Is Our Accounting System Flawed?

The accounting principle, the Law of Liabilities, asserts that a firm must carry its liabilities in the balance sheet at its value upon maturity, or at liquidation value,whichever is higher. This Law is universally ignored by present accounting standards,which threatens the economy with massive deflation through the destruction of capital, inview of the persistent fall of interest rates for the past 25 years, as it keeps increasing theliquidation value of debt

The Book-Keeper’s Dilemma

One of the plays of George Bernard Shaw branded “unpleasant” by the playwright himself isentitled The Doctor’s Dilemma. The protagonist is a physician who comes into conflict withthe Oath of Hippocrates (fl. 460-377 B.C.) He has developed a new treatment for a fataldisease, but the number of volunteers for the test-run exceeds the number of beds in his clinic

Unwittingly, the doctor finds himself in the role of playing God as he decides who shall liveand who shall die

By the same token Shaw could have written another “most unpleasant” play entitledThe Book-Keeper’s Dilemma. The protagonist, a chartered accountant, finds himself inconflict with the letter and spirit of book-keeping set out by Luca Pacioli (fl. 1450-1509). As aresult of compromising the high standards of the accounting profession, the book-keeperbecomes the destroyer of Western Civilization

Finest Product of the Human Brain

Luca Pacioli taught mathematics at all the well-known universities of Quattrocento Italyincluding that of Perugia, Napoli, Milan, Florence, Rome, and Venice. In 1494 he publishedhis Summa Arithmetica, Tractatus 11 of which is a textbook on book-keeping. The authorshows that the assets and liabilities of a firm do balance out at all times, provided that weintroduce a new item in the liability column that has been variously called by subsequentauthors “net worth”, “goodwill”, and “capital”. This innovation makes it easy to check theledger for accuracy by finding that, at the close of every business day, assets minus liabilitiesis equal to zero. If not, there must be a mistake in the calculation

But what Pacioli discovered was something far more significant than a method offinding errors in the arithmetic. It was the invention of what we today call double-entry book2keeping, and what Göthe called “the finest product of the human brain” (Wilhelm Meister’sApprenticeship.)Why was this discovery so important in the history of Western Civilization? Because,for the first time ever, it was now possible to calculate and monitor shareholder equity withprecision. This is indispensable in starting and running a joint-stock company. Without it newshareholders could not get aboard, and old ones could not disembark safely. There would beno stock markets. The national economy would be a conglomeration of cottage industries,unable to undertake any large-scale project such as the construction of a transcontinentalrailroad, or the launching of an intercontinental shipping line

The invention of the balance sheet did to the art of management what the invention ofthe compass did to the art of navigation. Seafarers no longer had to rely on clear skies in orderto keep the right direction. The compass made it possible to sail under cloudy skies with equalconfidence. Likewise, managers no longer have to depend on risk-free opportunities to keeptheir enterprise profitable. The balance sheet tells them which risks they may take and whichones they must avoid. It is no exaggeration to say that the present industrial might of WesternCivilization rests upon the corner-stone of double-entry book-keeping. Oriental (Chinese) andMiddle-Eastern (Arab) civilizations would have outstripped ours if they had chanced upon thediscovery of the balance sheet first. By the same token, the continuing leadership of the Westdepends on keeping accounting standards high and isolated from political influences

Barbarous Relic or Accounting Tool?

There is cause for concern in this regard. For the past 75 years the West has been fed thepropaganda line, attributed to John Maynard Keynes, that the gold standard is a “barbarousrelic”, ripe to be discarded. The unpleasant truth, one that propagandists have ‘forgotten’ toconsider, is that the gold standard is merely a proxy for sound accounting and, yes, for soundmoral principles. It is an early warning system to indicate erosion of capital. It was not thegold standard per se that politicians and adventurers wanted to overthrow. They wanted to getrid of certain accounting and moral principles, especially as they apply to banking, that hadbecome an intolerable fetter upon their ambition for aggrandizement and perpetuation ofpower. Historically, accounting and moral principles had been singled out for discard beforethe gold standard was given the coup de grâce

The attack on accounting standards and on the gold standard was heralded by theestablishment in 1913 of the Federal Reserve System (the Fed) in the United States, the chiefengine of monetizing government debt. Just how the monetization of government bonds hasled to a hitherto unprecedented, even unthinkable, corruption of accounting standards ― thisis a question that has never been addressed by impartial scholarship before

Bonds and the Wealth of the Nation

In order to see the connection we must recall that any durable change of interest rates has adirect and immediate effect on the value of financial assets. Rising interest rates make thevalue of bonds fall, and falling rates make it rise. As a result of this inverse relationship theWealth of the Nation flows and ebbs together with the variation of the rate of interest

Benefits and penalties are distributed capriciously and indiscriminately, without regard tomerit

This was hardly disturbing under the gold standard, as the rate of interest wasremarkably stable and the corresponding changes in the Wealth of the Nation were negligible

A lasting increase in the rate of interest could only occur in the wake of a national disastersuch as an earthquake, flood, or war. In all these cases a higher rate of interest was beneficial

3It had the effect of spreading the loss of wealth due to the destruction of property morewidely, easing the burden on individuals. Those segments of society that were lucky enoughto escape physical destruction had to share in the loss through the increased cost of servicingcapital due to higher interest rates. Everyone was prompted to work and save harder in orderthat the damage might be repaired quickly and expeditiously. As the rate of interest graduallyreturned to its lower level, the Wealth of the Nation expanded. Once again, everybody sharedequally, as the lower interest rate benefited all, through the reduction in the cost of servicingcapital

It is not widely recognized that the chief eminence of the gold standard is not to befound in stabilizing the price structure (which is neither desirable nor possible). It is to befound in stabilizing the interest-rate structure. By ruling out capricious and disturbing swings,the Wealth of the Nation is maximized

The gold standard ruled supreme before World War I. It was put into jeopardy whengeneral mobilization was ordered in 1914 by the manner in which belligerent governments setout to finance the war effort. Governments wanted to perpetuate the myth that the war waspopular and there was no opposition to the senseless bloodshed and destruction of propertythat could have been avoided through better diplomacy. The option of financing the warthrough taxes was ruled out as it might make the war unpopular. The war was to be financedthrough credits. In more details, war bonds were sold in unprecedented amounts, subsequentlymonetized by the banking system. Naturally, these bonds could not possibly be sold without asubstantial advance in the rate of interest. Accordingly, the Wealth of Nations shrank evenbefore a single shot was fired or a single bomb dropped

Under the gold standard bondholders are protected against a permanent rise in the rateof interest (which in the absence of protection would decimate bond values) by the provisionof a sinking fund. In case of a fall in the value of the bond the sinking fund manager wouldenter the bond market and would keep buying the bond until it was once more quoted at parvalue. Every self-respecting firm issuing bonds would offer sinking-fund protection

Even though governments did not offer it, it was understood and, in the case ofScandinavian governments explicitly stated, that the entire bonded debt of the governmentwould be refinanced at the higher rate, should a permanent rise in the rate of interest occur

Bondholders who have put their faith in the government would not be allowed to sufferlosses. The banks, guardians of the people’s money, could regard government bonds as theirmost trusted earning asset. They were solid like the rock of Gibraltar. Such faith, at least inScandinavian government obligations, was justified. The risk of a collapse in their value wasremoved. Governments, at least those in Scandinavia, occupied the moral high ground. Themoney they borrowed belonged, in part, to widows and orphans. They took to heart theadmonition and did not want to bring upon themselves the Biblical curse pronounced ontormentors of widows and orphans

Law of Assets

However, there was a problem with war bonds issued by belligerent governments. They werequickly 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 rulegoing back to Luca Pacioli that we shall refer to here as the Law of Assets, an asset must becarried in the balance sheet at acquisition value, or at market value, whichever is lower. In arising interest-rate environment the value of bonds and fixed-income obligations are falling,and this fall must be faithfully recorded in the balance sheet of the bondholder

There are excellent reasons for this Law. In the first place it is designed to preventcredit abuse by the banks and other lending institutions. In the absence of this Law banks4would overstate their assets that could be an invitation to credit abuses to the detriment ofshareholders and depositors. If the abuse went on for a considerable period of time, then itcould lead to the downfall of the bank. In an extreme case, when all banks disregarded theLaw of Assets, the banking system could be operating on the strength of phantom capital, andthe collapse of the national economy might be the ultimate result. For non-banking firms thedanger of overstating asset values also exists, and can serve as an invitation to recklessfinancial adventures. Even if we assume that upright managers would always resist thetemptation and stay away from dubious adventures, in the absence of the Law of Assets thebalance sheet would be an unreliable compass to guide the firm through turbulence, materiallyincreasing the chance of making an error. Managerial errors could compound and the resultcould again be bankruptcy

Economists of a statist persuasion would argue that an exception to the Law of Assetscould be safely made in case of government bonds. The government’s credit, like Caesar’swife, is above suspicion. The government will never go bankrupt. Its ability to retire debt atmaturity cannot be doubted. As a guarantee these economists point to the government’s powerto tax. However, the problem is not with paying the nominal value of the bond at maturity, butwith the purchasing power of the proceeds. Currency depreciation is a more subtle and, hence,more treacherous form of default. Governments, however powerful, cannot create somethingout of nothing any more than individuals can. They cannot give to Peter unless they havetaken it from Paul first. Nor is the taxing power of governments absolute. Financial annalsabound in cases where taxpayers have revolted against high or unreasonable taxes, sometimesoverthrowing the government in the process. If the taxing power of governments had beenabsolute, then they could have financed World War I out of taxes. Bondholders would havesuffered no loss of purchasing power as a result of debt-monetization, at least on the victors’side

It is true that governments as a rule do not go bankrupt, but this could be adisadvantage. Putting a value on bonds higher than what they would fetch in the market is afool’s paradise. Governments could use methods, fair or foul, to stave off ill effects of theirown profligacy. Awakening could be postponed, but it would be made that much ruder

A strict application of the Law of Assets would have made most banks and financialinstitutions in the belligerent countries insolvent. The dilemma facing the accountingprofession was this. If book-keepers insisted that the Law be enforced, they would be called“unpatriotic”, and be made a scapegoat held responsible for the weakening financial system

Demagogues would charge that the accountants were undermining the war effort. On theother hand, if they allowed banks to carry government bonds in the asset column atacquisition rather than at the lower market value, then they would compromise the time-testedstandards of accounting and expose the firm, and ultimately the national economy, to all thedangers that follows from this, not to mention the fact that they would also draw thecredibility of the accounting profession into question

Illiquid or Insolvent?

The story of how the accounting profession solved the dilemma has never been told. It may bea safe assumption that the dilemma was solved for it by the belligerent governments inprohibiting the public disclosure of the banks’ true financial condition. In the meantime a newaccounting code was created, far more lenient in adjudicating insolvency. The Law of Assetswas thrown to the winds, and was replaced with a more relaxed one allowing the banks tocarry government bonds at face value, regardless of true market value, as if they were a cashitem. A new term was introduced to describe the financial condition of a bank with a hole inthe balance sheet punctured by government bonds. Such a bank was henceforth considered5“illiquid”, but still solvent. Never mind that the practice of allowing the illiquid bank to keepits door open is a dangerous course to follow. It has far-reaching consequences, including thethreat to the very foundations of Western Civilization. The scandals involving Enron andBear-Sterns may be only the beginning of the unraveling of the financial system. It is clearthat the recent “sub-prime crisis” is a delayed effect of the unwarranted relaxation ofaccounting standards back in 1914

While I cannot prove that a secret gag-rule was imposed on the accounting profession,I am at a loss to find an explanation why an open debate of the wisdom of changing timehonoredaccounting principles has never taken place. Apparently there were no defectionsfrom the rank and file of the accountants denouncing the new regimen as unethical anddangerous. The underhanded changes in accounting practice have opened the primrose path toself-destruction

The dominant role of the West in the world was due to the moral high ground stakedout by the giants of the Renaissance, among them Luca Pacioli. As this high ground wasgradually given up, and the commanding post was moved to shifting quicksand, rock-solidprinciples gave way to opportunistic guidelines. Western Civilization has been losing its claimto leadership in the world. It comes as no surprise that this leadership is now facing its mostserious challenge ever

The chickens came home to roost as early as 1921 when panic swept through the U.S

government bond market. Financial annals fail to deal with this crisis (exception: B. M

Anderson’s Financial and Economic History of the United States, 1914-1946, posthumouslypublished in 1949, see reference at the end). Nor was it given the coverage it deserved in thefinancial press. Information was confined to banking circles. An historic opportunity wasmissed to mend the ways of the world gone astray in 1914. It was the last chance to avert theGreat Depression, already in the making

Law of Liabilities

Purely by using a symmetry argument we may formulate another fundamental principle ofaccounting: the Law of Liabilities. It asserts that a liability must be carried in the balancesheet at its value at maturity, or at liquidation value, whichever is higher. Since liquidationwould have to take place at the current rate of interest, in a falling interest-rate environmentthe liabilities of all firms are rising. This spells a great danger to the national economy, onethat has been completely disregarded by the economists’ profession, as it also has by theaccountants’ profession

Economists have failed to raise their voice against the folly of allowing the interestratestructure to fluctuate for reasons of political expediency, implicit in the application ofboth Keynesian and Friedmanite nostrums. It is possible that the reason for this failure wasthe fatal blind spot that economists appear to have in regard to the danger of overestimatingnational income in a falling interest-rate environment

The proposition that a firm must report liabilities at a value higher than that due atmaturity whenever the rate of interest falls is, of course, controversial. Let us review thereasons for this crucial requirement. If the firm is to be liquidated, then all liabilities becomedue at once. Sound accounting principles demand that sufficient capital be maintained at alltimes to make liquidation without losses possible. If the rate of interest were to fall, then,clearly, earlier liabilities had been incurred at a rate higher than necessary. For example, if aninvestment had been financed through a bond issue or fixed-rate loan, then better terms couldhave been secured by postponing it. A managerial error in timing the investment had beenmade. This is a world of crime and punishment where even the slightest error brings with it apenalty in its train. Marking the liability in the balance sheet to market is penalty for poor6timing. If the investment had been financed out of internal resources, penalty is still justified

Alternative uses for the resource would have generated better financial results

Even if we assume that the investment was absolutely essential at the time it wasmade, and we absolve management of all responsibility in this regard, the case for an increasein liability still stands. After all has been said and done, there is a loss that must not be sweptunder the rug. If the balance sheet is to reflect the true financial position, then the loss oughtto be realized. Any other course of action would create a fool’s paradise. To see this clearly,consider losses due to an accidental fire destroying physical capital uncovered by insurance

The loss must be realized as it is absolutely necessary that the balance sheet reflect thechanged financial picture caused by the fire. That’s just what the balance sheet is for. Theproper 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 incomestatements. As a result phantom profits would be paid out and losses would be reported asprofits. Not only would this weaken the financial condition of the firm, but it would alsorender the balance sheet meaningless, which may compound the error further

Exactly the same holds if the loss was due not to accidental fire but to a fall in the rateof interest. The way to realize the loss is analogous. A new entry in the asset column must becreated under the heading “fund to cover overpayment in servicing capital, due to a fall in theinterest rate”, against an equivalent entry in the liability column, to be amortized through astream of payments out of future income. This is not an exercise in pedantry. It is the onlyproper way to realize a loss that has been incurred as a result of the inescapable increase in thecost of servicing productive capital already deployed, in the wake of a fall in the rate ofinterest. Ignoring that loss would by no means erase it. It may well compound it

Historic Failure to Recognize the Law of Liabilities

I anticipate a torrent of criticism asserting that there is no such a thing as the Law ofLiabilities in accounting theory or practice. I submit that I have no formal training inaccounting, or in the theory and history of accounting. Nor do I recall having seen the Law ofLiabilities in any of the textbooks on book-keeping that I have perused (although I have seenthe Law of Assets in older textbooks that have long since been discarded by professors ofaccounting as obsolete). But I shall argue that either Law follows the spirit if not the letter ofLuca Pacioli. Affirming one Law while denying the other makes no sense. Every argumentthat supports one necessarily supports the other. The Law of Liabilities is a mirror image ofthe Law of Assets, arising out of the perfect logical symmetry between assets and liabilities

Ignoring either Law is a serious breach of sound accounting principles, possibly withgrave consequences. For example, if the rate of interest keeps falling for an extended periodof time, as it has in Japan for over fifteen years, then the present (in my opinion, deeplyflawed) accounting rules will allow losses to be reported as profits. Wholesale capitalconsumption/destruction may be the result, which the country may not realize until it is toolate. Banks and producing firms would operate on the strength of phantom capital, and wouldultimately collapse. This could bring the national economy to its knees, spelling deflation,depression, or worse (as it seems to be occurring in Japan right now). This depression appearsto be metastasizing across the Pacific to the United States through the yen-carry trade,foolishly encouraged by both central banks concerned

7Even if the fact were established that the Law of Liabilities has never been spelled outin any accounting code going back all the way to Luca Pacioli, we should still not jump to theconclusion that there is no justification for it. A convincing argument can be made explainingwhy the Law of Liabilities has escaped the notice of upright and knowledgeable accountantsin the past with the consequence that it has never been codified. Since time immemorial thepowers-that-be have shown a persistent bias favoring debtors against creditors, asdemonstrated by their desire to suppress the rate of interest by hook or crook. However, thiseffort has remained counter-productive before the advent of central bank open marketoperations in the 1920’s championed by the Fed. Indeed, the usuriously high rates charged onloans in pre-capitalistic times were not due to an alleged greed of the usurers. They were dueto the usury laws themselves. Charging and paying interest had been outlawed, but the resultwas not zero interest on loans as the authors of the usury laws had foolishly anticipated. Onthe contrary, the result was rates higher than what the free market would have charged,representing compensation for risks involved in doing an extra-legal business transaction. Forthese and other reasons the problem, traditionally, was not falling but rising rates. In such anenvironment the Law of Liabilities remains inoperative and is easily overlooked. It is hard todiscover a law that has been inoperative through all previous history

The situation changed drastically when the Federal Reserve started its illegal openmarket operations. (The practice was later legalized through retroactive legislation.)Speculators were happy to jump on the bandwagon of risk-free profits. They could easilypreempt the Fed by purchasing the bonds beforehand. After the Fed has bought its quota,speculators dumped the bonds and pocketed the profits. The net result was a falling interestrate structure

In fact, the opportunity for risk-free profits from bond speculation due to theintroduction of open market operations was a major cause of the Great Depression. Yet to thisday textbooks on economics hail open market operations as a refined tool in the hands ofmonetary authorities “to keep the economy on an even keel”. Only one other mistakeeconomists have made surpasses this one in enormity. Textbooks blame the Great Depressionon the “contractionist bias” of the gold standard

This is just the opposite of the truth. The Great Depression was largely caused by thegovernments sabotaging the gold standard in preparation for its overthrow, as I shall nowshow. The persistent fall of interest rates in the 1930’s has never been properly explained

What happened was that the only competition for government bonds, gold, has been knockedout through confiscation and other measures of intimidation. Freed from competition, thevalue of government bonds started to rise, making interest rates fall, causing prices to fall, too

The Great Depression was self-inflicted. Governments in their zeal removed the goldstandard, the policeman cordoning off the black hole of zero interest to prevent interest ratesfrom falling in. Speculators were quick to understand that this also meant the removal of aceiling on bond prices. For the first time ever, there was an opportunity to bid bond pricessky-high. Speculators abandoned the high-risk commodity markets in droves and flocked tothe bond market to reap risk-free profits made available by the regime of open marketoperations. You cannot understand the Great Depression without understanding howspeculators reacted to the removal of competition for government bonds. Only by searchingfor the consequences of the forcible removal of gold from the system can the unprecedentedfall in interest rates and the Great Depression be explained

Threat of a New Depression

Superficial thinking may suggest that if the rise of interest rates is bad, then their fall is goodfor the economy. Not so. A falling rate is even more damaging than a rising one. I am aware8that my thesis is highly counter-intuitive. I have been challenged by many other economistswho deny the validity of my contention. They argue that if the present value of future incomeis lower when discounted at a higher rate, then it must be higher when discounted at a lowerrate of interest. We may admit that this statement is true. However, obviously, the firm has tobe around to collect the higher income. Many of them won’t be, as they succumb to capitalsqueeze caused by falling rates. My critics hold that falling rates are always beneficial tobusiness and it is preposterous to suggest that they aggravate deflation. These critics confuse afalling structure of interest rates with a low structure. While the latter is beneficial, the formeris lethal to producers. When interest rates are falling, the low rates of today will look like highrates tomorrow. A prolonged fall creates a permanently high interest-rate environment. Thisparadox explains the reluctance of the mind to admit that falling rates spell deflation and, inan acute case, depression

Falling rates mean that businesses have been financed at rates far too high. This factought to be registered as a loss in the balance sheet, and be compensated for by an injection ofnew capital. If businesses choose to ignore the loss, and they merrily go on paying outphantom profits in the form of dividends and executive compensation, then they will furtherweaken capital structure. When they finally plunge into bankruptcy, they wonder what has hitthem. They don’t understand that they have failed to augment their capital in the face offalling interest rates. Their downfall is due to insufficient capital. In a falling interest rateenvironment all producers are affected by the elusive process of capital destruction. This wastrue in the 1930’s; it is still true today. Incidentally, this also explains why Americanproducers have been going out of business in droves since the mid-1980’s, resulting in theexport of the best-paying industrial jobs to Asian countries such as China and India wherelabor costs were lower

The U.S. government may be unconcerned about the fact that the liquidation value ofits debt is escalating by several orders of magnitude due to falling interest rates. After all, theFed has the printing presses to create dollars with which any liability can be liquidated,however large. American producers are not so fortunate. They have to produce more and sellmore if they don’t want to sink deeper in debt. But selling more may not be possible in afalling interest-rate environment, except at fire-sale prices. What this shows is that the causeof deflation is not falling prices: it is falling interest rates. As they fall, a vicious circle is setin motion. Bond speculators take advantage of the opportunity created by the central bank’sopen market operations. They forestall central bank buying of government bonds. Theresulting fall in interest rates bankrupt productive enterprise that could not extricate itselffrom the clutches of debt contracted earlier at higher rates. The debt becomes ever moreonerous as its liquidation value escalates past the ability to carry it. The squeeze on capitalcauses wholesale bankruptcies among the producers

What central bankers never consider is that, while they have the power to putunlimited amounts of irredeemable currency into circulation, they have no power to make itflow in the “approved” direction. Money, like water, refuses to flow uphill. In a deflation itwill not flow to the commodity market to bid up commodity prices as central bankers havehoped. Rather, it will flow downhill, to the bond market, where the fun is bidding up bondprices. As the central bank has made bond speculation risk free, the bond market will act as agigantic vacuum cleaner sucking up dollars from every nook and cranny of the economy. Asense of scarcity of money will become pervasive

In feeding ever more irredeemable currency to the markets the central bank cuts thefigure of a cat chasing his own tail. More fiat money pushes interest rates lower; fallinginterest rates squeeze producers more. They cut prices in desperation, and cry out for thecreation of still more fiat money, completing the vicious circle. The interest rate structure and9the price level are linked. Subject to leads and lags, they keep moving together in the samedirection

The Fed through its open market operations generates a deflationary spiral that mayultimately bankrupt the entire producing sector. Like the Sorcerer’s Apprentice, the Fed canstart the march to the black hole of zero interest, but hasn’t got a clue how to stop it when thepull of the black hole becomes irresistible. At that point the deflationary spiral gets out ofcontrol

Stop the March to the Black Hole of Zero Interest!

Restoring sound accounting standards is imperative if we want to avoid the pending disaster

We must stop turning a blind eye to the deleterious effect of a falling interest rateenvironment on capital deployed in support of production. Open market operations of the Fed,the chief cause of deflation as demonstrated by the pull of the black hole of zero interest, mustbe outlawed

Only the gold standard can effectively cordon off the black hole of zero interest. Byopening the Mint to gold, the U.S. government must restore the gold standard

Antal E. Fekete

San Francisco School of Economics

aefekete@hotmail.com

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