Treasury Inc.: The Shadow National Debt

It has been a rare opportunity to share with this forum my new paper, Treasury Inc.: How the Bailout Reshapes Corporate Theory and Practice, forthcoming with the Yale Journal on Regulation and available here.  This week we have enjoyed a rigorous discussion about the implications of the government as a shareholder in the financial services and automotive industries.

As I expected from the Volokh community, the comments have offered a rigorous intellectual contribution to my work, and for many of the commentators I recommend reading the full paper for answers to their insightful questions.  For this post, I will shift to the implications of Treasury Inc. for the federal budget, the subject of an in-process paper forthcoming with the Louisiana Law Review that will also be the focus of my comments at this years Federalist Society National Lawyer’s Convention.

Government deficits and debt have captured national attention in the last few months owing to their role in the venomous debate over health care reform.  Our nation’s debt is officially $11 trillion. Yet the government’s accounting practices for its ownership in the automotive and financial sectors omit a big slice of the real national debt and annual budget deficit.

When Peter Orszag ran the Congressional Budget Office, he fought the Bush administration over consolidating Fannie and Freddie’s debt into the national budget. His position was that two principles of government accounting require consolidation. Principle one, we control these companies; principle two, we guarantee their debt.  For more, take a look at, after I testified on this issue here, this press release from the Congressional House Oversight Committee about how I discovered the problem described in this post.

The Treasury disputes its control of TARP companies. Yet the government tells GM what kind of cars to build and GM and Citigroup which directors to elect. It tells Fannie and Freddie which mortgages to subsidize.  Secretary Geithner affirms that we stand behind the banks, which means we stand behind their debt as well.  Budget consolidation principle one, check. Principle two, check.

This doesn’t mean we should consolidate debt of all companies taking TARP money, and government accounting principles aren’t fully prepared for this unique situation.  Since the government is acting like a private investor by purchasing common stock, private financial accounting principles also provide useful guidance.

The first useful rule in financial accounting is that consolidation of debt is appropriate where a parent company controls another company by owning a majority of its stock.  This covers GM at 60% Treasury ownership, AIG at 85%, and Fannie Mae and Freddie Mac at 100%.  The second rule is that even if a shareholder has less than 50% ownership, if the equity and non-equity position of the parent combined make it the beneficiary of most of the company’s future profits, consolidation will also be appropriate. This should clearly cover Citigroup, with 34% government ownership (purchased with $40 billion of TARP money) and an additional $301 billion in outstanding guarantees from Treasury.

Look only at the outstanding debt of these five TARP companies (out of over 600 of them). Citigroup has $1.8 trillion in debt; AIG, $807 billion; Fannie and Freddie, $5.2 trillion; and GM, $10 billion. This means that $7.8 trillion is missing from the national debt.

The government predicts annual budget deficits of $1.75 trillion this year, $1.1 trillion next year and similar amounts going forward.  Now, let’s consider adding $7.8 trillion to the national debt.  Amounts added to the national debt should be added over time (in accounting jargon, amortized) into the annual budget deficit.  Over 10 years, that’s an extra $780 billion each year. This means the annual budget deficit would increase by roughly 80%.

Sure, one day we may be able to sell off our government’s equity interests in TARP companies, and eventually remove them from our nation’s balance sheets.  That would be great, and fiscal hawks would be happy to buy the champagne for such a celebration.

Until then, let’s remember that accounting statements for governmental bodies and private companies alike are intended to portray accurate pictures of those organizations at a certain point in time, reflecting the uncertainty of the future and the likelihood that significant owners (or residual credit holders) of most of a firms assets are likely to stand behind that firms debts, for no other reason that it is in their self interest.  Particularly when a shareholder stands as both a creditor AND an unchecked regulator of the company in which they hold shares.

When the U.K. recently recognized in its budget the debt from its two bank bailouts, its national debt doubled overnight. Warnings later emerged that the U.K.’s Triple-A bond rating may be in jeopardy, unprecedented for a modern Western nation.

If we properly accounted for our debt and deficit, we might be in the same situation.  A downgrade of U.S. debt may even be beneficial, a sign that we’ve hit rock bottom and need to recover from this deficit addiction.  Credit warnings would result in a diminished appetite for Treasury bonds, force the Treasury Department to borrow at higher interest rates and curb its habit for runaway spending.

Administrations are short-lived.  But the debt remains, and it is a legacy by which our children will rightly judge us.

The full faith and credit of the U.S. is not a depthless well, and our nation’s current budget policies risk turning Treasury bonds into the ultimate subprime loan.  Future generations could be saddled with inflation, increased taxes and interest payments on Treasury bonds that take up an ever-increasing share of the federal budget.

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