The things we know that aren’t true
October 18, 2016 § 49 Comments
Most not-financially-literate people think that sound financial management is about cash flow. This is wrong, even badly so, but it is at least somewhat workable for a household to a first approximation: as long as you keep bringing in more cash than you spend, the wheels stay on.
Institutions are nothing like that. (Even households aren’t really like that, but it kinda sorta works to a first approximation). What is more, what looks like cash flow for an institution like the United States Government, isn’t. So everything you think you know about USG finance is wrong: an illusion created by a superficial, outright false analogy.
In layman’s terms, a balance sheet is an inventory of all of the property that an institution controls and all of the various financial claims against that property. It is impossible to know the financial health of an institution, including whether things are getting better or worse financially, without understanding (under whatever labels) the institution’s balance sheet and the trajectory of its balance sheet; that is, the changes happening to its balance sheet.
In traditional accounting these are reported as balance sheet (at a point in time), profit and loss (over some interval), and cash flow (over the same interval). The first is a fundamental snapshot of the financial state of the institution; the latter two tell us specifically how the institution is changing financially.
Balance sheet is fundamental. It provides the current financial state of the institution at a particular point in time. The other two reports tell us what financial changes happened to the institution over the reporting period.
Profit and loss measures (roughly speaking) the gain or loss in ‘equity’, that is, it answers the question (in great detail) “what has happened to the value of all of the property on the balance sheet, minus the satisfaction of all of the remaining financial obligations against that property?”
Cash flow measures the flow of liquid property (“cash and equivalents”): property which can be easily and quickly traded for something else. Cash flow is of secondary importance: you have to keep an eye on it to make sure you keep enough liquid property on hand to pay your bills on time, but in general liquid property is not as productive as other capital so it is best to keep it to a manageable minimum.
People think that USG revenues, expenditures, and deficit numbers give meaningful insight into cash flow. And many believe that the ‘national debt’ provides meaningful insight into the health of the (nonexistent) USG balance sheet.
They don’t. Intake and outflow of fiat dollars does not constitute cash flow or an approximation of it, and the balance sheet and P&L are a complete black hole.
The reason fiat dollar flow doesn’t constitute a USG equivalent for cash flow — as I have explained many times now — is that we can’t measure the change in balance sheet liquidity of an institution using securities issued by that very institution as a metric. Measuring Google ‘stock flow’ is not meaningful information, in itself, about changes in the health of Google’s balance sheet. And in the case of USG we don’t even know what kinds of things we ought to be using to measure, or what specifically we ought to measure, etc.
That is, we cannot answer the question “what is happening to the liquidity of USG’s balance sheet?” — BECAUSE WE DON’T HAVE A BALANCE SHEET.
We also cannot answer the question ‘what is happening to retained earnings’, or a thousand other pertinent questions.
What we actually have in terms of real information is no balance sheet, no P&L, no cash flow, and some back-and-forth in the institution’s own securities which create the illusion of something kinda sorta similar looking to cash flow as long as you don’t pay attention.
And the biggest danger here is not the things we don’t know. As some wag said, the biggest danger here is the things we know that aren’t true.