Measuring the Cost of Government Activities That Involve Financial Risk

Many of the federal government’s activities involve financial risk, which can take various forms. For example, the government provides support for risky credit activities through investment and insurance programs. In addition, the government issues loans and guarantees loans made by private financial institutions, which expose it to the risk of high rates of default. It insures bank deposits and pension funds, which expose it to the risk of higher costs if many banks fail or if pension investments earn smaller returns than expected. The government levies taxes, which produce revenues that fluctuate depending on the performance of the economy. Likewise, spending automatically varies for the safety-net programs that the government provides, again depending on economic conditions.

All of those activities create the risk that deficits will be larger than expected when the economy is weak, as well as the possibility that they will be smaller than expected when the economy is strong. That risk is passed on to government stakeholders—both beneficiaries of government programs and taxpayers—for whom, as investors, it would have a cost. An increased deficit in a weak economy occurs when resources are scarce and particularly valuable and incomes are low. Because people find costs to be particularly burdensome under those circumstances, positive and negative deviations from the average do not balance out when people weigh the risks associated with future outcomes.

One approach to measuring the cost of government activities uses their projected average budgetary effects. The estimated cost of most government activities, including those that are subject to risk, is based on their average projected effect on the government’s cash flows. For example, the Federal Credit Reform Act of 1990 (FCRA) bases the cost of loans and loan guarantees on their average default rates and the associated losses.

An alternative approach, called fair value, incorporates a fuller cost of risk than is reflected in the average budgetary effects. Fair value includes market risk, which is the financial risk that remains even with a well-diversified portfolio and that depends solely on the performance of the economy. Government stakeholders are exposed to that risk when the government provides credit assistance or invests in a financial asset, such as an ownership stake in a private business. The fair-value approach provides information to policymakers on the cost of such risk, whereas the FCRA approach does not.

Estimated costs can differ significantly depending on how they are measured—budget savings under FCRA can become costs under fair value, for instance—and those costs directly affect the federal budget and the resulting deficits and debt. This Congressional Budget Office report explains the details of each approach, the qualitative differences between them, and their application to various activities and programs.