Michael Perelman, Railroading Economics: The Creation of the Free Market Mythology (New York: Monthly Review Press, 2006).
By Lambert Strether of Corrente.
Continuing our series of book reviews in time for the holiday gift-giving season, here’s a quick look at Michael Perelman’s Railroading Economics, a title, and a subject, that intrigued me for two reasons. Trivially, as readers know, I’m by way of being a rail fan; more importantly, when I was a mere sprat, I read Matthew Josephson’s Robber Barons. Josephson’s tales of Jim Fisk watering the stock of the Erie Railroad — “Gone where the woodbine twineth” was Fisk’s answer to where the money went — and his running buddy Jay Gould — “I can hire one half of the working class to kill the other half” (attributed) — trying to corner the gold market would inoculate anyone from belief in the ideology of “perfect competition.” They certainly did me. Perelman begins (p.1):
The title of this book, Railroading Economics, has multiple meanings. The verb “railroading” refers to the ideological straitjacket of modern economics, which teaches that the market is the solution to all social and economic problems. The adjective “railroading” refers to the experience of economists during the late nineteenth century when the largest industry in the country, railroading, was experiencing terrible upheavals. Many of the leading eocnomists at the time came to grips with the destructive nature of market forces. Competition, which according to conventional economics, is supposed to guide business to make decisions that will benefit everybody, was driving business into bankruptcy and common people into poverty.
That lesson was never allowed to take hold among economists. In fact, the same economists continue to teach their students that markets work in perfect harmony, while they advised policy makers to take quick action to put the brakes on competition. In effect, the railroad economists railroaded economics into perpetuating a free market mythology.
This is a long and complicated story, and Perelman tells it well. Since Perelman is a radical economist from a non-Ivy League School, reviews of his book are few and far between. Here’s one from an orthodox economist (latest book: The Wal-Mart Revolution) that to my untutored eye seems to summarize Perelman’s thesis fairly:
[Michael Perelman’s new book] is a highly readable, lucidly written, and provocative account of the evolving American economy. Moreover, readers of this site would be pleased that this is a rare economist who draws very heavily on insights from economic history and even the history of economic thought in reaching conclusions about the contemporary American economy. Also, the book has lots of solid footnotes showing a serious appreciation of much of the relevant scholarly literature of the past century or more….
According to Perelman, classical economics emerged out of an agrarian society where the presumption of pure competition was fairly reasonable. Over time, however, massive capital-intensive businesses evolved, notably the railroads, with very high fixed costs. The neoclassical notion that profit-maximizing firms would produce where marginal costs equaled marginal revenue and price (in pure competition) simply did not fit the reality of these new natural monopolies. Competition was destabilizing, led to overinvestment, and paved the way for unscrupulous financiers like Jay Gould. In Perelman’s view, “the increasing relative importance of fixed costs means that … competition … would lead to utter chaos” (p. 46). A group of “railroad economists” or corporatists understood all this, but they were largely ignored by conventional economists who developed a “quasi-religious” and “ideological” (p. 99) fervor towards their theoretical models, a fervor that persists today.
Perelman thinks that in pursuing competition, prices were forced so low that many railroads were forced into bankruptcy, much as is happening in airlines today. This opens the door for the “financial capitalists” who make money reducing competition (via mergers) and reorganizing bankrupt companies, getting rich in the process and hurting workers of the involved companies. The Enron/WorldCom problems of the early twenty-first century are not that different from those created by J.P. Morgan organized mergers of a century earlier, best symbolized by the formation of U.S. Steel.
In Perelman’s eyes, the instability arising from the lack of realization of the importance of fixed costs, the machinations of financial interests, and so forth, have caused internal contradictions in capitalism. He opines that “an economy built increasingly on finance is a disaster waiting to happen” (p. 198), concluding “I look forward to the day when we no longer rely on competition for monetary rewards … when cooperation and social planning replace the haphazard world of the market place” (p. 200).
Needless to say, the orthodox reviewer vehemently disagrees; readers can follow up at the link. At this point, however, magpie-like, I want to pass on from assessing Perelman’s thesis to display a bright, shiny object I collected from the text. As the post title suggests, it’s about accounting! (Note the focus on fixed, long-lived capital; railroads have rather a lot of it.) From pp. 58-59:
What about accounting as an anchor for business rationality? Certainly, the widespread adoption of seemingly solid accounting practices contributed to the illusion of a sound basis for business action. Even as astute an observer as Max Weber associated accounting practices with rationality.This attitude toward accounting is not surprising. Indeed, the erratic movements of markets disappear in the accountant’s ledgers, which exude a misleading image of straightforward calculations of profit and loss.
First, accounts are necessarily backward-looking. Accountants must necessarily base their calculations on historical costs, even though they can make allowances for changes that have occurred since the original purchase. … Since account books are based on historical information, they will be better guides if the business is a relatively short-lived affair. After all, tomorrow is more likely to resumble today than sometime in the far-off future will.
Second, the methods that accountants use to make these adjustments are necessarily based on inexact conventions rather than precise measurements. Finally, as the dot com bubble proved [the book was published in 2006] accountants can easily mislead even supposedly sophisticated investors. Accounting firms even accommodated failing corporations by providing fraudulent information [of which more below] rather than risk losing lucrative contracts.
So much for accounting. But wait! There’s more!
The treatment of capital in conventional economic theory had its origins in the long-obsolete accounting principles of early merchants. … The economic environment of the early merchants’ shops conditioned later accounting practices, especially their treatment of fixed capital. Even as late as the time of Adam Smith more than two centuries ago, fixed capital requirements were relatively modest. … Since accountants have never been able to discover a satisfactory method of handling long-lived capital goods, accounting provides a frail foundation for business rationality in a developed economy where long-lived fixed capital assumes great importance.
Ronald Coase… once noted that an accountant would say that the cost of a machine is the depreciation of the machine. The economist would say that “the cost of using the machine is the highest receipts that could be obtained by the employment of the machine in some alternative use.” If no alternative exists, the cost of the machine is zero
Ideally, Coase is correct. Unfortunately, no economist can hope to calculate the highest receipts that could be obtained. To do so would require knowledge of the future of all industries that could possibly use the machine. As a result, economists generally either accept the accountant’s calculations in violation of their own principles or they assume away the problem of long-lived capital goods.
Economists rarely consider this defect in economics because they avoid any serious consideration of time in their models. Instead, in dealing with investment decisions, the models typically pretend that investors are able to accurately foresee the future.
All that is solid melts into air. (Orthodox) economics assumes a soothsayer. And accounting provides no basis for business rationality (at least if one is more than a shopkeeper). How does one even begin to process that information? (Here let me welcome corrections and clarifications from readers familiar with current accounting practice and theory.)
Accounting industry and SEC hobble America’s audit watchdog
The Public Company Accounting Oversight Board was set up [by Dodd-Frank] to oversee the auditing profession after a rash of frauds. The industry got the upper hand, as the story of the board’s embattled chief shows.
James Schnurr, just two months into his job as chief accountant at the U.S. Securities and Exchange Commission, stood before a packed ballroom in Washington last December and upbraided a little-known regulator.
The Public Company Accounting Oversight Board, or PCAOB, oversees the big firms that sign off on the books of America’s listed companies. And the board was “moving too slowly,” Schnurr said, to address auditing failures that in recent years had shaken public confidence in those firms.
These were fighting words in the decorous auditing profession, and they hit their target. PCAOB Chairman James Doty was among those attending the annual accounting-industry gala where Schnurr spoke. And Schnurr was Doty’s new supervisor.
“This is going to get ugly,” Doty said to a colleague afterward.
In his new SEC job, Schnurr now had direct authority over the PCAOB – a regulator that just a few years earlier had derailed his C-suite ambitions at Deloitte & Touche. As deputy managing partner at the world’s largest accounting firm, Schnurr had commanded an army of auditors – until a string of damning PCAOB critiques of Deloitte’s audits led to his demotion.
Then, in August 2014, SEC Chair Mary Jo White named Schnurr to his SEC post. It was a remarkable instance of Washington’s “revolving door” for professionals moving between government and industry [sic] jobs. …
Schnurr’s speech was part of a yearlong campaign to oust Doty and thwart his efforts to implement rules that would increase auditors’ accountability to investors and their independence from the companies they audit. …
Deloitte, Ernst & Young, PricewaterhouseCoopers and KPMG audit companies that account for 98 percent of the value of U.S. stock markets. During the crisis, nine major financial institutions collapsed or were rescued by the government within months of receiving clean bills of health from one of the Big Four. While Schnurr was deputy managing partner at Deloitte, the firm signed off on the books of Bear Stearns, Washington Mutual and Fannie Mae. Each went bust soon after, costing investors over $115 billion in losses.
Doty’s efforts have floundered, in large part because Schnurr’s office has used its oversight powers to block, weaken and delay them, according to a dozen current and former SEC and PCAOB officials. Schnurr’s staff has also campaigned to have Doty removed from office, these people said.
Doty’s term ended on Oct. 24. He continues to serve as PCAOB chairman day-to-day, waiting for the SEC to decide whether or not to reappoint him.
The standoff is a test of who holds sway with regulators in Washington – investors large and small who seek better disclosure of what really goes on inside companies, or the financial-services establishment that’s supposed to serve those investors.
Why, one might almost conclude that the accounting “industry” exists to enable accounting control fraud, rather than to prevent it — especially given the limitations that Perelman points out. Although, to be fair, perhaps fraud is what “business rationality” is all about these days.
So, from Perelman, we learn that accounting has severe limitations that make it unsuitable as a basis for business rationality. Moreover, it’s not suitable (in its current form, at least) for making decisions — any decision — about long-lived, fixed capital allocation — and isn’t capitalism supposed to be all about that? And finally, if we ask what accounting is good for, we find that it’s certainly useful for enabling fraud. It’s very difficult to know how deep the rot goes.
Readers, are these thoughts too grim?