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.

The imaginary economy?

Speaking at the Asia-Europe summit Chinese Premier Wen Jiabao recently said, “The biggest responsibility is to stabilise the financial order as soon as possible. We need to use all available tools to prevent the crisis from harming real economies.” The Premier’s comment is hardly in isolation. Take, for example, an article recently published in the Times under the heading Banking crisis infects the real economy, or one from The Economist on Oct 9th titled The banking crisis overflows into the real economy. You will note the continued use of the phrase “real economy” in all of these articles – as though Wall Street and the banking sector could somehow be considered in isolation from that other place where people are born, work, eat, sleep and die.  

I even met a student of economics (studying at the University of Vienna) who told me that the entire banking crisis was ridiculous and that the problem was simply mass hysteria… a psychological problem. Her belief was that if everyone simply believed in the system that it would be fine. The problem, in her view, was a lack of faith. Once again, I was surprised by the hidden implication that losses in the money markets were somehow unrelated to daily affairs – as though the bankers and stock brokers of the world were busying themselves by day playing an elaborate game of monopoly which bore no relation to the homes we live in or the food we eat.

However only those leading the meanest of subsistence lifestyles, completely divorced from any kind of trade, could be somehow immune to events of the markets. In the era of specialization we are all bound to the market. Firstly it is the place in which we sell our products and services (which are far too specific and specialized to be useful in such abundance to us as individuals) and secondly they are where we source all those things which we do not make ourselves – which for most of us is virtually everything.

And in the market place it invariably occurs that one individual might need the services of another, without having any services that the other person might want in exchange. The lawyer who wants a haircut, for example, can probably offer very little to the hairdresser in terms of legal advice, in exchange for the haircut. Instead the lawyer must find (and offer) the hair dresser something that the hairdresser does want. And even the hairdresser cannot necessarily offer the baker haircuts every day or every week in exchange for bread. Perhaps the baker is bald. So the hairdresser too needs something of value to offer the baker, the dentist and the plumber in exchange for their services (especially if all these later happen to be bald). Naturally people seek out products which are readily tradable to fulfil this purpose – a commodity which others will readily accept for their services – and this becomes money. Money is a readily tradable commodity which emerges from the economy – a medium of exchange to help resolve the problem that all of the various business people above have – the double coincidence of wants.

However, although this function (a medium of exchange) is important and can hardly be overstated – perhaps money’s most important role is much less obvious. For money, as Carl Menger pointed out, having emerged from the economy initially as a medium of exchange then starts to serve a very different purpose. Once money has emerged and one can readily trade goods for money and money for goods, it becomes possible to compare the prices that people pay for goods in the economy in terms of that common reference. Of course, people will pay different things for even the same goods. One person might pay $1.10 for a loaf of bread where another pays $1.20, but in sufficiently large markets where competition is present someone who happened to have a few hundred loaves of bread would probably be able to gauge with a fair degree of accuracy how much he or she might be likely to sell that bread for based on the recent sales of similar products in the market. And so one might be able to estimate the potential monetary value of, for example, a few hundred loaves of bread or a box of beer or a house or a swimming pool.

The monetary value that we attribute to things (based on recent prices that they fetched in the market place) then makes it possible to compare the relative exchange values of different products and services in the economy and makes possible the otherwise impossible task of accounting. With a common unit of estimated value that can be attributed to each of the assets that a person holds, as well as a unit by which they might measure their revenues and expenses, it is possible to gauge the profitability of one’s activities. And when seen as an aggregate, the sum of the activities of all of the businesses in a particular region might be tallied to gauge whether their activities have been profitable or not.

What exactly does profitable mean in this case though? Certainly, in the absence of inflation or deflation, someone running a profitable business will end up either with more money and/or controlling more capital at the end of the year than they had at the start. This will no doubt be the primary incentive for individuals to own and maintain profitable companies. For the economic system as a whole though, the most important characteristic of profitable companies has very little to do with money. What is important for the economic system is that when companies are profitable they consume less than they produce. By contrast, when companies consume more than they produce they are said to make a loss. Of course, the consumption, production, profits and losses are all expressed in monetary terms but that does not mean the companies are actually consuming money (it doesn’t “disappear” when they use it – it is merely transferred). What they consume is resources, such as steel, iron, health insurance, mathematical modelling services etc. And what they produce is some similar form of real, tangible good (maybe computers or apple pies). 

So although the profits of companies are expressed in monetary terms, the real benefit that profit making enterprises bring to the economic system is much more important than money. What profitable companies provide to the economy is goods and services of a higher exchange value than that of the goods/services that they consume. Perhaps these enterprises produce a greater quantity of goods than they consume (as might be the case of an Orchardist who borrows a bin of apples, uses the seeds to plant trees and then gives back a few tonnes of apples a year a little further down the line – essentially taking 50 apples and turning them into 50,000 apples), or more likely they transform things that are liked less into things that are liked more. They take wood and turn it into houses, steel and turn it into cars. You give them rags and they give you back lavish gowns. In short, they make people wealthy.

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. Those companies in our economy which make losses cost us (normally shareholders – but in the present day the government has taken it upon themselves to spread the pain far and wide, to be borne by any productive citizen that they can get their paws on) and the cost is not merely monetary. 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).

The creation of new money cannot fill the void that loss making companies (or banks) leave in their wake. Indeed, the losses that companies make are made on the basis of historical records and time, as we all know, only moves in one direction. There is no way, short of a time machine, to undo the losses that those companies make. The only thing that can be done is to try to prevent such companies from making losses again in the future, which is best achieved quite simply by dissolving the companies in question – freeing the resources that they consumed (including labour) to be used by the remaining companies in the economy that are profitable.