The real cost of poor accounting

I recently wrote about the tangible consequences of the profits and losses that entrepreneurs in the economy make:

“When companies make a loss then, what goes missing from the economy is not money either… indeed, if under our present banking system this happens from time to time this is entirely incidental. More importantly, for human concerns, is the fact that loss making companies consume many more resources than they give back to the economy… The loss is not fictive or imaginary – it is not some wild hysteria or a lack of faith in the system – it is the loss of those real resources that the company consumes (steel, iron, health insurance and mathematical modelling services).”

However it must be remembered that the profits and losses that companies announce are estimated on the basis of the company’s accounts. These accounts will be maintained, and thus the profits and losses expressed, in monetary terms, and the ledger entries in theses accounts will contain monetary valuations of the various assets, liabilities, revenues and expenses relating to the company’s operations. 

In the absence of any significant inflation or deflation of the currency, these valuations will ordinarily be fairly accurate estimates of the relative values of the capital used to operate the company. For, the goods and services that make up the capital, income and expenses of companies will be purchased in markets and the monetary value of these things will be the result of a all of the market participants trying to outbid one another for available resources (such as land, labour, wood and steel). Different companies may pay different things for the same goods and some companies will abstain from purchasing goods that they consider too expensive at a price that is entirely acceptable to other companies that happily purchase at that same price (thus reflecting the fact that these goods have different values for different companies). However if the average price paid for a kilo of oak is higher than the average price paid for a kilo of steel then we can say that oak has a higher relative value, per kilo, than steel to the economic system as a whole. This is perhaps because it is preferred by consumers or perhaps because it is more scarce than steel. Regardless, it will indicate that oak can only economically be put to more important uses whereas steel might be used for purposes that were more mundane.

What if, however, we were to hack into the accounts of all of the companies in the nation and replace the prices that they actually purchased or sold steel for with some other random price? Surely their profit and loss statements at the end of the year would be much less accurate than they were before, would they not? If the price that we substituted into their accounts was lower than the price that they had actually paid then the companies that purchased steel would appear to be more profitable and the companies that sold steel would appear to be less profitable than they actually were. Such an accounting error might force some of the steel producers into liquidation, despite the fact that these companies were in reality entirely beneficial to the economy and producing much needed steel. Similarly, such an accounting error might prevent various companies that buy steel from realising that they were not profitable – with the result that these loss making entities would continue to consume real resources from the economy where it simply was not rational for them to do so, from the point of view of the economic system as a whole.

Even if the switcheroony that we performed with the steel prices didn’t cause any companies to liquidate entirely, it would certainly confuse the price signals in the market place such that steel producers were tricked into believing there was less demand for their product than was the case (thus cutting production) and such that steel consumers were tricked into believing there was more steel available than was the case (causing them to wastefully put steel to uneconomic uses).

The negative consequences of our meddling would therefore be twofold. On the one hand our actions would imbalance supply and demand and, if we were to continue to meddle with the company’s books over a long period of time, would eventually lead to a steel shortage. Secondly however, our actions would undermine the ability of companies (and thus the economy as a whole) to accurately gauge their profitability. Of the two side effects, this later could well be the more serious since it will cause ongoing long term real losses to society and the economy as a whole.

One of the primary costs of most companies, of course, is the cost of borrowing. However interest rates do not currently emerge naturally from a free and competitive market. Indeed, in as much as they concern our present discussion the price paid for savings by borrowers is set by central banks entirely arbitrarily. This is not to say the interest rates are set randomly without any consideration to current market conditions. However the relative preferences of consumers (borrowers) and producers (savers) are entirely ignored by central banks when setting interest rates and even the relative scarcity or abundance of real savings in the market place, it seems, is paid very little heed. Primarily what motivates central banks in setting interest rates today is a peculiar Keynesian notion of full employment and, as though the two were somehow diametrically opposed, a “watchful eye” on inflation to balance this.

The fundamental meaning of the accounting concept of profitability, it seems, does not even enter into the equation. Certainly attention is paid to broad statistics such as the CPI, PPI and the GDP. However the fact that interest rates – one of the primary costs incurred by every entrepreneur in the economy – are not an accurate reflection of the real costs of borrowing both to companies and to the economy as a whole means that the ability of every entrepreneur and every borrower in the economy to gauge their profitability has been severely undermined, in real terms. Hence the ability of central banks to calculate the profitability of the economy as a whole and the relevance of statistics such as the GDP is also undermined (even if these statistics were accurate – which is rather doubtful considering the methods currently used to calculate both inflation and the GDP).

What this means is that the normal mechanisms for ensuring that only profitable activities take place (i.e. liquidation and bankruptcy) and that production remains positive with respect to consumption are not working properly. There are millions (perhaps billions) of entrepreneurs all over the planet making what they believe to be profits when in fact these entrepreneurs are a burden to the societies that they live in – consuming scarce savings of real resources which are, as a consequence, no longer available to be put to truly profitable uses. In wasting those resources, the societies that employ central banks have prevented the existence of countless profitable companies that most certainly otherwise would have existed and which, far from being a burden on our societies, would have enriched them and employed just as many people (if not more) than the unprofitable companies resulting from a misguided Keynesian “full employment” policy.

Fundamentally the fault of central banks is that they do not focus on that which should be the focus of all economics – the satisfaction of human needs. Instead they focus on the much narrower goals of the “need for employment”. And in their pursuit of that narrower goal they disregard entirely whether or not the “employment” that they seek to encourage is profitable or not, and thus whether or not their actions (even should they succeed in realising the desired objective) will be good or bad for the economy.

Socialism and central banking

As Mises demonstrated in his brilliant essay “Die Wirtshaftsrechnung im sozialistischen Gemeimwesen” (Economic Calculation in the Socialist Commonwealth), the crucial failing of socialism is the absence of any pricing mechanism with regard to producer goods (which are owned by the state). Although money operates in a socialist state, its uses are confined to the purchase of consumer goods. Producer goods (such as factories etc.) are “publicly owned” and directed by the state, as is their productive output. The result was that it was impossible for any prices to form in the markets for  manufacturing goods because there were no such markets. The socialist administrators could not say whether a new tractor was more urgently needed than a new plane or train… whether 100,000 spanners was more valuable than 500,000 nuts and bolts. They had absolutely no objective means of determining what quantities of the manufacturing goods in their economy (which were owned by the state) were required in order to satisfy people’s present and future needs by producing all of the consumer goods that were demanded. They could perhaps say that people wanted more spanners, but without any objective means of calculating the cost of producing these it was impossible to say whether this was an economic use of scarce resources – whether they should produce these instead of nuts and bolts, if they ever found themselves in a situation where they had enough resources to produce one but not the other (which in a world filled with scarcity they invariably did).

Mises’ argument is quite subtle and better explained by Mises. If you were to pull a basic lesson from the essay though, it would be that prices are essential to a healthy functioning economy. Steer well clear of any inclination to use tariffs, price ceilings, price floors, price targets etc.

The problem with our current banking system is essentially the same as that of the Socialist Commonwealth – namely that it is centrally controlled. There is no competition in the money making industry and nor is there any semblance of market determined pricing. The only institution that can inject further US monetary reserves into the global economy is the Federal Reserve Bank and when they do so they fiddle with a price – that being the price of savings (i.e. interest rates). But, as Mises pointed out, prices can only emerge from a free market when individuals are able to trade freely. There is no way that a central authority can calculate what the price of goods should be in the absense of any free market exchange of those goods. Furthermore, prices serve a pivotal role in the economy. They serve as a communication mechanism between producers and consumers. On the one hand, prices communicate to consumers the relative scarcity or availability of goods and consumers can use this information to make sure that they’re only putting goods to economical uses. On the other hand prices serve as a signal to producers as to the relative importance of goods. If the price of something goes up, producers know they need to up production (and if they don’t then new entrants will come into the market to do so, in a freely competitive market).

In a free market the prices of consumer goods will determine what people use them for. Take the price of grain for example. If grain is relatively expensive then, likely as not, people will continue to eat it but they won’t be feeding it to their livestock. If the price of grain plummets to an all time low (lets say 50 cents a tonne) then people would start doing all sorts of crazy things with it. At that price, it would be cheaper than hay, so they’d feed it to their cows, their goats and their horses. They’d probably even make compost out of it to put on the vegetable garden; they’d feed it to birds at the park and use it to paint jackets on snow men at Christmas time. All of this would be fine if grain was at 50 cents a tonne because there was actually way too much grain around and grain producers literally couldn’t get rid of this stuff. The logical result in such a case would be for the price to fall until inventories could be cleared and probably for a few grain producers to get the hell out of the market. However, if there was actually a grain shortage going on and global grain stocks were falling, and governments decided to react to this shortage and seeming inaccessibility of grain to the poor by capping the price of grain or subsidizing the price of grain, what happens is the following. Firstly, the fact that the price of grain is not allowed to float up prevents a crucial signal from being sent to the producers, letting them know that increased production of grain is required. Secondly, the artificially low prices of grain in the markets trick consumers into thinking that certain uses of grain (for example feeding cattle) are economical even though this is not the case given the current supply of grain. What results in such cases are wide scale shortages. Producers don’t produce enough and what little grain there is can be obtained by some people for unrealistically low prices so that they use it to feed their cattle whilst other people that desperately need it for more important uses (such as eating it) go hungry.

Now, back to the banking industry. The Fed sets an extremely important price. It sets the price at which savers sell their savings to borrowers. What’s difficult to grasp here is that savings are not just abstract dollar notes. When I save, I am implicitly producing something of value (e.g. I bake some bread) and providing it to the economy whilst simultaneously not consuming anything (I don’t take anything back from the economy). As the baker, I might save a couple of hundred dollars a week. What I’m actually saving though is not dollars, but loaves of bread – I’m creating a surplus of a few thousand loaves of bread in the economy which have been created, but not consumed, and are available to be “invested” by a borrower who can eat that bread for a while, during which he will not be baking any bread (e.g. while he’s building a garage in his back yard). All around the economy there are millions of people in all walks of life that are saving in this manner. Some of them are saving flour, some are saving metal, some are saving wooden planks – yet others are saving accounting services and computer programming services and yet others again are saving health insurance or health care. All of these things are very real physical resources – resources that will be required by investors that need to “borrow” from the economy to start new companies or buy tractors for their farms etc. and the interest rates that savers negotiate with borrowers is the “price” of savings. This price serves as a crucial signal between savers and borrowers (investors that will be starting companies or building new homes or whatever) as to the quantity of real savings that are available to be borrowed.

If you muck around with that price then what happens is exactly the same thing that you get in any other industry (for example the grain industry). If you cap the price of savings (i.e. interest rates) artificially to levels that are below what they would otherwise be in a free market, you do not in any way magic into existence any additional real savings. What you do is prevent crucial signals being sent to producers (savers in this instance) to indicate that additional savings are required – so people stop saving. Additionally you provide false signals to borrowers such that they are tricked into thinking that the use of these scarce savings towards certain purposes is economical where, in fact, if they knew the true market price for these savings (a price which reflected their actual scarcity) it would be clear that this was not the case. The result is that people borrow money to build homes that it wasn’t economical to build or they borrow money to start dot com companies that sell toilet paper on line or any number of other hair brained schemes that never would have been undertaken if the cost of borrowing was 8% or 12% or whatever market rates would emerge for savings in the absence of the Federal Reserve.

What we see emerging from this system so far is the random allocation of scarce real savings via subsidized interest rates to all manner of uses, some of which are economical and some of which are not (the same phenomenon that was witnessed with regard to producer goods in the former Soviet Union). Some of the people borrowing money have genuinely good and profitable businesses to start with it, but there is no discrimination between these good uses of the money and unprofitable uses. If interest rates were higher then only those businesses which were capable of turning a profit at higher interest rates would continue to borrow – the rest would go out of business fairly quickly and so the unprofitable activities would be culled off. However with artificially low interest rates savings are put to both the economical and uneconomical uses. This is a mistake since there are not enough real savings to see the successful completion of both the genuinely profitable businesses and the uneconomical ones (such as the online toilet paper business). There are only enough savings for some of these enterprises to succeed and by lending money (and real savings) to both you not only ensuring the certain failure of many (or even all) but do not even necessarily ensure that the profitable businesses are the ones that succeed (if any do). At some stage, midway through the various business ventures that are being undertaken, it will be discovered that the quantity of real savings available in the economy was not sufficient to see the successful fruition of all of those projects that were started and then you have an economic crisis. Even though we might try to pretend for a while that savings are less scarce than they actually are (by artificially lowering interest rates) reality comes home to bite eventually when the level of real savings is discovered (typically when they are exhausted). In basic terms, because the price of savings is too low, essentially the little grain you have is being used to feed the cattle while the people go starving.

What needs to be done, and must be done, if we want to avoid ever more serious wide scale shortages of real savings resulting in cyclical failures in the economy (recessions and depressions) is to eliminate the monopoly that the Federal Reserve currently has on the issuing of money. If the issuing of notes was left to the free market and both the banks and the public knew that there was no “lender of last resort”, then people would quickly become aware that putting your money in an interest bearing account at the local bank was not in fact the safest thing that you could do with it, so long as that bank retains any less than 100% reserves (which will be almost unavoidable if they are to pay you interest). People would quickly realize that putting money in banks was implicitly an investment that had risks associated with it (quite serious risks – most banks only maintain 3% reserves so they are basically leveraged 30 to 1 – more risky than most futures or options trades carried out by day traders) and after a couple of banks went under and everyone lost their deposits, no doubt they’d start looking for alternative places to put their money. For example, people might put their money in money warehouses which maintained 100% reserves but charged a fee for storing your money. Perhaps a solution in between a money warehouse and a bank would emerge – for example a bank that maintained say 80% reserves and didn’t charge you a fee but didn’t pay you interest, or any number of other combinations which would certainly result in a genuine free market in banking. In such a free market, the failure of individual banks would not engender a global economic collapse and would be no more serious than the failure of a large supermarket or any other business. It certainly would not require trillions of dollars of tax payer’s money, increased regulation or government intervention.

There is nothing inevitable about the socialist nature of our current banking system. Banking does not have to be centrally controlled any more than baking bread must be centrally controlled, in order to ensure its stability. Flour mills and bakers have been supplying our cities with bread for quite literally hundreds of years without so much as a minor hiccup in supply. There have been no bread crisis, no regular bread cycles or wild fluctuations in the price of bread… they’ve just been stoically pumping out a good quality reliable source of food for billions of people for as far back as anyone can remember. This miracle is achieved by Adam Smith’s famous invisible hand – i.e. by the emergence of free market prices which are so conspicuously absent from our modern banking system.

The collapse of so many societies in history has been accompanied by a debasement of their currency that it would be impossible to count them. We cannot get rich by pretending we live in a fairy tale universe where water, metal and oil are any less scarce than they actually are. All that we can do is decide (as far as possible) the most pressing uses for scarce resources and make sure that as much as possible these are the uses they get assigned to. To date, the only mechanism we have discovered of performing that immensely complex task is the free market pricing system (not, you will note, as mainstream commentators are indicating, increased government regulation or coordinated central banking policies).