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Revisionist View of the Great Depression - Part II


The Finest Invention of the Human Brain
One of the plays of George Bernard Shaw branded "unpleasant" by the playwright himself is entitled The Doctor's Dilemma. The protagonist is a physician who comes into conflict with the Oath of Hippocrates (fl. 460-377 B.C.) He has developed a new treatment for a fatal disease, but the number of volunteers for the test-run exceeds by one the number of beds in his clinic. Unwittingly, the doctor finds himself in the role of playing God to decide who shall live and who shall die.

By the same token Shaw could have written the 'most unpleasant' play of them all entitled The Book-Keeper's Dilemma. In it the protagonist, a chartered accountant, finds himself in conflict with the norms and rules of book-keeping as set out by Luca Pacioli (fl. 1450-1509). Our book-keeper was willing to compromise the high standards of the accounting profession. Beforehand the question "how much is two times two?" was categorically answered "four". Now, creative accounting would respond: "how much do you want it to be?" Our book-keeper dropped a snowball that caused an avalanche, ultimately destroying Western Civilization down in the valley.

Luca Pacioli taught mathematics at most universities of Quattrocento Italy including those of Perugia, Naples, Milan, Florence, Rome, and Venice. In 1494 he published his Summa Arithmetica. Tractatus 11 of that work is a textbook on book-keeping. The author shows that the assets and the liabilities of a firm will exactly balance out, provided that we introduce a new item in the liability column that has been variously called by subsequent authors "net worth", "undivided surplus", "shareholder equity" or, simply, "capital". This innovation makes it easy to check the ledger by finding that, at the close of every business day, assets minus liabilities is exactly equal to zero. If it is not, then there is an error somewhere in the books. But what Pacioli discovered was something far more significant than a method to find errors in the arithmetic. It was the invention of what we today call double-entry book-keeping, and what Goethe has called "the finest product of the human brain" (cf. Wilhelm Meister's Apprenticeship).

Why was this discovery so important in the history of Western Civilization? Because, for the first time ever, it was possible to calculate and monitor shareholder equity with precision. This is indispensable in starting and running a joint-stock company. Without it new shareholders couldn't get aboard and old ones could not disembark safely. Nor would stock markets, mergers, acquisitions be possible. The national economy would be a conglomeration of cottage industries quite unable to undertake any large-scale project such as the construction of a transcontinental railroad, or the launching of an intercontinental shipping line. The invention of the balance sheet did to the art of management what the invention of the compass did to the art of navigation. Seafarers no longer need to rely on clear skies in order to keep the right direction. The compass has made it possible for them to sail under cloudy skies with equal confidence. Likewise, managers no longer have to depend on risk-free opportunities to keep their enterprise profitable. The balance sheet tells them what risks they may take and which ones they must avoid. It is no exaggeration to say that the present industrial might of Western Civilization rests on the corner-stone of double-entry book-keeping. Oriental (Chinese) or Middle-Eastern (Arab) Civilizations would have outstripped ours had they chanced upon the discovery of the balance sheet first.

Barbarous Relic or Accounting Tool?
For the past 70 years the world has been fed the propaganda-line, due to Keynes, that the gold standard is a "barbarous relic" long since ripe to be discarded. The unpleasant truth, one that propagandists have forgotten to mention, is that the gold standard is merely a proxy for sound accounting (as well as moral) principles. Nor was it the gold standard per se that politicians wanted to overthrow. Certain accounting and moral principles had become an intolerable fetter upon their ambition for aggrandizement and perpetuation of power. Historically these principles had been singled out for discard before the gold standard was given the coup de grâce. The first successful attack on accounting standards was heralded by the establishment in 1913 of the Federal Reserve System, the engine for monetizing government debt. Just how this has led to a hitherto unprecedented, even unthinkable, corruption of accounting standards — this is a question that has never been addressed by impartial scholarship before.

The Rate of Interest and the Wealth of Nations
In order to see the connection we must recall that any durable change in the rate of interest has a direct and immediate effect on the value of all financial assets, just as tides and ebbs have on the level of boats anchored in the harbor. Rising interest rates make the value of bonds fall, and vice versa. But while a rise makes the Wealth of Nations shrink and a fall in the rate of interest makes it expand, the benefits and penalties are distributed capriciously and indiscriminately, without regard to merit. This was hardly disturbing under the gold standard as the rate of interest was remarkably stable and changes in the Wealth of Nations were negligible. A lasting increase in interest rates could only occur in the wake of a national disaster such as a flood, earthquake, or war. In all these cases higher interest rates were beneficial. They had the effect of spreading the loss of wealth due to the destruction of property more widely. Those segments of society that were lucky enough to escape physical destruction still had to take their share in the loss through the increased cost of servicing capital due to the higher rate of interest payable on future borrowing. Everybody was prompted to work and save harder in order that the damage might be repaired more quickly and expeditiously. As interest rates gradually fell back to their original level, the Wealth of Nations expanded. Again, benefits were shared in the form of reduced cost of servicing productive capital on future borrowing. It is not widely recognized that the eminence of the gold standard is not to be found in a stable price structure (that is neither possible nor desirable) but in a low and stable interest-rate structure maximizing the Wealth of the Nations, ruling out capricious and disturbing swings in it. The gold standard, which was taken for granted before World War I, was put at risk once general mobilization was ordered in 1914 by the manner in which belligerent governments set out to finance their war efforts. They wanted to perpetuate the myth that the war was popular, and there was no real opposition to the senseless bloodshed and destruction of property that could have been prevented through better diplomacy. The option of financing the war effort through taxation was discarded as it would make the war less popular. The war had to be financed through credits. In more details, war bonds were to be issued in unprecedented amounts, subsequently monetized by the banking system. Naturally, these bonds could not possibly be sold without a substantial advance in the rate of interest. Accordingly, the Wealth of Nations was shrinking even before a single shot was fired or a single bomb dropped.

Tormenting Widows and Orphans
Under the gold standard bondholders are protected against a permanent rise in the rate of interest (which in the absence of protection would decimate bond values) by the provision of a sinking fund. In case of a fall in the value of the bond, the sinking fund manager would enter the market and keep buying the bond until it was once more quoted at par value. Significantly, sinking fund protection was offered by every self-respecting firm issuing bonds. Even though governments as a rule did not offer it, it was understood and, in the case of the Scandinavian governments explicitly stated, that if a permanent rise in the rate of interest occurred, then the entire bonded debt of the government would be refinanced at the higher rate. Bondholders who had put their faith in the government would not be allowed to suffer losses. The banks, guardians of the people's money, could regard government bonds as their most trusted earning asset. Such faith, at least in the case of Scandinavian government obligations, was justified. The risk of a collapse in bond values was removed. Governments, at least those in Scandinavia, occupied the moral high-ground. They had borrowed money which, in part, belonged to widows and orphans. They took to heart the Biblical admonition. They did not want to bring upon themselves the curse pronounced on the tormentors of widows and orphans.

The Law of Assets
But there was a problem with war bonds issued by belligerent governments. These bonds were quickly monetized by the banking system making the refinancing of bonded debt impossible. This created a dilemma for the accounting profession. According to an old book-keeping rule going back to Luca Pacioli that we shall here refer to as the Law of Assets, an asset must be reported in the balance sheet at acquisition price, or at the market price at the time of reporting, whichever is lower. In a rising interest-rate environment the value of all financial assets such as bonds and fixed-rate obligations are falling, and the fall must be faithfully recorded in the balance sheet. There are excellent reasons for this Law. In the first place, it is designed to prevent credit abuse. Without it banks and other lending institutions could easily overstate the value of their assets — an invitation to reckless use of credit to the detriment of shareholders and depositors. If the abuse went on for a considerable period of time, then it could lead to the downfall of the bank. In an extreme case when all banks disregarded the Law of Assets, the banking system could be operating on the strength of phantom capital and a general credit collapse might be the result. For non-banking firms the possibility of overstating asset-values also exists, and could likewise serve as a temptation for financial adventures. Even if we assumed that upright managers would always resist it and would not knowingly get involved in such adventures, in the absence of the Law of Assets the balance sheet ceased to be a reliable compass to guide the firm, materially increasing the chance of making an error. Managerial errors would compound, and the result could again be bankruptcy.

Economists of a statist persuasion argue that an exception to the Law of Assets could safely be made in case of government bonds. The government's credit, like Caesar's wife, is above suspicion. The government's ability to retire debt at maturity cannot be doubted. As a guarantee, these economists point to the government's power to tax, as well as to its power to collect seigniorage. However, the problem is not with paying the nominal value of government bonds at maturity, but with its purchasing power. Currency debasement is a more subtle and hence more treacherous form of default. The government, however powerful, cannot create something out of nothing any more than an individual can. It cannot give to Peter unless it has first taken it from Paul. Nor is the taxing power of the government absolute. Financial annals abound in cases where taxpayers revolted against high or unreasonable taxes, thereby causing the overthrow of government and forcing the cancellation of bonded debt. If the taxing power of the governments had been absolute, then World War I could have been financed out of taxes and no loss of purchasing power to bondholders through debt-monetization would have occurred.

A strict application of the Law of Assets would have made most banks and financial institutions in the belligerent countries insolvent. The dilemma facing the accounting profession was this. If accountants insisted that the Law be enforced, then they could be considered "unpatriotic", and be held responsible for the weakening financial system of the country. Demagogues could charge that the accountants were undermining the war effort. On the other hand, if they allowed the banks to report government bonds in the asset column at acquisition-value rather than the lower market value, then they would compromise the time-tested standards of accounting and expose the firm, and the economy, to all the dangers that may follow from this, not to mention the fact that they would also bring the credibility of their profession into question.

Insolvent or Illiquid?
The story of how the accounting profession solved the dilemma has never been told. It appears a safe assumption that the dilemma was solved for it by the belligerent governments themselves through secret directives making it clear that public disclosure of the banks' true financial condition would not be tolerated. Nor could a public discussion of the subtle changes in accounting theory, following those in accounting practice, be entertained. These included the throwing of the Law of Assets to the winds, replacing it with a new and more relaxed one allowing the banks to carry government bonds in the asset-column at acquisition value, regardless of true market value, as if it were a cash item. A new term was introduced in the dictionary to describe the financial condition of the bank with a hole in its balance sheet, provided that it could still meet the new relaxed criteria for solvency. Such a bank was henceforth called "illiquid". We shall see later why the practice of allowing illiquid banks to keep their doors open is a dangerous course to follow, as it has far-reaching consequences threatening, as it does, the very foundations of Western Civilization. (The recent scandal involving the American giant Enron is in fact a scandal involving not just one accounting firm as alleged, but the entire profession. In the final analysis, the scandal has its origin in the unwarranted relaxation of accounting standards back in 1914, which has never since been rectified.)

I am in no position to prove that a secret gag-rule was imposed on accountants. But I am at a loss to find an explanation why an open discussion of the wisdom of changing time-honored accounting principles has never taken place. Apparently there were no defections from the rank and file of the profession denouncing the new regimen as unethical and self-defeating. These underhanded changes in accounting standards have opened the primrose path to self-destruction. The dominant role of Western Civilization in the world was due to the moral high-ground staked out by the giants of the Renaissance, among them Luca Pacioli. As this high-ground was gradually given up and the commanding post was moved to shifting quicksand, and as rock-solid principles gave way to opportunistic guidelines, Western Civilization has been losing its claim to leadership in the world. It should come as no surprise that this leadership is presently facing the most serious challenge of its entire history.

The chickens came home to roost in 1921 when panic swept through the U.S. government bond market. Financial annals fail to deal with this panic (exception: Benjamin M. Anderson's posthumously published Financial History of the United States). Nor was it given the coverage in the financial press it deserved. Information was confined to banking circles where the panic hit hardest. Clearly, it was in the interest of the government and the banks to hide the news under the bushel. There was an unprecedented peace-time jump in long-term interest rates, causing devastation in the market for long-term U.S. government bonds. Upright bankers looked at bond quotations in disbelief and desperation. The strongest pillars of their balance sheet were subjected to an unprecedented meltdown, taking place before their very eyes.

The crisis of 1921 was swept under the rug as the Federal Reserve banks stepped in the breach and shored up the balance sheet of their member banks. An historic opportunity was missed to mend the ways of the world that had gone astray in 1914. It was the last opportunity to avert the Great Depression, already in the making.

The Law of Liabilities
Purely by using a symmetry-argument we may formulate another fundamental principle of accounting, the Law of Liabilities. It states that a liability must be reported in the balance sheet as the amount(s) payable at maturity, or as the amount that would liquidate it at the time of reporting, whichever is higher. Since liquidation must take place at the current rate of interest, in a falling interest-rate environment the liabilities of all firms are rising. The possibility of a simultaneous rise in the liabilities of all productive firms represents a great danger to the national economy. This danger has been disregarded by the economists' profession, an error of omission that ought to be rectified without any further delay. This is in fact that the present paper has set out to do. As we know, mainstream economists failed to raise their voice against the folly of cutting the interest-rate structure adrift and letting it fluctuate for reasons of political expediency — implicit in both Keynesian and Friedmanite nostrums. Is it possible that the reason for this failure was the fatal blind spot mainstream economists appear to have with regard to the danger of overestimating national income in a falling interest-rate environment?

The proposition that a firm must report liabilities at a level higher than what is due at maturity whenever the rate of interest falls is, of course, controversial. Let us review the reasons for this crucial requirement. If the firm comes up for liquidation then, of course, all liabilities become due at once. Sound accounting principles demand that sufficient capital be maintained to make liquidation without losses possible at all times. If interest rates were to fall, then clearly earlier liabilities had been incurred at a rate higher than necessary. For example, if an investment was to be financed through a bond issue or a fixed-rate loan, then better terms could be secured by postponing it until the lower rate would become available. In other words, making the investment earlier was a managerial error of timing. This is a world of crime and punishment, and even the slightest error brings a penalty in its train. The increase of liability in the balance sheet is just the penalty for that managerial error. Even if the investment has been financed out of internal resources, penalty is still justified. Alternative uses for the resource would have brought better financial results.

But let us assume that the investment was absolutely necessary to make at the time it was made. There was no managerial error of timing. At any rate, we absolve management of all responsibility in this regard. The case for an increase in liability still stands. After all has been said and done, there still is an obvious loss due to the fact that servicing investment must be made at a rate higher than that available in the market. This loss ought to be realized if we want the balance sheet to continue to reflect the true financial position. Any other approach would create a fools' paradise. To see this more clearly we may point out that these losses are analogous to the ones due to an accidental fire destroying physical capital not covered by insurance. The loss still has to be realized as it is absolutely necessary that the balance sheet reflect the changed financial picture caused by the fire. If the loss was small enough, it could be charged directly to shareholder equity. But in the case of larger losses shareholder equity may not be sufficient for the purpose. In this case (the remaining part of) the loss will have to be charged against future earnings. The proper way to go about it is a three-step adjustment as follows:

(1) Create an entry in the asset-column called "fund to cover fire loss".
(2) Create an equivalent entry in the liability-column.
(3) Amortize the liability through a stream of payments out of future income.

It is clear that if the accountant failed to do this, then he would falsify future income statements. As a result, losses may be reported as profits, or phantom profits may be paid out in the form of dividends. Not only would this weaken the financial condition of the firm, but it would also render the balance sheet meaningless. As this might lead to further errors, losses would be compounded.

Exactly the same is true if the loss was due not to fire but to a fall in the rate of interest. The way to realize the loss is analogous. For a larger fall in the rate of interest shareholder equity may not be large enough to cover the corresponding loss. In this case a new entry must be created in the asset-column called "fund to cover overpayment in servicing capital, made necessary by a fall in the rate of interest", against the creation of an equivalent entry in the liability column, to be amortized by a stream of payments out of future income. This is not an exercise in pedantry. It is the only proper way to realize a real loss which has, I repeat, been incurred as a result of the inescapable increase in the cost of servicing productive capital already deployed in the wake of a fall in the rate of interest. Ignoring that loss would not erase it, while it might certainly compound it.

The Historic Failure to Recognize the Law of Liabilities
I anticipate a torrent of criticisms asserting that there is no such a thing as the Law of Liabilities in accounting theory and practice. I submit that I have no formal training in accounting, nor have I made an independent study of the theory and history of accounting. I am not able to provide reference to original sources to which the Law of Liabilities could be traced. (By contrast, the Law of Assets appears in several older textbooks that have long since been discarded by practicing accountants as well as professors of accounting.) But I shall argue that either Law follows the spirit, albeit, perhaps, not the letter of Luca Pacioli. Affirming one while denying the other makes no sense. Every argument that supports one necessarily supports the other. There is a perfect logical symmetry between the two Laws, arising out of the symmetry of assets and liabilities in the balance sheet. Ignoring either Law is a serious breach of sound accounting, possibly with extremely grave consequences. For example, if the rate of interest keeps falling for an extended period of time, as it has in Japan for almost a decade now, then present (in my opinion, deeply flawed) accounting standards will allow losses to be reported as profits. The resulting wholesale capital destruction, which the country may not realize until it is too late, could bring the national economy to its knees spelling depression, deflation, or both (as it seems to be occurring in Japan right now).

Even if the fact could be established that the Law of Liabilities has never been spelled out in any official accounting code going back all the way to that of Luca Pacioli, we should still not jump to the conclusion that there is no justification for it. A convincing argument can be made explaining why this Law might have escaped the notice of upright and knowledgeable accountants in the past, with the consequence that the Law has never been codified.

We couldn't blame Luca Pacioli if he had failed to foresee the level of duplicity and bad faith displayed by the politicians and bankers of the twentieth century. In particular, I refer to the affront represented by the act of calling in gold coinage and then writing up its value — all to the detriment of the people (as it was done in the United States in 1933). He had lived before any central bank was established. It is a pity that Luca Pacioli failed to anticipate the chicanery of open market operations for the purpose of manipulating interest rates to political ends. If he had, he might have been able to warn us of the danger of the coup in which the sorcerer's apprentice grabbed the initiative from the sorcerer with the consequence that interest rates could be driven down to zero in order to bleed white the saving and producing segment of society. But Luca Pacioli firmly believed in upright business deals and honorable dealings between the government and the people. The chicanery of gold manipulation would have appeared incredible to him, as if it had belonged to the realm of phantasy. Without gold manipulation, the only way for the rate of interest to have a prolonged fall could occur only if savers continued to save despite the fall. Even then, the fall in the rate of interest would be so gradual that no producer would be hurt by it. A decline from 15 to 5 percent per annum (as occurred in the United States during the past twenty years) would have been impossible. No wonder that Luca Pacioli did not provide for such an eventuality in his code of accounting standards!

In the 1930's agitation against the gold standard started in earnest. Britain abandoned the gold standard in September, 1931, and the United States, in March, 1933. The last obstacle removed, the door to suppressing the rate of interest to political ends through open-market operations was thrown wide open. Bond speculators, especially the banks, were electrified by the undreamed-of opportunity to become rich without shouldering any countervailing risk. As a result of government monetary policy and private bond speculation interest rates were falling throughout the 1930's. The size and the rate of the fall were unprecedented. The world was unprepared for a revolution of such proportions, potentially greater than the subversion of the national economy in Bolshevik Russia barely a decade earlier. The world was lacking an accounting code to cope with the unprecedented across-the-board increase in liabilities that hit the productive sector as a consequence of the confiscation of the people's gold by a government supposedly standing for private property and sanctity of contracts.

Falling Interest Rates Squeeze Profits
Here is a paradox. Falling interest rates squeeze the profits of productive enterprise. This is paradoxical since the general consensus is that lower interest rates are salubrious to business. In truth, however, fluctuations in either direction hurt. Higher rates make the cost of servicing future investment soar, while lower rates do the same with regard to past investments. Recall that the reason for the latter is that the present value of debt rises. As it does, the cost of liquidating liabilities goes up. This creates a loss which ought to be a charge against future earnings.

Some of my critics, while agreeing that losses occur in the liability column, would argue that these are offset by gains in the asset column. Falling interest rates increase the present value of future earnings, thus increasing the value of assets. The trouble with this argument is that it ignores the Law of Assets which does not allow putting values on assets higher than historic cost, regardless of any expected increase in future earnings. As the proverb says, "there is many a slip between cup and lip". Unforeseen liquidation of the enterprise would reduce all future earnings to zero. The book-keeper has no choice but to charge the increased cost of liquidation unilaterally to the liability column.

Revisionist View of the Great Depression - Part III - INVISIBLE PILFERAGE

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