"Orwellian accounting cannot damp economic cycles"

The very fact an op-ed piece (more accurately, comment, as they call them in the Financial Times) by Paul Boyle against airbrushed accounting needed to be written at all is troubling.

A move is afoot that appears further advanced than I realized is to fool with financial firm statements so as to reduce the procyclical impacts, ahem, namely that asset prices rise in boom periods and fall in busts.

This is the ultimate contradiction of “free markets” thinking. One of its tenets is that you don’t need regualtion because ever-wise “the market” will quickly figure out fraudsters. No joke, folks like Frank Eastabrook (a leading light of the law and economics crowd) argues that the fact that people buy stocks means “the market” does an adequate job of policing. Um, that “the market” just happens to have strict requirements re disclosure, accounting, and bans against insider trading and market manipulation like front running.

But we went a fair way down the “free market” path, the banks and the public went on a leverage spree, and now we have a really big costly mess.

Since it is costly to clean up the wreckage, we are going to have phony accounting to make banks look better to induce people to invest. The whole point of this exercise is to lower the cost of capital. Just like housing prices in the US are the result of misunderstanding and irrational pessimism, so to is leeriness to invest in large capital markets firms that are increasingly hedge funds in banks’ clothes also clearly the result of faulty thinking, So in addition to having the Fed buy tons of mortgage paper to keep financing rates down to boost home prices, the proposal is on the table to massage bank financials so as to correct investor misunderstandings about them.

The entire logic behind the “free markets” school of thought was that they were ever and always virtuous, that markets could always price the risks of firms correctly, and the best approach was to impose regulatory capital requirements that would mimic what “the markets” would require. I am not making this up; Greenspan said precisely that in a speech in Tokyo in 1996.

Now that that movie did not end as happily as everyone expected, the powers that be are trying to manipulate perceptions that admit the construct failed.

From the :

The financial crisis has generated a philosophical debate about the role of accounting, notably the extent to which it is pro-cyclical, exacerbating booms and busts….

Yves here. Boyle largely dispatches this idea, but he somehow fails to assault the core problem. Any collateralized lending is pro-cyclical, period. As asset prices rise, banks think their loans are better secured and that their customers are richer, since they have stronger balance sheets. Even if they do not loosen lending standards, the mere fact of rising asset prices means they will lend more against the same collateral. This process tends to continue until debt servicing becomes a problem (unless asset prices are well behaved and do not rise faster than GDP or incomes) and asset prices start to fall because strained borrowers don’t want to take on more debt. Fewer buyers for the same assets means prices start to fall, and the leverage leads to a stronger downswing just as it fed the rise. This has nothing to do with accounting, it is a function of how collateralized lending can easily an asset bubble. Back to the article:

However, it is not clear that accounting has the potential to be a public policy tool to reduce pro-cyclicality, nor that it would be appropriate to use it in this way.

An equally, or perhaps even more, dangerous argument now gaining currency is that accounting should be given an explicit role in promoting financial stability, rather than its traditional role of providing information useful to investors in their decision-making. The implication of this view is that accounting measures that show volatility should be adjusted to create an impression of stability.

Accounting is a measurement system that presents the financial performance and position of a company in as neutral a way as possible. It is not surprising that banks report substantial profits when the economy is doing well and reduced profits, or even losses, when the economy is doing badly. This is accounting reflecting the economic cycle, which is a good characteristic of a financial measurement system.

Can this reflection of the economic cycle become too much of a good thing, and pro-cyclical?

To answer this, it is worth considering the dangers of altering other measurement systems to make them less pro-cyclical. It could be argued, for example, that unemployment statistics have damaging pro-cyclical effects. Low unemployment numbers make consumers feel confident, thus encouraging them to borrow and spend at levels which might prove unsustainable. High unemployment numbers make consumers worried, causing them to reduce their spending and pay off debts, with the undesirable consequence of even greater unemployment.

Yet no-one seriously argues that it would be in the public interest for the unemployment statistics to be adjusted in the interests of financial stability.

One could also argue that house price statistics are pro-cyclical; reports of rising prices encourage consumers to make more purchases at higher values, thereby driving up prices further. Reports of falling prices have the opposite effect. I have not heard pleas that the national statistics agencies should intervene to prevent these seditious numbers being disclosed to a public who cannot be trusted to react in a way consistent with financial stability.

If there were to be an intervention to adjust the reported economic numbers then the monetary authorities, and perhaps a small number of other people in influential positions who could be trusted to respond appropriately, would have to be permitted to see the true figures.

Most people would regard this as a deeply unattractive prospect with Orwellian implications. It is for this reason that calls to adjust accounting measures to make them less pro-cyclical should be treated with suspicion.

The way in which consumers or investors will react to statistical or accounting information is not easy to determine in advance, as it will be influenced by a large number of variables. It is, therefore, not reasonable to expect that national statistics agencies or accounting standard-setters should be asked to predict those reactions, far less take a view as to whether those reactions are “good”, in making their measurement choices.

Those who argue that accounting should be amended to make it less pro-cyclical must believe investors are not to be trusted to react appropriately to unadjusted numbers. Once again, however, there would be certain people, including prudential regulators, who would have to be trusted to see the raw figures.

It would, though, be hard, perhaps impossible, to persuade investors to fund financial institutions without showing them the true, unadjusted numbers…

It may well be appropriate to attempt to reduce the volatility of economic cycles, but there are more appropriate tools than accounting to achieve this.

A related comment, “I” by Bernie McSherry, is also worth reading.

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20 comments

  1. Anonymous

    That is the most long-winded explanation of "Earnings Smoothing" that I've ever read.

    It's still illegal, right?

    IdahoSpud

  2. attempter

    Yet no-one seriously argues that it would be in the public interest for the unemployment statistics to be adjusted in the interests of financial stability.

    I don't know how things are in Britain, but in America that's exactly what they've been doing with unemployment, inflation, consumer price, and "growth" data for at least fifty years now.

    It's funny that he calls this a "philosophical debate" when it's just the same old tactical debate on what kinds of lies to tell to prop up market fundamentalism as an ideology. Is the old lie still sufficient, or do we need a new one?

    In this case, the old lie was that accounting was neutral in theory. Now they feel the need to ask whether it should be rendered explicitly political.

    Here again America already took a demagogic step, replacing mark-to-market with what sarcasm aptly calls "mark-to-management".

  3. Richard Kline

    Boyle: "Yet no-one seriously argues that it would be in the public interest for the unemployment statistics to be adjusted in the interests of financial stability." No one argues for this; everyone just goes ahead and does it and hopes that the public won't catch on to the con. And so the Big Financials are whining, "If the government does it why can't we?"

    Investors buy plenty of things with opaque financials; these are called 'corporations.' The answer? Don't buy it, build it. Where's yer entrepreneurial sprit fellas?

  4. Dave

    This seems like a terrible idea. Encouraging companies to fudge the numbers? Really? I can't get behind this one at all. How would this interact with Sarbanes-Oxley in the US? It's a strange financial world these days.

    -Dave

  5. Siggy

    This is a discussion that should not be occuring. Acounting statements should reflect the current state of the enterprise. Editing the statements to present a most favorable picture in the name of promoting market stability is nothing more than sewing up a wardrobe of emporers clothes.

  6. Anonymous

    "Yet no-one seriously argues that it would be in the public interest for the unemployment statistics to be adjusted in the interests of financial stability.

    One could also argue that house price statistics are pro-cyclical; … I have not heard pleas that the national statistics agencies should intervene to prevent these seditious numbers being disclosed …"

    That's because no executives are compensated for reducing unemployment, nor for stabilizing home prices. In fact, given many executive compensation schemes, a few layoffs will only increase the amount of money paid to those at the top, at least short-term. And make no mistake about it, short-term is ALL that counts.

    This is just another aspect of a contradiction in our understanding and use of Psychology — we are constantly telling persons to do one thing, while simultaneously providing attractive incentives to behave in exactly the opposite way.

    Leaders can jawbone corporations, financial and otherwise, all they want about doing the right thing socially — avoiding pro-cyclical RIFs, re-negotiating mortgages and the like. As long as there are tons of money to be made by pro-cyclical behavior, it is just hypocritical (and plain stupid) to expect that talk to trump cash.

  7. Thinking Accountant

    The new accounting rules are the worst of both worlds. Fair value accounting will still encourage excessive leverage through secured borrowing in bull markets while flexible fair value accounting and weak impairment rules make banks looks better in bear markets.

  8. Hugh

    If cooking the books got us into this mess, then cooking them can get us out of it. What could go wrong?

  9. zaebst

    Curious as to what prompted this. Did anything happen recently or is it the new Mark to Market guidelines:

    "Financial institutions are still required by the rules to mark transactions to market prices but more so in a steady market and less so when the market is inactive (Wikipedia Mark-to-market)"

  10. skippy

    Let me get this straight, I would need a CPA, Psychologist and Merlin to encode/decode a financial statement. Sweet, it brings on a new dimension to boardroom meetings, round table filled with a cast of characters (Renaissance fair at work).

    I decree codpiece's for all!

    Skippy…Hay Vinny G. new growth industry for you mate!

  11. moslof

    If you read Paul Krugman's columns about banks before and after his dinner meeting at the White House you can surmise that Orwell is alive and well…….

  12. JO

    I am tired of hearing the message about how "free markets" are to blame. Make no mistake, we have not had anything close to free market capitalism…a debt based, highly leveraged fractional reserve, fiat money system is the result of explicit gov't action to allow a private agency (the Fed) the right to micro manage short term interest rates, misdirect captial, and make other policies that extended the leverage in the system. A true free market banking system, while very likely never possible due to political wishes, would be based on a currency managed to maintain a value based on a commodity index, and no central bank. In addition, leverage in the system would be reduced until such time the fractional reserve ponzi / counterfeiting operation is eliminated as the amount of credit outstanding roughly matches the amount of savings. Taking it one step further, in a pure free market monetary system, the gov'ts monopoly on legal tender would be eliminated as the large banks would issue their own currencies backed by their reputation and safety ratings…other basic elements that contributed to this nonsense we are going through and prove it is gov't/central bank/commercial bank manipualtion that caused this is all gov't laws that seek to provide an advantage to an industry or create artifical demand in a sector. None is a better example than the home insurance buying programs where the weakest borrowers were permitted to buy homes using fraudulent taxpayer backed "guarantees" which allowed a massive issuance of shaky debt with weak covenents and artificially low rates. I can go on and on, but the point is free markets were not the main cause of this deep recession…look to your friends in government and the Fed. The danger of letting the myth of the big bad free markets go on is that the same morons who got us into this will preach for more regulation and control over our lives…meaning less wealth and less liberty.
    JO

  13. Yves Smith

    JD,

    You need to read Steve Keen. You are mistaken re credit mechanisms. We live in a credit money system, not a fractional reserve banking system. Fractional reserves do not contrain lending.

    Second, I am not fan of the Fed, but do your homework. We had far more frequent panics in the 19th century, under a hard money system. You also need to do your research on the record of the gold standard. Infation rates whipsawed under it. going from marked and volatile inflation to deflation. The record for any gold standard country will show that pattern. That is very destructive to investors and to businesses. You cannot plan or make investments with that much uncertainty.

  14. Hugh

    You know JO when Bush had 90% approval ratings after 9/11, conservatives were saying that he represented the triumph of conservatism and that Republicans would be in the majority forever. But after years of lies, bungling, and deception Bush's approval ratings went into the toilet in his second term and stayed there. Suddenly, conservatives discovered that Bush really wasn't a conservative at all, and that therefore conservatism was not to blame for his failures.

    Now the same thing seems to be happening among free marketeers. On the upside of the bubble, free markets got all the credit. Securitization and deregulation proved that the markets really did know better. All we had to do was let the unseen hand work its magic. And then housing crashed and then finance generally. And suddenly markets were no longer free, never had been, etc. In other words, in good times, markets worked and in bad times, it was government's fault.

    Personally, I doubt if there has ever been a truly free market in the history of the world. I do not see this as a bad thing, just the way things are. For me, what is important is who controls the market and for whose benefit. Knowing that helps me understand what has and will happen in the economy.

    As a postscript, I should note that, unlike the conservatives' embrace and then rejection of Bush, progressives never claimed Obama as one of their own. Even for those who supported him eventually in his campaign he was their third or fourth choice. For myself, I have already started a scandals list on Obama, something I did not do on Bush until early 2007. When Obama crashes and burns it will not be because he pursued progressive ideals but because he saw his Presidency as Bush and Clinton's third terms.

  15. skippy

    @Yves said…We live in a credit money system, not a fractional reserve banking system.

    From reserve to credit manufacture of currency and the difference in flow direction/velocity upon creation is beastly (markets usage). On one hand one affords rapid adjustment, where as the other tries to smooth out the curve especially in trying times(pick your poison?).

    Is the Fed's problem staff or mandate…um don't know, but I do have a GS frat boy problem (collusion).

    Skippy…have I learned any thing yet teach.

  16. attempter

    As a postscript, I should note that, unlike the conservatives' embrace and then rejection of Bush, progressives never claimed Obama as one of their own. Even for those who supported him eventually in his campaign he was their third or fourth choice. For myself, I have already started a scandals list on Obama, something I did not do on Bush until early 2007. When Obama crashes and burns it will not be because he pursued progressive ideals but because he saw his Presidency as Bush and Clinton's third terms..

    That's almost word for word how I might've phrased it. It was last December that I started my "Obama Ownership" sheet, where I would list Bush policies as Obama took personal ownership of them.

    It's already a pretty long list.

    (For anybody who's interested in this subject, my last blog post is my "Obama Six-Month Report Card".)

  17. skippy

    @Hugh and attempter…agreed [?] America is under new management for re-branding, but from the same investors and for their vested interest and not the over all health of the country, economic or socially.

  18. Dave Raithel

    What all this brings to my mind: Fred Von Hayek's little essay on the problems of central planning due to information flows. Of all the arguments offered for "free markets", it's one I've taken seriously (which is not to say I concur, but only that I still think about counter-arguments.) So what's worse (and worse for whom, would follow): Inefficiencies due to bad data at central planning, or calamity accounting for all the facts?

    From whom do we permissibly withhold the truth? Small children and the feeble minded. Yeah, let's build a culture on that motif ….

    Wait, we might already have one.

  19. Anonymous

    That's because no executives are compensated for reducing unemployment, nor for stabilizing home prices.

    shhhhhh… Don't tell Obama!

  20. M_Biz

    Coming from an engineering background, this seems to be a positive back loop with too high of a gain & very little damping. You could dial back the gain (raise capital requirements) in order to elimitate the bubbles, but that would be too much of a drag especially when coming out of the hole of a recession. The other (better) approach is to add damping to the system to smooth the zigs and zags. One possiblity is to require banks and government spending to be managed to moving average of a number of years, perhaps 10 or 20 (inflation adjusted of course). It is not a perfect solution but would be far better than the extreme boom/bust cycles that otherwise will occur.

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