Toxic Economic Theory, Fraudulent Accounting Standards, and the Bankruptcy of Economic Policy

Transcription

1 Toxic Economic Theory, Fraudulent Accounting Standards, and the Bankruptcy of Economic Policy

2 Toxic Economic Theory, Fraudulent Accounting Standards, and the Bankruptcy of Economic Policy R. A. Rayman

3 Robert Anthony Rayman 2013 Softcover reprint of the hardcover 1st edition All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No portion of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, Saffron House, 6 10 Kirby Street, London EC1N 8TS. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act First published 2013 by PALGRAVE MACMILLAN Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited, registered in England, company number , of Houndmills, Basingstoke, Hampshire RG21 6XS. Palgrave Macmillan in the US is a division of St Martin s Press LLC, 175 Fifth Avenue, New York, NY Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world. Palgrave and Macmillan are registered trademarks in the United States, the United Kingdom, Europe and other countries. ISBN ISBN (ebook) DOI / This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. Logging, pulping and manufacturing processes are expected to conform to the environmental regulations of the country of origin. A catalogue record for this book is available from the British Library. A catalog record for this book is available from the Library of Congress.

4 Contents List of Tables List of Figures Preface Acknowledgements vii ix x xvi Part I A Very Dismal Science 1 The Greatest Pyramid Scheme since the Time of the Pharaohs? 3 2 From Economic Miracle to Credit Crunch: Thirty Years of Self-Delusion 9 Part II The Microeconomic Market-Value Fallacy 3 A Mediaeval System of Accounting 25 4 Fair-Value Accounting and Balance-Sheet Myopia 37 5 The Market-Value Delusion and the Credit Crunch 47 Part III The Macroeconomic Single-Gear Fallacy 6 The Topsy-Turvy Wonderland of Single-Gear Economics 65 7 Traffique: The Praeheminent Studie of Princes 76 8 Capitalism and Socialism: The Fatal Conceit 84 9 A Genuine Free-Market Alternative 93 Part IV The Tax that Got Passed by Mistake 10 Income Tax: A Two-Hundred-Year-Old Myth The Assessed Taxes Not So Much a Tax, More an Anti-Avoidance Provision The Growth of the Monster 126 Part V Reform of the Tax System 14 Economic Efficiency or Social Justice? Taxation and The Law of the Market Pay As You Spend 160 v

5 vi Contents 17 Pay As You Spend: The Social Justification Pay As You Spend: The Economic Justification 181 Part VI The Bankruptcy of Economic Policy 19 Toxic Economic Theory and Global Recession 197 Technical Appendices: The Source of the Poison Appendix A The Fatal Flaw in Accounting Theory: The Present-Value Fallacy 209 Appendix B The Fatal Flaw in Macroeconomic Theory: The Single-Gear Fallacy 220 References 242 Index 247

6 List of Tables 2.1 The United Kingdom economy from the bad old days to the NICE decade Expected and actual operations of the two companies Summary of the conventional historical accounts of the two companies The influence of the volume of activity on the accounting return Initial balance sheet of the Fair-Value Company Balance sheet of the Fair-Value Company after the event The effect on investors of a reported fair-value gain of 100, The effect of price changes on a home owner intending to buy a more expensive house House-price changes: winners and losers The UK house-price bubble during the NICE decade From 1960 to 2000: temporary side-effect or change of gear? The mutual gains from trade GEORGII III. Cap.40. (10th May 1798) GEORGII III. Cap.41. (10th May 1798) GEORGII III. Cap.16. (12th January 1798) Abatement under section IV Abatement under section III The British non-system of taxation Two dimensions of fairness Pay As You Spend: alternative methods Taxes to be replaced under the proposed alternative Where the whole item of income is consumed immediately 186 vii

7 viii List of Tables 18.2 Where the whole item of income is saved for one year 187 A.1 Fisher s measure of performance dependent on investors preferences 211 B.1 The effect on macroeconomic equilibrium of changes in microeconomic preferences 227

8 List of Figures 2.1 Twenty-five years of calm seas prior to the storm of Annual percentage change in UK GDP 202 A.1 Initial market-clearing equilibrium 214 A.2 New market-clearing equilibrium 216 B.1 UK unemployment thousands 230 B.2 Allocation of total resources 232 ix

9 Preface Economic Crisis or Crisis of Economics? Only a crisis actual or perceived produces real change. When that crisis occurs, the actions that are taken depend on the ideas that are lying around. That, I believe, is our basic function: to develop alternatives to existing policies, to keep them alive and available until the politically impossible becomes politically inevitable. [Milton Friedman, Capitalism and Freedom (1982 edn), p. ix] In a television interview in the autumn of 2011, the Governor of the Bank of England gave his view of the current economic situation: This is the most serious financial crisis we ve seen, at least since the 1930s, if not ever. [Sky News, 6th October 2011] Only three years earlier, in his Mansion House speech of 18th June 2008, he had been looking back on the period since the Monetary Policy Committee was set up in 1997 as the NICE decade of Non- Inflationary Consistent Expansion. During that period, the market value of the UK housing stock had tripled from 1.3 trillion to 4 trillion. The heroes, whose widely acclaimed ingenuity and enterprise had achieved this apparent gain of 2.7 trillion, were the bankers. In the summer of 2007, the property market began to collapse. Within a year, the credit system almost seized up, and the economy was tipped into recession. The most enthusiastic cheerleaders of one of the greatest pyramid schemes in financial history became its harshest critics. The crisis was widely blamed on the banking and financial sector. Reckless, and occasionally outrageous, behaviour certainly aggravated the crisis; but it was a symptom, not the cause. The real blame lay with the bankruptcy of economic policy. The root cause of bankrupt economic policy was toxic economic theory; and it still is. The Revival of Classical Economics The source of the poison can be traced back to the neo-classical consensus which emerged in the late 1970s. What amounted to a theological x

10 Preface xi schism between rival Keynesian and monetarist sects was healed by the acceptance of a compromise classical theoretical foundations with a Keynesian empirical superstructure. It signalled a return to the classical doctrine of Adam Smith; and it established a fundamentalist belief in freedom of competition as the sole route to economic salvation and the promised land of full employment. Smith, however, had been guilty of a serious oversight. He was an admirer of François Quesnay ( ) and the Physiocrats, whose laws were inscribed, as it were, on two tablets of stone. The Law of Competition was on the tablet that Smith brought back from a visit to France during the mid-1760s. The tablet containing their Law of Circulation he left behind. According to Smith, the Physiocratic system represented perfect liberty as the only effectual expedient for rendering this annual reproduction [of the wealth of nations] the greatest possible [(1776) vol.ii, p.176, emphasis supplied]. But he overlooked the Law of Circulation enshrined in the first of their maxims : That the whole of the revenue enters into the annual circulation, and runs through it to the full extent of its course; and that it is never formed into monetary fortunes. [Quesnay (1758) p.3] Disregard of the Law of Circulation is responsible for the widespread modern error that a perfectly competitive economy in market- clearing equilibrium is sufficient to guarantee (1) the efficient allocation of resources, and (2) full employment. This involves two major fallacies. A Tale of Two Fallacies The microeconomic fallacy is the conviction that an increase in the market-value of an asset (over the general level of prices) necessarily represents an increase in real wealth. The market-value fallacy has corrupted the system of accounting and finance by infecting both practitioners and regulators with balance-sheet myopia the inability to see beyond a firm s balance sheet. Home owners and lenders have been deluded into believing that house-price rises can be relied upon to make increased consumption and borrowing affordable. The macroeconomic fallacy is the belief that the economy is a single-gear machine requiring only the lubrication of perfectly flexible

11 xii Preface markets to operate efficiently at its full-employment potential. The single-gear fallacy is responsible for the failure of macroeconomic policy to shift the economy into the highest possible gear. The market-value fallacy is the root cause of the financial crisis of 2007/8; but it is the single-gear fallacy that caused the recession and remains the main obstacle to an effective solution. Both fallacies have their origin in the artificial split of modern economic theory into separate micro and macro compartments. The market-value fallacy is an object lesson in the folly of conducting microeconomic theory without regard to the macroeconomic repercussions. The single-gear fallacy is an object lesson in the folly of conducting macroeconomic theory without regard to the microeconomic foundations. Neglect of the Law of Circulation is the foundation of the modern single-gear policy consensus that the only effective long-term cure for unemployment is liberalisation of the market structure to bring the real world closer to the theoretical ideal of perfect competition: Economists disagree about a lot of things but not about how to get people back to work. Labour markets, they say, need to clear and the best way to ensure they do is to keep them flexible. [The Economist, 5th April 1997, p.21] The policy is misconceived, not because the theoretical ideal is difficult to achieve in practice, but because it is a flawed ideal even in theory. Observance of the Law of Competition, though vitally necessary, is not sufficient. Equally important is observance of the Law of Circulation; but that is not recognised by the neo-classical consensus. Exposure of the fallacy proves the point of the Physiocrats first maxim that a monetary economy is a multi-gear machine. To operate at its full employment potential, there are two basic essentials: (1) freedom of circulation (to maintain the economy in top gear ) and (2) freedom of competition (to keep the economy well lubricated). The single-gear consensus is only half right. Structural reform is undoubtedly an essential lubricant for stimulating economic growth; but it is by no means sufficient: you cannot lubricate a machine, or an economy, out of second-gear.

12 Preface xiii What s Wrong with Economic Policy? The Governor of the Bank of England may well be right: This is the most serious financial crisis we ve seen, at least since the 1930s, if not ever. [Sky News, 6th October 2011, quoted on p.x] Yet the policy response has not changed. It is the same old prescription as before: The best recipe for growth is to raise productivity through structural reforms. [The Economist, 12th November 2011, Special Report, p.6] Two and a half centuries ago, the Physiocrats were clearly much more in tune with today s problems. Their acute awareness of the multi-gear nature of the economy is the reason for their warning of the dangers of foreign trade deficits [Quesnay (1758) p.3], loss of business confidence [p.4], inappropriate government policy [p.4], and excessive national debt [p.14]. In their obsession with the Law of Competition, modern single-gear theorists have blinded themselves to the Law of Circulation. That is the reason for the bankruptcy of modern economic policy. The conventional wisdom relies on market liberalisation to cure all economic ills. Anything else is dismissed as a temporary expedient no more than a short-term palliative, which in the long run will only do more harm. Since the root cause of the bankruptcy of modern economic policy is toxic economic theory, there can be little progress until the two fundamental theoretical fallacies are discarded. The Law of Competition and Reform of the Accounting System Perfect competition requires accurate information. The market-value fallacy, however, is responsible for two particularly serious sources of misinformation. By encouraging the belief that increases in market value necessarily represent increases in real wealth, it is an incentive to the formation of asset-price bubbles fuelled by credit pyramids. The same fallacy has also undermined accounting standards to such an

13 xiv Preface extent that real economic losses can be reported as accounting gains and vice versa. This gives a totally distorted view of economic reality and renders financial reports totally unreliable for either assessing or comparing business performance. The obsession with current market values is a major cause of short-termism and rewards for failure ; and it is a source of the current controversy over executive pay. Instead of operating as an instrument for corporate governance by well-informed market forces, the accounting system has become a major stumbling block. The Law of Circulation and Reform of the Tax System The single-gear fallacy is responsible for two fatal errors in modern macroeconomic policy for stable economic growth: (1) structural reform to reduce market imperfections is wrongly accepted as the only effective long-term policy for economic growth; and (2) fixing interest rates is mistakenly regarded as a safe method of controlling inflation because of the misconception that any depressing side-effects are merely temporary. As a result, the gains from microeconomic liberalisation have been thrown away by stifling the economy in a macroeconomic straitjacket of monetary restriction. The economic miracle achieved by Britain in the 1980s is a myth fostered by apologists for this policy. The reality is thirty years of lower growth and higher unemployment than in the bad old days of the 1960s when Britain was the sick man of Europe (see Table 2.1). The Bankruptcy of Single-Gear Economic Policy Perhaps the most useful aspect of the recent economic crisis is that it has exposed single-gear economic policy as a choice of evils. The choice on offer is between single-gear austerity (with no mechanism to prevent 1930s-type depression) and single-gear growth (with no mechanism to prevent 1970s-type inflation). Rapid economic growth without inflation requires freedom of circulation as well as freedom of competition. The bankruptcy of economic policy is directly attributable to neglect of the Law of Circulation. The Multi-Gear Alternative The case for economic reform is presented in two volumes. This, the first volume, identifies and seeks to correct, two fundamental fallacies

14 Preface xv of conventional economic theory. The policy implications are developed in the second volume entitled A Multi-Gear Strategy for Economic Recovery. Economic recovery requires observance of both of the basic laws of economics. The Law of Competition cannot operate effectively until corporate governance is brought under the control of market forces. Accounting reform is vital for curing balance-sheet myopia; and law reform is essential for correcting highly distorted views of risk. Above all, the Law of Circulation needs to be established as the core of macroeconomic policy. Freeing interest rates by handing them back to market forces allows control over the level of prices to be exercised by a market-related tax system operating as the equivalent of automatic traffic lights triggered by the flow of traffic itself. Before these changes can be implemented, however, a major obstacle to the goals of economic policy needs to be removed. The Dysfunctional Tax System The current system of taxation is highly dysfunctional. It achieves neither economic efficiency nor social justice. An essential prerequisite for the policy proposals in the second volume is wholesale reform of the system of taxation on the lines suggested in this volume. It is designed to convert the tax system from a major obstacle to the goals of economic policy into a powerful weapon for their achievement. The Relevance of Multi-Gear Policy to Current Economic Problems The single-gear solution to imbalances between member states of single-currency unions like the euro zone seems to require increased centralisation and progress towards fiscal uniformity. The multi-gear preference, by contrast, is to allow countries (or even regions within countries) the fiscal autonomy necessary for freedom to change gear. In tackling addiction to debt it can be counter-productive to threaten the debtors the addicts; it may be more effective to penalise the creditors the pushers. The Law of Circulation has been neglected for over two and half centuries. The current crisis may be a perfect opportunity for its revival.

15 Acknowledgements This book (together with its companion volume on economic policy) represents the development of a number of apparently disconnected articles on accounting, economics, and taxation. Although they contained some highly unorthodox views, they were published in various professional and academic journals in the late 1960s and early 1970s. It is unlikely that they would have seen the light of day without the help of open-minded people who, while frequently not sharing my views, nevertheless felt that they deserved to be discussed. I am grateful to Professors Anthony Lowe, Sidney Davidson, and William Baxter for supporting the publication of the idea of a Segregated System of Funds and Value Accounting in the Journal of Accounting Research (1969). I am similarly grateful to Professors John Pinder, Richard Stone, James Meade, and John Sparkes for their support in the publication of Price Stability and Full Employment (1975). Particular thanks are due to Professor Victoria Chick whose enthusiasm for independent ideas was an inspiration in embarking on Economics Through the Looking-Glass (1998), and to Professor David Weir who, in addition to his support during the preparation of the manuscript, was instrumental in its publication. Dr Allister Wilson (Senior Technical Partner at Ernst & Young) was a valuable source of encouragement in the preparation of Accounting Standards: True or False? (2006). It is a sad inevitability that, during the forty odd years that have elapsed since the late 1960s, some of those to whom I owe a debt of gratitude have passed away. Thanks are also due to the following publishers for permission to reproduce extracts from previously published work. The epigraph to the Preface, which is a quotation from Capitalism and Freedom (M. Friedman, 1982 edn. p.ix), is reproduced by permission from the University of Chicago Press. An extract from Accounting Standards: True or False? (Rayman, 2006, pp ) is reproduced in Appendix A with permission from Routledge (Taylor & Francis Group), Abingdon. In Appendix B, an extract from Price Stability and Full Employment (Rayman, 1975, pp.51 60) is reproduced with permission from the Policy Studies Institute, London. xvi