reported examples are most likely the tip of the iceberg and provide another warning sign that a global financial debt bubble is evident, and that the bubble is likely to be materially larger and more unsustainable than that which is publicly understood.
The implications resulting from the deployment of such techniques are significant, not only for public policy makers, but also for the average Australian citizen who is managing their own economic affairs.
For Australian policy makers who are responsible for:
assessing Australian and international economic and financial market conditions including determining domestic and international levels of systemic risk; and
setting macroeconomic and macroprudential policies such as fiscal, monetary and banking policies;
the deployment of such techniques that cannot be identified in real time mean that policy makers are likely to have incomplete data and therefore inaccurate risks assessments.
As a result, public policy makers are likely to misread domestic and international economic conditions and set inappropriate public policy settings necessary to promote sustainable economic growth.
Moreover, for the average Australian who is seeking to protect and grow their wealth, the ability to identify the deployment of aggressive accounting techniques, especially for those with either a lack of time or forensic accounting skills, is extremely difficult.
For these Australians, therefore, the ability to assess the commercial attractiveness of potential investment options and of financial risk becomes very challenging.
Alternatively, those Australians who hope that professional financial advisors and investment managers would be better able and better equipped to identify sophisticated legal and accounting masking techniques and therefore be able to protect and grow client wealth are likely to be disappointed.
Professional money managers have, time and again, been caught out by accounting and legal tricks.
A recent example is Scottish Asset Manager Kiltearn Partners who lost approximately 70 million pounds on its investment in Carillion as they relied heavily on the company’s financial statements to determine their investment attractiveness.
Ultimately, Australians who are seeking to protect and grow their wealth, especially during times of economic booms and financial bubbles, need to consider what asset classes and investment options are less likely to be subject to potential financial accounting and legal trickery and therefore cannot be subject to financial manipulation.
Investors who can allocate capital to specific investments within these asset classes prior to economic booms and financial bubbles collapsing are more likely to retain their wealth relative to other investors who typically experience significant financial losses.
For those investors who are seeking not to be a victim of accounting and legal trickery, the answer lies in real physical assets such as land, real estate, precious metals, fine art and collectables which the owner has direct ownership and physical control over.
John Adams is the Chief Economist at As Good As Gold Australia