The time for real public financial management has arrived

4 December 2022

Based on the introductory part of a lecture given at the Aula Magna in the University of Pisa for the European Court of Auditors Autumn School By Jorge Nunez Ferrer (23 Nov 2022) (shortened version)

Public expenditure as share of GDP has been rising over the 80s and 90s considerably, this means that in real terms it simply has been rising faster than GDP itself. Today the share is often close to 50% of GDP and in some cases beyond. From a political point of view, we should consider that we are somewhat hitting the ceiling on the size of and taxation by the public sector. The fiscal space is limited and for many countries their bed sustainability is at risk.

Thus, when seeking to address today’s challenges we have to consider seriously public accounting and financial management. We cannot look only at spending MORE money, but rather at spending BETTER.

The share of public spending on DGP has a strong impact on the socio-economic performance of countries. But somehow performance was not assessed and the ‘raison d’Etat’ has often been accepted as a normal justification for government actions.

Somehow, until the recently public expenditure evaluation seemed to be considered largely unnecessary. Most countries do not follow existing international guidelines for public accounting standards (IPSAS) and waste is by many considered as a necessary side effect of public expenditures. It was mentioned to me once as a (partial) joke that the GDP growth is value added of the private sector minus the GDP losses of the public sector. Well, it is in fact more true than it seems. Is this necessary? not at all, it is a choice. But things are changing!

Today’s returns to public expenditure are not a given. The 70s, 80s and 90s large returns to basic infrastructures are over. Mistakes can be costly when operational costs exceed returns across many badly made “investments”. Repeated crisis and no fiscal space require a change in attitude.

The financial crisis revealed bad mistakes like big bleeding wounds, with countries having been net recipients of EU funds seeing the worst impacts from the crisis. An explanation of the bad performance of Greece can be found in the concerning and puzzling results in studies that found the impact on the growth rates of Greece disappointingly low and in some cases negative for regional growth. Behind such results many point out institutional factors.

The pressure is mounting to assure that the overall performance of public expenditure offers a strong value added, because wasted funds may not only be a loss to the state but have considerable negative implications to the economy and society. This is even more valid at national level than for the EU budget, which is rather limited in size.

There is a wide practice of economists erudite in the jargon of economics to discuss large flows of billions of Euro ignoring the details of the actual targets of expenditure leaving this nuisance to accountants. Over time, however, the more we focus on the economic impact of public investments, the more difficult it becomes to escape the realisation that tedious and boring accounting, monitoring and auditing are not just some kind of tedious tasks of lesser value to be placed on accountants and auditors, but are central to public sector efficiency and macroeconomic sustainability.

In other words, details matter, and public financial accounting and management needs a big leap in quality. Many public authorities seem to be unable to distinguish public investments from running costs, consider the returns to investment of expenditures to society, or the need to protect key investment areas of high value added when public funds are cut.

The times of the quick return of the ‘public buck’ are truly over, so we need to learn to reform public expenditure and investment quality.

Dag Detter, author of the PUBLIC Wealth of Nations (an acclaimed book by the Economist), has been insisting for years on the need to reign on accounting standards and increase the number of accountants in the public sector. In addition, public financial management is in dear need in many countries. Public accounting standards and financial management are key to the famous “RESILIENCE” objective we have plastered on the recovery programme, but these are sorely neglected, everybody focusing instead in attributing to every country an obligation of spending the same fixed percentage in green and digital expenditures regardless of local needs and circumastances.

The IMF itself is increasingly focusing on the accounting standards, noting that the financial crisis has hit hardest where public accounts were worse, cadastres incomplete and public financial management absent. As a famous motto says, “what you do not measure you cannot manage”.

Many practices in the public sector financial (mis)management deserve being buried deep. In fact, the same accounting and reporting practices in the private sector would land you in prison, for example for not fully reporting assets and liabilities. Annual budgeting practices need to be overhauled, bringing in lifecycle costing and the net worth of the expenditure, not only on some marginal green procurement.

A measure that now should become core is net worth:

What is net worth? This is the net value of assets held by individuals, sectors, or the government. The public sector net worth increases the value of public assets, and we can also estimate the impact on the economy in general. New Zealand introduced this in the accounts as a pioneer, with net worth in the public sector balance sheet, and measuring the change in net work in the national accounts for businesses, households, and government. It allows a clear picture of the direction of the economy and incites better policy making, influencing the policy debates.

We should pay more attention and have some standards across the EU. With 50% of GDP we are approaching a ceiling in the fiscal space, i.e. ability to tax further. This is shifting the attention to finding innovative borrowing, but that has limits and can be very damaging in the Eurozone over time. The problem was very clearly expressed by Paul Kazarian (CEO of Japonica and expert on bond markets and public accounts) in the CEPS annual ideas lab 2018:

Ideas Lab short interview with Paul Kazarian

Lack of proper public accounting standards and the lack of transparency affects the trust between member states and negatively impacts trust in the Eurozone. The extreme differences in the net worth impact of the bailouts during the financial crisis has very detrimental effects in the ability of the member states to agree on common responses to economic shocks. for details please refer to the CEPS report “Beyond Public Debt – The Hidden Rapid Erosion of EU Government Balance Sheets is a Financial Threat to Society – How to stop it“.

Not all is lost and behind the scenes the message has partially passed through. Greece announced the full introduction of international public accounting standards and public financial management standards. Portugal is also advancing fast in this direction, as the consequences of not knowing what the government assets are and the state of financial assets were extremely costly.

The seriousness of the impact of public policy structures in member states is reflected in the important structural reforms requirements in the Recovery and Resilience Facility (RRF), which include administrative reforms. However, public accounting standards are not directly addressed by the RRF and financial management only indirectly.

As the pressure mounts on public finances and debt sustainability concerns rise, a serious look on the efficiency of funding and the management of public assets becomes essential. Will we see the dawn of proper financial accounting, transparent and complete government balance sheets, and proper financial management practices in the public sector?

The most important potential role of public accounting standards is the ability to use of the accounts as their capacity to inform policy makers in their decisions. Their timely publication should be accompanied with estimations of the net worth of public assets (and their change) and estimations on the value added the public expenditure has generated directly or indirectly to the economy. Without a clear useful picture from the accounts, their publication becomes irrelevant for policymaking and a lost opportunity for society. Given the limited fiscal space and levels of public debt, this area offering considerable space for improvement must be considered.