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 Financial Times:
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 feed 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, “Investors have to be sure statistics do not lie” by Bernie McSherry, is also worth reading.
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That is the most long-winded explanation of "Earnings Smoothing" that I've ever read.
It's still illegal, right?
IdahoSpud