How good accounting can save the world – including Greece

Jacob Soll, author of the acclaimed history of accounting, The Reckoning: Financial accountability and the rise and fall of nations, is more than a little unnerved by the Greek financial disaster.

“It’s crazy,” he says. “My historical data is getting played out in real time.”

For years, successive Greek governments relied on cheap international credit to fill a growing chasm between weak tax revenues and massive spending. Official statistics that showed average growth rates of 4.2 per cent a year between 2000 and 2007 lulled investors into complacency. Greece, it seemed, was one of the eurozone’s star performers. 

As it turns out, this economic success story was an illusion. Following a change of government in 2009, it was revealed that Greece’s budget deficit, instead of being the previously reported 3.7 per cent of GDP, was in fact 13.6 per cent.

It soon became apparent that the Greek government had for years been using flawed and misleading statistics to provide a dangerously inaccurate picture of how the economy was faring.

As we now know, crisis beckoned, and the cost of such deception is being felt not only by Greece’s citizens, but those across the eurozone as well. For Soll, a history professor at the University of Southern California and winner of a MacArthur Fellowship (the “genius grant”), it’s depressingly familiar. The Reckoning (Basic Books, New York, 2014), released last year to widespread acclaim, sets out to show that good accounting has been a foundation of prosperous societies.

 

"Societies not prepared to hold themselves to account are setting themselves up for crisis."

 

He details how through the ages, sovereigns and governments indulging in shonky accounting practices have paid a price – and their citizens have paid right along with them.

Soll links the rise of the Medici family in Renaissance Florence, the vast commercial success of the Dutch Golden Age of the 1500s and 1600s, and the strength and reach of the British Empire, to the exercise of robust and transparent accounting standards, particularly the use of double-entry bookkeeping.

While Soll argues good accounting is a well-established key to prosperity, it is a lesson that through the ages has been frequently forgotten or ignored.  Neglecting accounting has frequently imposed a cost on individuals, families and shareholders.

To Soll, for instance, the Medici Bank declined as the family’s younger generations drifted away from the rigorous accounting practices of their hard-nosed patriarch, Cosimo de’ Medici.

Soll draws a connection between accounting and accountability not just in business but also in governments and entire societies. He says the seeds of the French Revolution were sown when the Sun King, Louis XIV, decided not to replace his top accountant, Jean-Baptiste Colbert, after Colbert died in 1683.

The monarchy lost track of the nation’s finances, and by the time of Louis XIV’s passing in 1715, France was bankrupt.

No accounting for crisis

So what can a history of accounting tell us about the current dire financial state of countries including Greece, and prospects for the international economy? Quite a lot, it seems.

By most analyses, the global financial crisis had its origins in the private sector, as banks and other lenders offered easy credit to increasingly marginal borrowers, and packaged those debts in opaque bundles that were traded on financial markets with little regard to their quality.

Soll draws a connection between accounting and accountability not just in business but also in governments and entire societies.

The public sector’s financial fragility also became painfully apparent. Governments on both sides of the North Atlantic, as well as in Japan, quickly racked up massive debts as their revenues plunged and they moved to bail out beleaguered banks.

Nations including Ireland, Greece, Spain and Portugal went to the financial brink. Yet while the financial crisis might be the proximate cause of the financial woes of many governments, Soll contends that lax accounting standards over many years laid the ground for the current difficulties.

He also argues that while in many respects Greece’s successive governments and major banks must carry much of the blame for the country’s current predicament, its creditors, most notably Germany, are just as culpable.

Beware Germans bearing gifts

While the German government has tended to play the role of the importuned benefactor in the current eurozone crisis, the American historian says the Germans, and to a lesser extent the French and the Italians, have had a direct hand in helping get Greece into such deep financial trouble and keeping it there.

He particularly points the finger at a succession of restructuring plans in 2010, 2011 and 2012 in which the Greek government was loaned billions of euros at the virtually giveaway rate of 2 per cent over a 40-year term. To give such loans on such terms to a country that was already in such desperate financial and economic straits, Soll considers the height of irresponsibility.

More than that, he says, it was the start of the political crisis in which the euro area now finds itself mired.

 

"The seeds of the French Revolution were sown when the Sun King, Louis XIV, decided not to replace his top accountant."

 

Despite its gripes about bailing out debtor countries, Germany has been a major beneficiary of the arrangement, Soll points out. If Germany still had a standalone currency it would be much stronger than the euro, particularly since the global financial crisis struck. Pricing its exports in the euro has kept German exports keenly competitive in international markets.

This alone gives Europe’s strongest economy a compelling reason to try to maintain the viability of the euro. The German public’s patience with its indebted euro neighbours, however, appears to have all but run out (a Politbarometer poll on 30 January found 76 per cent opposed any further bailouts).

Soll maintains it is only thanks to opaque accounting practices that Germany has been able to hide the true cost of its Greek bailouts from its citizenry.

While many governments around the world, including Australia and New Zealand, use accrual accounting in accordance with International Public Sector Accounting Standards, Germany’s federal government continues to report on a cash basis. This has allowed the German government to treat its multibillion euro contributions to the Greek bailouts as loans which can be counted as assets. If they were straight-out transfers or grants, they would be counted as losses. (Given the poor repayment prospects, however, a loss is the more realistic outcome.

 

"Sovereigns and governments indulging in shonky accounting practices have paid a price – and their citizens have paid right along with them."

 

“That transfer, those grants, don’t go onto the books for the Germans, so it appears they have no deficit, when in fact they have a much bigger deficit than they say,” Soll explains.

Maintaining the appearance of strong public finances has become very important politically for the German government, he says, because it has held open the lifeline of cheap credit: while Germany can borrow at 2 per cent, neighbouring governments are being forced to borrow at rates of 10 per cent or more.

What’s more, by not booking the losses, the German government does not have to admit to its citizens that it has essentially given tens of billions of euros to Greece, with almost no prospect of ever getting it back.

If  Greece were to default, the Germans could then credibly blame the loss on the Greek government. It is, Soll says, “the most irresponsible policy I have ever seen in my life … The Greeks are at fault massively, but a lot of it is the fault, in particular, of the Germans. Greece is a mess.”

The historian is aghast that the German government has pursued what he considers a calculated gamble to push Greece to the financial brink – or even over the brink – in order to paper over its central role in the saga, regardless of the likely cost in human misery and potential political instability in the strategic eastern Mediterranean.

“It’s a scary situation. It will undermine the European Union, it will undermine the euro, it will lead to extremist parties in Europe. It is also a humanitarian disaster. This is like a World War I-type scenario.”

The next financial shock

While Europe, and particularly Greece, has occupied much of the world’s attention, another serious financial storm may be developing on the other side of the Atlantic.

In June the government of Puerto Rico, a US territory, declared it was no longer able to service its US$73 billion of debts and put creditors on notice that many would have to take on losses.

Puerto Rico’s plight has followed a string of bankruptcies affecting several US cities and counties since the global financial crisis, most notably the City of Detroit, which in 2013 declared itself bankrupt owing US$18 billion.

Detroit’s crisis was caused by a combination of accumulated large liabilities – particularly unfunded municipal employee pension schemes, economic recession and heavy population loss. Last year the city managed to crawl its way out of bankruptcy after its creditors, including the pension funds and bond holders, agreed to accept a US$7 billion loss.

Soll thinks these are far from isolated cases. He warns that while the financial books of the US federal government are rigorous and transparent, the same cannot be said for many state and local governments. Lax accounting standards have allowed major states and cities including Massachusetts, Illinois and Chicago to rack up huge liabilities, particularly unfunded employee pension plans.

Instead of granting municipal staff, teachers, police officers, firefighters and other local and state employees pay rises that would go straight on the books, many local and state governments have offered workers increasingly generous pension schemes without making proper provision for the accumulating liability. The result, says Soll, is to push these administrations into an increasingly precarious financial position.

Though the prospect of a major US state such as Massachusetts declaring bankruptcy appears remote (and may not be legally possible), it is hard to see how such a financial shock can be anything but damaging for the world’s largest economy, which is still recovering from recent traumas.

Relearning the lessons

He may have a deeper perspective than most, but Soll is not a lone voice on accountability for debts. The chairman of the International Accounting Standards Board, Hans Hoogervorst, recently reflected that opacity was the scourge of financial markets, observing that “what is not measured is not managed”.

Soll warns that societies not prepared to hold themselves to account are setting themselves up for crisis. The basic lessons of medieval Italian accounting are still as pertinent today as they were 700 years ago. In particular, accounting and financial accountability are essential to wealth and political stability – but also “incredibly difficult, frail and even perilous”.

It’s frustrating that such a hard-earned lesson has so frequently been ignored or forgotten.