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Thursday 2 August 2012

Screwed: Fictional Profits, False Accounting and Financialization

Double Entry: How The Merchants of Venice Created Modern Finance by Jane Gleeson-White
"So it has come to this. The global biodiversity crisis is so severe that brilliant scientists, political leaders, eco-warriors, and religious gurus can no longer save us from ourselves. The military are powerless. But there may be one last hope for life on earth: accountants."

Back in the Thirteenth Century, when Venice ruled the waves, we can find the origins of modern capitalism.  Back then the portents were vague, but the invention of bookkeeping and the introduction of Arabic numerals foreshadowed a revolution based on the stunningly original idea of being able to figure out whether or not your business was making a profit.

Roll forward six hundred years and we find that those inventions, suitably adapted, have not just stood the test of time, but have insinuated themselves into every nook and cranny of modern life.  Welcome to the world of financialization where earnings per share is an imaginary number and money is the only objective measure of everything. Only it isn't.

Cost-Benefit Paralysis

Despite the inauspicious title  Double Entry has a fascinating and relevant tale to tell, cutting a swathe across history from the creation of double entry bookkeeping – probably in India – through its documentation by Luca Pacioli in 1494 – and its viral spread via the introduction of printing (see: Book Value).  The idea that bookkeeping underpins and may have even been responsible for capitalism itself is an underlying theme, and a fascinating one.

However, it’s when the story reaches the twentieth century, and bookkeeping turned into accountancy and accountants became the arbiters of what is right and wrong that the tone turns to a darker shade.  Three factors contributed to this – the increasing complexity of accounts, the creation of national accounting systems, and the widespread introduction of cost-benefit analysis as a basis for decision making.

Creative Accounting

Ever more complex accounts have led, inexorably, to a rise in creative accounting to the point where the concept of earnings is an entirely malleable one.  Amongst many fascinating anecdotes Gleeson-White tells the tale of one Australian firm whose first set of accountants declared the firm entirely solvent, whose second set determined that it was bankrupt and whose third set (brought in to arbitrate between the first two) decided that both these positions were correct.  So much for objectivity. And the firm went bust anyway.

The development of the concept of national accounts based on the concept of double-entry bookkeeping, aka GNP, largely spurred by John Maynard Keynes’ attempts to quantify the economic status of countries during and after the Second World War, has led to nations increasingly focussing on this single number as a measure of economic health.  As Keynes, and many others have pointed out, this ignores so many aspects of a nation’s critical performance, that it’s a nonsense to rely on it alone.  Gleeson-White quotes Bobby Kennedy's famous 1968 speech approvingly:
"Yet the gross national product does not allow for the health of our children, the quality of their education, or the joy of their play. It does not include the beauty of our poetry or the strength of our marriages; the intelligence of our public debate or the integrity of our public officials. It measures neither our wit nor our courage; neither our wisdom nor our learning; neither our compassion nor our devotion to our country; it measures everything, in short, except that which makes life worthwhile. And it tells us everything about America except why we are proud that we are Americans."
Unfortunately, as is often the way of these things, it’s easier to rely on an objective number that doesn’t mean anything than subjective ones that do.

Scarcity is not a Number

Finally, cost-benefit analysis, the demon brethren of accounting, has become the predominant method of allocating scarce resources and therefore making decisions.  This has led to a moral calculus in which companies will sometimes sacrifice safety features for customer deaths, because the books show that this is the economically "sensible" thing to do:
"Ford waited eight years because its internal "cost benefit analysis", which places a dollar value on human life, said it wasn't profitable to make the changes sooner."
Pinto Madness, Mark Dowie

The problem with this is that cost-benefit analysis can only take into account things which actually have a financial value: so to make this work human life has to be monetised, and once that happens so can terrible moral misjudgements if corporations use profit maximisation as their touchstone.  This problem extends to things like trees, which generally don't have an economic value until they’re cut down and hewn into useful things like stakes for hammering into the hearts of immoral businessmen.  In essence the whole of economics regards nature as a cost free benefit, so it never appears on either side of the books.

These factors have contributed to the financialization of the world – the increasing preference for managing all aspects of our existence in terms of the numbers as they appear on the balance sheet.  Yet as we’ve seen, these numbers are often either fictitious or erroneous, and the general effect is to ensure we’re all left in a state that I'd technically describe as "screwed".

Gleeson-White gleefully relates the various accounting scandals of the past decade, everything from Worldcom to Enron to Madoff, in relation to these problems, and pins the collapse of the banking system in 2008 on much the same set of issues.  The financialization of the world’s decision making process has removed morality and replaced it with extreme short-termism, where the next quarter’s profits are regarded as more important than … well, than anything.

Derivative Dangers

Overall this has led to an extreme focus on cost-cutting and huge job insecurity, the creation of a class of extremely insecure but highly incentivized managers and a belief that profit maximization is the only measure of success, no matter what the consequences in the longer term.  The objective measure of a firm’s performance, the accounts, can become a subjective set of opinions, open to manipulation and even fraud in order to achieve these ends in the hands of the wrong people – and, as we saw in Is Your CEO a Psychopath?, these measures are ensuring that the wrong people are increasingly in positions of power in our corporations. 

The outcome of this race to the bottom is that we can’t really trust the books of any company that’s engaging in anything to do with derivatives, or other complex accounting treatments.  Basically, if you can’t understand the accounts then you shouldn’t invest – because the likelihood is that either the firm’s managers don’t understand them (see Totally Addicted to Debt) or they do but don't want us to.  This would have the beneficial side-effect of meaning we would avoid most financial corporations, which is no bad thing as business models based on picking up pennies in front of a steam-roller are never sustainable.

Our Last Best Hope

Double Entry is a history lesson, an accounting primer and an economics thriller.  It’s riddled with good research, throwaway anecdotes and pithy commentary.  Perhaps, though, its main lessons are simple – there are no objective measures of corporate truth outside our trust in managements. Such is the power of financialization that it’s unlikely it will be reversed so the alternative is to conscript it to our aid.  Rather than relying on a world dominated by economic cost-benefit analysis coming to its senses we need to start developing proper systems of accounting for the value of the natural resources we’re so happily using without thought for the future.

It would be ironic if the thirteenth century invention of bookkeeping that we described in In The Beginning Were The Accountants was to lead to us destroying the environment that we depend on.  Unfortunately while we’ve evolved the urge to reproduce we haven’t evolved a similar urge to ensure our offspring have a decent world in which to live (see Tax Notes To An Unborn Grandchild).  By a strange and ironic quirk of fate it seems that our last, best chance lies in the hands of the accountancy profession that's responsible for screwing up the world.  Heaven help us.

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  1. Thanks for the wonderful review.

  2. Thank you for the review. I will definitely have to check this book out.