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I. INTRODUCTION
Fly in the Ointment
There
are two standard views of the Great Depression of the 1930's. Keynesians
maintain that the capitalist system is, by its very nature, prone to
overproduction and, in the absence of government intervention, excessive
inventories will periodically lead to falling prices and to growing
unemployment which will further compound the collapse in demand. They
advocate public works financed, if need be, by massive deficit spending. The
central bank must be instructed to buy up all the government bonds that the
market is unwilling to absorb. According to the Keynesian view in the early
1930's the current economic fetish, the balanced budget, prevented an
increase in public spending to boost demand. Thus, then, faulty fiscal policy
is to be blamed for the economic collapse that followed. On the other hand
Friedmanites maintain that, although the central bank should churn out new
money at a steady rate, something that even a "clever horse could be
trained to do", yet the Federal Reserve was issuing money erratically.
Sometimes it issued too much as in the stock-market frenzy of the 1920's, and
sometimes too little as after the stock-market collapse in the 1930's. In the
latter episode the economy was squeezed through a shortage of money causing
prices to fall. Thus, then, faulty monetary policy is to be blamed for the
economic collapse that followed.
For
some time it has been increasingly clear that both views fall short of the
mark. The Friedmanites ignore the fact that while the central bank has the
power to issue money at any preconceived rate through open market purchases
of bonds, yet it is utterly powerless
to determine how this money shall be used by market participants.
Commodity speculation is not the only use to which newly created money can be
put. Another possibility is bond speculation which instead of raising the
prices of goods will raise the prices of bonds or, what is the same to say,
will lower interest rates. Thus the sorcerer, the central bank, finds itself
in competition with its apprentices, the bond speculators, and control will
shift to the latter. On the other hand, the Keynesians ignore the fact that
financing public works is a depressant on enterprising exuberance.
Entrepreneurs are not prepared to compete unconditionally with the government
for funds to finance projects. They want to be convinced that theirs will be
profitable before they commit funds to increase inventory and productive
capacity. Deficit spending by the government brings profitability of
enterprise into question.
Although
superficially these two approaches to the problem appear to argue from
different angles, they are in fact the same, if in different disguises. Both
the Keynesians and the Friedmanites advocate the application of the same
nostrum: central bank purchases of bonds, for the same purpose: to suppress
the rate of interest for political ends. But there is a fly in the ointment
prescribed by quacks of either persuasion, namely, the bond speculator. The
so-called fiscal and monetary stimulus to boost demand is a myth. Either
stimulus, rather than boosting demand for commodities, shall only boost
speculative demand for bonds. If the bond speculator knows that tomorrow the
central bank will buy bonds in the open market, then he will buy bonds today.
Come tomorrow, he wants to feed them to the central bank at a hefty price
advance.
Loading
the Dice
Here
is the description of the process in more details. The bond market is
destabilized by the extraneous demand for bonds for purposes other than
saving, in particular, for political purposes. There is an increase in the
volatility of bond prices, and a corresponding increase in the volatility of
interest rates. Bond speculators, dormant while the interest-rate regime is
stable as under a gold standard, will come to life with a vengeance as soon
as volatility appears. Individual speculators as well as financial
institutions will duly note that big money is to be made by trading (as
opposed to holding) bonds. There is more. In the new casino (the bond market)
the dice are loaded. Those armed with this intelligence can take advantage of
a free ride to riches. How? Since the central bank is a buyer practically all
the time and hardly ever a seller, the risk inherent in bond speculation has
been eliminated, or at least greatly reduced, by the so-called
contra-cyclical monetary policy. All the speculator has to do is buy before
the central bank does, and sell afterwards. Little wonder that speculation
will snowball and become rampant, exceeding even the worst excesses of the
earlier stock-market speculation.
Stabilizing or Destabilizing Speculation?
The
observation that both the Keynesian and Friedmanite nostrums (allegedly
suitable to prevent depressions) are counter-productive in that they
aggravate rather than alleviate the crisis, has been ignored by economists.
They accept the conventional wisdom that speculation tends to dampen
volatility in any market. However, this generalization is patently false. One
must distinguish between two kinds, stabilizing and destabilizing
speculation, according as it deals with risks created by nature, or with
risks created by man. The thesis that speculation is smoothing out fluctuations
is true only of the first variety, for example, speculation in market for
agricultural commodities. With regard to the second, speculation in markets
dealing with risks created by man (including risks created by governments and
central banks) fluctuations will increase as a result of speculation. For
example, in the bond market more speculation means more volatility, not less,
as speculators seek to induce and ride price trends, rather than resisting
them. They do not act randomly as speculators in the commodity markets do.
Bond speculators march in lockstep.
Falling
Interest Rates Squeeze Profits
We
shall see that bond speculation has a pivotal role in the genesis of
depression and deflation. The buying of bonds for speculative purposes tends
to depress interest rates. The mechanism that transmits the fall in the
interest-rate structure to a fall in the commodity price structure is the
rising bond price. It makes the present value of debt rise. As it does, the
liquidation-value of enterprise also rises. Here is a paradox: falling
interest rates squeeze the profits of productive enterprise. This is also the
missing link economists have failed to find: the rise in the
liquidation-value of enterprise causes an uncontrollable increase in the cost
of servicing capital deployed in production. As costs increase, profits fall.
We conclude that the squeeze on profits is not caused by the falling
price-structure as previously assumed. Falling prices are themselves an
effect, not a cause. The real cause is the falling interest-rate structure
which reveals that productive capital has been financed at rates far too
high. As a result of the squeeze, profits are turned into losses. Many firms
fail, taking others down with them in a domino-effect as receivables get
harder to collect. Demand collapses, prices fall.
The
central bank is desperately trying to apply damage-control by putting more
money into circulation. However, more money is just oil on fire. It is not
flowing to the commodity markets as expected. It flows to the bond market
where the action is. By bidding up bond prices to ever higher levels bond
speculators push the rate of interest to ever lower levels. This puts further
pressure on profits and makes more productive enterprise fail. A vicious
circle is set into motion. As already mentioned, once Keynesian
fiscal policy and/or Friedmanite monetary policy have become official,
bond speculators face virtually no risk. Central bank intervention will
provide a nice tail-wind to make their sails bulge.
Stealthy
Wealth-Transfer
It
is not hard to identify the chief culprit of bond speculation. It is the
banking fraternity trying to rebuild bank capital that has been devastated
during the preceding boom. The banks suffered huge capital losses in the bond
portfolio, thanks to the relentless rise in interest rates. Further serious
losses were sustained in the investment portfolio due to the proliferation of
non-performing loans, in consequence of commercial borrowers having become
over-extended in the face of rising interest rates. Now the rate of interest
is falling, and the banks once more have the upper hand. Bankers are
determined to make most of it.
The
point is that the wealth of failing productive enterprise does not go up in
smoke during the depression, as it has been wrongly assumed by earlier
writers. It is being siphoned off and will show up as capital gains in the
banks' bond portfolio. In this revisionist view, the Great Depression appears
to have been caused by a massive wealth-transfer from the productive sector
to the financial sector, denuding the former of its capital. The stealthy
wealth-transfer has been made possible in the first place by the
destabilization of the interest-rate structure. For this, mistaken government
policies caving in to anti-gold propaganda and agitation for unlimited
deficit-spending are squarely responsible.
Collapse
of Demand or Collapse of Production?
In
the second part of this essay we shall put the patience of the reader to test
by a detour to discuss some fundamental book-keeping principles. This will be
necessary for a full understanding of the stealthy wealth-transfer from the
productive to the financial sector, that would never be possible if the
balance sheets of individual firms in the productive sector showed the true
financial picture at all times and the accounting profession raised the alarm
about the ongoing capital consumption. But in a falling interest-rate
environment the balance sheet ignores the huge increases in liquidation-value
and the corresponding destruction of capital, of which all productive firms
are suffering. Worse still, phantom profits are being paid out which further
eats into capital, ultimately leading to the downfall of the productive
sector of the economy.
In the third part, out of these elements we construct the revisionist
theory of the Great Depression, and warn of the consequences concerning the
present falling interest-rate environment in which the same forces are again
at work. The conclusion is that causes of the Great Depression are to be
found in the fatally relaxed accounting standards, the creation of the
Federal Reserve banks in 1914, and the destruction of the gold standard in
1933. They interacted to cause wholesale capital destruction in the
productive sector. It was not the collapse in demand that caused the collapse
of production, as asserted by the currently fashionable Keynesian and
Friedmanite orthodoxy. It was the exact opposite: the collapse in production
causing the collapse of demand. As pointed out already, the collapse in
production occurred in response to the invisible destruction of capital due
to the falling interest-rate structure which, in turn, was engineered by the
bond speculators, chief among them the banking fraternity.
II.
THE BOOK-KEEPER'S DILEMMA
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 Paciuoli
(fl. 1450-1509). As a result of compromising the high standards of the
accounting profession, the book-keeper will unwittingly become the destroyer
of Western Civilization.
Luca
Paciuoli taught mathematics at most universities of Quattrocento Italy
including those of Perugia, Napoli, Milan, Florence, Rome, and Venice. In
1494 he published his Summa Arithmetica. Tractatus 11 of that work is a
textbook on book-keeping. In it 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", "goodwill", or "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. Otherwise there must be a mistake. But what Paciuoli 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. Stock markets, mergers,
acquisitions would not be possible. The national economy would be a
conglomeration of cottage industries, unable to undertake any large-scale
project such as a transcontinental railroad construction or 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
have 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 if they had
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 that the gold
standard is a "barbarous relic", 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. It was not the gold standard per se that politicians wanted to
overthrow, but certain accounting and moral principles that had become an
intolerable fetter upon their ambition for aggrandizement and perpetuation of
power. Historically, accounting and moral principles had been singled out for
discard before the gold standard was given the coup de grâce. The
attack on accounting standards and the corruption of the gold standard were
heralded by the establishment in 1913 of the Federal Reserve System, the
engine for monetizing government debt. Just how the monetization of
government bonds led to a hitherto unprecedented, even unthinkable,
corruption of accounting standards - this is a question that has never been
addressed by impartial scholarship before.
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. 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 the corresponding 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 share the loss through the increased
cost of servicing capital due to the higher rate of interest. Everybody was
prompted to work and save harder in order that the damage might be repaired
more quickly and expeditiously. As interest rates gradually returned to their
lower level, the Wealth of Nations expanded. Again, everybody would benefit
through the reduced cost of servicing productive capital. It is not widely
recognized that the chief 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,
while ruling out capricious and disturbing swings in it.
The
gold standard ruled supreme before World War I. But once general mobilization
was ordered in 1914, it was put at risk by the manner in which belligerent
governments set out to finance their war effort. These governments wanted to
perpetuate the myth that the war was popular and there was no opposition to
the senseless bloodshed and destruction of property that could have been
avoided through better diplomacy. The option of financing the war effort
through taxation was ruled out as it might make the war unpopular. 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 shrank 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. Sinking fund protection was
offered by every self-respecting firm issuing bonds. Even though governments
did not offer it, it was understood and, in the case of the Scandinavian
governments explicitly stated, that in case of a permanent rise in the rate
of interest 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 a loss. 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 their value 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 admonition and did not want to bring upon
themselves the Biblical curse pronounced on the tormenters 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 Paciuoli 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 by banks and other lending institutions. In the
absence of this Law banks could overstate the value of their assets that
could be an invitation to credit abuses to the detriment of shareholders and
depositors. If the credit 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 the collapse of the national economy
might be the result. For non-banking firms the possibility of overstating
asset-values also existed and could similarly serve as an invitation to
reckless financial adventures. Even if we assume that upright managers would
always resist the temptation and would not intentionally get involved in such
adventures, in the absence of the Law of Assets the balance sheet would still
cease to be a reliable compass to guide the firm, materially increasing the
chance of making an error. Managerial errors could compound and the result
could again be bankruptcy.
Economists
of a statist persuasion would 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 right to seigniorage in the
process of issuing money. However, the problem is not with the nominal value
of government bonds at maturity, but with the purchasing power of the
proceeds. Currency depreciation 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 if has taken it from Paul first. 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 technically 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 in 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 report 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 below 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 may, the very foundations
of Western Civilization. (The recent scandal involving the American giant
Enron is in fact a scandal involving the entire accounting profession, which
stems from the unwarranted relaxation of accounting standards back in 1914.)
While
I am in no position to prove that a secret gag-rule was imposed on the
profession, 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
accounting 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 Paciuoli. 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 comes
as no surprise that this leadership is facing the most serious challenge of
its 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 posthumous Financial History of the United
States published in 1949). 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 at its value at maturity, or at its liquidation
value, whichever is higher. Since liquidation would have to take place
at the current rate of interest, in a falling interest-rate environment the
height of 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 completely
disregarded by the economists' profession. As we know, economists have failed
to raise their voice against the folly of allowing the interest-rate
structure to fluctuate for reasons of political expediency, implicit in the
application of both Keynesian and Friedmanite nostrums. It is possible that
the reason for this failure was the fatal blind spot economists appear to
have in regard to the danger of overestimating national income in a falling
interest-rate environment.
The
proposition that a firm must report liabilities at a value higher than that
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 has to be liquidated for whatever reason, then of course all liabilities
become due immediately. Sound accounting principles demand that sufficient
capital be maintained at all times to make liquidation without losses
possible. If the interest rate 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 have been secured by postponing the investment. In other
words, a managerial error in timing has been made. 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
managerial error. If the investment had been financed out of internal
resources, penalty is still justified. Alternative uses for the resource
would have brought better financial results.
But
even if we assume that the investment was absolutely necessary to make at the
time it was made, and 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 losses due to an accidental fire destroying
physical capital which the insurance company for whatever reason fails to
cover. 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.
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, that is, if he failed to
realize the loss due to fire, then he would falsify future income statements.
As a result, phantom profits may be paid out (or losses may be reported as
profits). Not only would this weaken the financial condition of the firm, but
it would also render the balance sheet meaningless, which may lead to further
errors.
Exactly
the same is true if the loss was due not to fire but a fall in the rate of
interest. The way to realize the loss is analogous. 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 been, I repeat, 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, or in the theory and history of
accounting. Nor do I recall having seen the Law of Liabilities in any of the
textbooks on book-keeping that I have perused (although I have seen the Law
of Assets in many older books 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 Paciuoli. 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 can 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 Paciuoli, 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. For
centuries, the powers that be have shown a persistent bias in taking the side
of the debtors' class against that of the creditors', as demonstrated by
their desire to suppress the rate of interest by hook or crook. However, this
effort has remained counter-productive before the advent of open-market
operations. Indeed, the usuriously high rates charged on loans in
pre-capitalistic times were not due to an alleged greed of the usurers. They
were due to the usury laws themselves. The charging and paying of interest
had been outlawed. The result was not zero interest as the authors of the
usury laws had foolishly hoped. On the contrary, the result was rates higher
than what the free market would have charged. The excess represented
compensation for risks involved in doing an extra-legal business transaction.
For these and other reasons, the problem traditionally was not lower or
falling rates. It was higher or rising rates. But the Law of Liabilities
remains inoperative in such an environment. Furthermore, when open market
intervention of the central bank came into vogue with the establishment of
the Federal Reserve System, the United States was still on the gold standard
which set a limit to the lowering of interest rates for political purposes.
The Law of Liabilities continued to be inoperative. It is hard indeed to
discover a Law that has been inoperative all through previous history.
The
picture changed decisively in the 1930's when agitation against the gold
standard started in earnest. Britain abandoned the gold standard in
September, 1931, and the United States, in March, 1933. Finally, the last
obstacle has been removed, and the door to suppressing the rate of interest
for political purposes through central-bank open-market purchases of bonds
was thrown wide open. Interest rates were falling throughout the 1930's.
Considering its magnitude, the fall appears to be unprecedented by historical
standards. Thus, then, we have the first
instance ever in history that the Law of Liabilities could become operative.
I think it did. The proof is that the Great Depression did indeed take place.
Antal E. Fekete
San Francisco School of
Economics
aefekete@hotmail.com
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all the other articles written by Antal E. Fekete
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AND CONFLICTS
THE PUBLICATION OF THIS LETTER IS FOR YOUR INFORMATION AND AMUSEMENT ONLY.
THE AUTHOR IS NOT SOLICITING ANY ACTION BASED UPON IT, NOR IS HE SUGGESTING THAT
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COMPLETE OR ERROR-FREE, AND IT SHOULD NOT BE RELIED UPON AS SUCH. IT IS TO BE
TAKEN AS THE AUTHORS OPINION AS SHAPED BY HIS EXPERIENCE, RATHER THAN A
STATEMENT OF FACTS. THE AUTHOR MAY HAVE INVESTMENT POSITIONS, LONG OR SHORT,
IN ANY SECURITIES MENTIONED, WHICH MAY BE CHANGED AT ANY TIME FOR ANY REASON.
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© 2002-2008 by Antal E. Fekete - All rights reserved
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