Toxic economic theory, fraudulent accounting standards, and the bankruptcy of economic policy

Toxic Economic Theory, Fraudulent Accounting Standards, and the Bankruptcy of Economic Policy R... Part I A Very Dismal Science 1 The Greatest Pyramid Scheme since the 2 From Economic M

Standards, and the Bankruptcy of Economic Policy

Toxic Economic Theory, Fraudulent Accounting Standards, and the

Bankruptcy of Economic Policy

R A Rayman

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Part I A Very Dismal Science

1 The Greatest Pyramid Scheme since the

2 From Economic Miracle to Credit Crunch:

Part II The Microeconomic “Market-Value” Fallacy

Part III The Macroeconomic “Single-Gear” Fallacy

6 The Topsy-Turvy Wonderland of Single-Gear Economics 65

Part IV The Tax that Got Passed by Mistake

12 Not So Much a Tax, More an Anti-Avoidance Provision 116

Part V Reform of the Tax System

17 Pay As You Spend: The Social Justification 172

Part VI The Bankruptcy of Economic Policy

Technical Appendices: The Source of the Poison

Appendix A The Fatal Flaw in Accounting Theory:

Appendix B The Fatal Flaw in Macroeconomic Theory:

List of Tables

2.1 The United Kingdom economy from the “bad old days”

3.1 Expected and actual operations of the two companies 29 3.2 Summary of the conventional historical accounts

3.3 The influence of the volume of activity on the

4.2 Balance sheet of the Fair-Value Company

4.3 The effect on investors of a reported fair-value “gain”

5.1 The effect of price changes on a home owner

5.3 The UK house-price bubble during the NICE decade 51 6.1 From 1960 to 2000: “temporary side-effect” or

16.2 Taxes to be replaced under the proposed alternative 16718.1 Where the whole item of income is consumed

immediately 186

18.2 Where the whole item of income is saved for one year 187 A.1 Fisher’s measure of performance dependent on

B.1 The effect on macroeconomic equilibrium of changes

List of Figures

2.1 Twenty-five years of calm seas – prior to

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 alter-natives 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 sus which emerged in the late 1970s What amounted to a theological

consen-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 (1694–1774) 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

repro-duction [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

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 repercus-sions The single-gear fallacy is an object lesson in the folly of con-ducting 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.

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 conven-tional 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 funda-mental 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

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 paring business performance The obsession with current market values

com-is a major cause of “short-termcom-ism” and “rewards for failure”; and it com-is a source of the current controversy over executive pay Instead of operat-ing 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 roeconomic policy for stable economic growth:

mac-(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

con-trolling 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 mon-etary 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 vent 1930s-type depression) and “single-gear growth” (with no mechan-ism to prevent 1970s-type inflation)

pre-Rapid economic growth without inflation requires freedom of lation as well as freedom of competition The bankruptcy of economic policy is directly attributable to neglect of the Law of Circulation

circu-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

of conventional economic theory The policy implications are

devel-oped 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 mac-roeconomic 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 ther 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

nei-to convert the tax system from a major obstacle nei-to the goals of nomic policy into a powerful weapon for their achievement

eco-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

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 con-tained 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.211–215) 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

Part I

A Very Dismal Science

1

The Greatest Pyramid Scheme

since the Time of the Pharaohs?

The value of the UK’s private housing stock rose by

an estimated 9% in 2007 to reach £4 trillion, says the

Halifax That figure has more than tripled over the last

decade, rising by 208% from £1.3 trillion recorded in

1997

[BBC News website, 12th January 2008]

In a speech delivered on Wednesday 18th June 2008 at the Lord Mayor’s Banquet for Bankers and Merchants of the City of London, the Governor of the Bank of England referred fondly to the period “since the Monetary Policy Committee was set up in 1997” as “the NICE dec-ade” of Non-Inflationary Consistent Expansion

What made the decade especially nice for UK home owners was the tripling of the market value of the housing stock from £1.3 trillion to £4 trillion The apparent gain of £2.7 trillion was more than twice the size of the UK National Income for 2007 and four times greater than the National Debt It enabled politicians to make the proud boast of the “increase in the value of your homes” to a largely admiring electorate Home owners, who found themselves on the way to becoming millionaires without any effort of their own, praised the Government and were duly thankful.The real heroes were the bankers whose widely acclaimed ingenuity and enterprise had raised the market value, not only of property, but also of bank shares, to truly astronomical heights.1 For this remarkable achievement, all they took for themselves were a few paltry tens of

1 British bankers were not alone in this achievement: there were equally strong contenders elsewhere, particularly in the United States and Spain.

millions in bonuses and pensions as the modest reward for the huge increase in prosperity that they had conferred on society.

Then all of a sudden, in the summer of 2007, just as everyone was settling down to live happily ever after with all their nice new wealth, something nasty occurred The property market collapsed, the credit system seized up, and, before long, the global economy was tipped into recession

The Hunt for Scapegoats

Almost overnight, those who had been the most enthusiastic ers of the greatest pyramid scheme in British history became its sternest critics According to the House of Commons Treasury Select Committee,

cheerlead-it was all the fault of the bankers:

Bankers have made an astonishing mess of the financial system

to the book”, it was the wrong book – the crisis would still have occurred:Personal greed is often the explanation given for the disastrous forays

of the world’s banks into America’s subprime mortgages In Germany, however, many of the worst decisions were made not by the bonus-driven crowd in Frankfurt but by ostensibly well-intentioned public servants in the country’s public banks, or Landesbanken

[The Economist, 9th May 2009, p.79]

“Reckless and excessive risk taking” certainly aggravated the cial crisis, but it was not the root cause The massive losses sustained ten years earlier by Long-Term Capital Management, an investment fund founded by two Nobel-Prize winners, had shown what could be achieved by academic scholarship alone.2

finan-2 The loss, in 1998, of over $4,000 million within a few months is described

in Chapter 5 It is a dreadful warning of the danger of relying on sophisticated mathematics.

The real culprit was not bad practice, though there was no shortage of outrageous examples (ranging from negligence to downright criminal-ity), but bad theory.

The Market-Value Fallacy and Pyramid Lending

The root cause of the credit crunch is toxic economic theory, which has corrupted the textbooks of accounting and finance The poison lies in the apparently innocuous proposition that an increase in the market value of an asset (in excess of any increase in the general level of prices)

necessarily represents a genuine increase in real wealth Although it is

firmly entrenched as part of the conventional economic wisdom, the proposition is totally false

An increase in the price of houses (unaccompanied by an increase

in their quantity or quality) cannot benefit the economy as a whole; it simply creates winners and losers It represents an inflationary bubble, rather than a genuine increase in real wealth The widespread abuse of the “wealth effect” argument to encourage the explosion of credit dur-ing the NICE decade – by a multiple of 2.4 [Office for National Statistics, series VZRI] – was therefore wholly unjustified

The market-value fallacy makes mortgage lending appear to be responsible as long as the loans are adequately covered by the market value of the property It therefore erodes the normal income constraint

on borrowing and lending The inevitable result is a spiral of increasing property values making possible ever-increasing loans push-ing up ever-increasing property values

ever-Pyramid schemes are normally against the law, but pyramid ing has been made respectable by the market-value fallacy Yet it is unlikely that the pyramid could have expanded to its enormous size, if the corruption of international accounting standards had not crippled the (already seriously defective) mechanism for keeping the financial system under control

lend-The Market-Value Fallacy and Fraudulent Accounting

Standards

Provided that it is carried out with due diligence, conventional

accounting is ideal for stewardship reporting on the custody and keeping of enterprise resources For performance reporting on their

safe-efficient and profitable use, however, it has a fatal flaw: the ity of activities which produce returns relatively quickly is routinely overstated This provides a perverse and almost irresistible incentive to

profitabil-short-termism – the pursuit of quick returns to the detriment of term profitability.

long-Fair-value accounting, imposed without adequate debate on a largely unwilling profession by the International Accounting Standards Board, does nothing whatsoever to remedy the fatal flaw On the contrary, because the market-value fallacy has been incorporated as a funda-mental theoretical principle, fair-value accounting makes matters worse Increases in market value are reported as gains, and decreases are reported as losses Although this feature appears eminently plau-sible, it is based on the dangerous fallacy which is discussed more fully in Chapter 4 By exaggerating the news, whether good or bad,

it reinforces swings in the economic cycle and acts as a destabilising influence

In refusing to answer objections from the business community and the accountancy profession, the International Accounting Standards Board has given the impression of dealing with difficulties by pretending that they do not exist It has also ignored explicit warnings of the dan-gers of fair-value accounting (FVA) – even from bodies like the European Central Bank:

FVA … can lead to a misallocation of resources and sub-optimal investment behaviour because, in an economic upturn, non-viable projects may get financed, while in a downturn even very promising projects may be rejected In addition, systemic risk could increase,

an illustration being the fuelling of an asset bubble during economic upturns through generous credit conditions and higher collateral values The subsequent bursting of the bubble may result in a bank-ing crisis and a credit crunch

[European Central Bank, Monthly Bulletin, February 2004, p.78]

Financial reports drawn up in accordance with International Financial

Reporting Standards are liable as a matter of normal routine to present

actual economic failure as accounting success and actual economic success as accounting failure Some of the most outrageous “rewards for failure” have been made possible, not by the flagrant violation of accounting standards, but by their strict observance

The market-value fallacy is responsible, not only for encouraging the house-price bubble, but also for corrupting the standards-setting process

so thoroughly that accounting standards themselves have become ently fraudulent Their implementation may result in “false accounting” within the meaning of section 17 of the Theft Act 1968: the production

inher-of accounts known to be “misleading, false or deceptive in a material particular”.

Perhaps the market-value fallacy can be seen in a clearer perspective

if the news item quoted at the head of this chapter is restated in terms

of the “tulipomania” which ravaged Holland in the 1630s:3

The value of the UK’s private tulip stock rose by an estimated 9% in

2007 to reach £4 trillion That figure has more than tripled over the last decade, rising by 208% from £1.3 trillion recorded in 1997

[BBC News website, 12th January 2008 (slightly amended)]

So powerful and popular is the illusion of real wealth that, even in some

of the best-informed quarters, the penny has still to drop Members of the Treasury Select Committee have concurred with the chairman of the International Accounting Standards Board in expressing the hope that property (and tulip?) prices will return to their former heights

The market-value fallacy does, however, have one redeeming feature: the bad news is not quite as bad as it seems

The Not-So-Bad News

A house-price bubble (even as one as large as £2.7 trillion) is like any other economic bubble When it inflates, no real wealth is created; there

is simply an illusion of overall gain When it deflates, no real wealth is destroyed; there is simply an illusion of overall loss

The illusion can, nevertheless, be extraordinarily powerful:

Total mark-to-market losses across the [UK, USA, and EU] currency areas … have risen to around US$2.8 trillion

[Bank of England, Financial Stability Report,

28th October 2008, p.14]Difficult though it may have been to believe, however, the Earth had not been hit by an asteroid which had wiped out most of its wealth The real economy was perfectly sound

In spite of the astronomical sums involved in the inevitable collapse

of the lending pyramid, no real wealth was directly involved It was a

3 For an account of the tulip-price bubble from 1634 until its collapse in 1636, see Mackay (1841) pp.89–97 As a result “the commerce of the country suffered a severe shock, from which it was many years ere it recovered” [p.97].

question of circulation All those billions and trillions had not been lost; they were merely stuck in the financial pipelines Even in the real world

of sub-prime mortgages, no real wealth had been destroyed Property values might have fallen, but the houses and apartments were still standing They had not been bombed

How a Manageable Financial Problem Turned into a Real Economic Crisis

The lesson supposed to have been learned from history – particularly from the Wall Street Crash of 1929 – was the necessity for the central bank to step in as “lender of last resort” and for the government to step

in as “spender of last resort” It was the failure to act immediately and decisively, not only when the warnings were issued by the European Central Bank in 2004, but even after the dangers had clearly begun to materialise in the summer of 2007, that allowed important areas of the credit system to seize-up and spending to drop What should have been

a manageable financial problem was allowed to develop into a serious global economic crisis

Although “moral hazard” was put forward as an excuse, the cause of the policy paralysis was a different – even more virulent – strain of toxic economic theory

Following its revival in the last quarter of the twentieth century, the false nineteenth-century view of the economy as a “single-gear” machine has been re-established as an article of faith in the textbooks of macroeconomics It owes its present stranglehold over economic policy

to the widespread, but totally misplaced, belief in what has come to be known as “the economic miracle”

2

From Economic Miracle to

Credit Crunch: Thirty Years of

in 1978 led to the fall of its Labour successor One of the most enduring images of the 1979 election campaign was a winding dole queue displayed

on Conservative Party posters under the slogan “Labour isn’t working” The message was irrefutable: with over one million people out of work, unemployment had gone beyond levels not seen since the 1930s

But, barely noticed amid the fierce political controversy of those times, there occurred what can only be described as an economic miracle

The End of Sectarian Conflict: the Revival of the Old

Orthodoxy

The economics profession, which had for over a generation been riven

by sectarian conflict between Keynesians and Monetarists, reunited in

a fundamentalist revival of the ancient classical free-market religion It was based on a strict interpretation of the purist theology published in

1874 by Léon Walras in his Éléments D’Économie Politique Pure.

According to the Old Classical Orthodoxy, any unemployment in the real world was a “natural rate” determined by imperfection and inflex-ibility in the market structure Any deviation from the natural rate could only be temporary – during the time that it took for responses to change to overcome frictional resistances in the market structure

Economic policy became delightfully simple: the only lasting cure for unemployment was to get rid of restrictive practices (on both sides

of industry and in the professions) and to make markets more flexible This has now re-emerged as the modern consensus:

In most areas of public policy, such as crime or education, governments

at least have the excuse that experts give conflicting advice Not so with unemployment 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]

It follows with apparently inexorable logic that “spending one’s way out of a recession” (whether by increasing government spending or by encouraging private spending through reduced taxation) is no more than a temporary expedient It can push unemployment below its natu-ral rate for a short time, but the only lasting result will be an increase

in the level of prices

By the same token, a policy of monetary restriction to control price inflation appears to be safe Although it is freely admitted that it may produce a “fairly protracted, period of economic recession or slowdown and of relatively high unemployment”, this is dismissed as a “tempo-rary … side-effect” [Friedman (1974) p.9]

The economy is treated as a “single-gear” machine which requires:(1) lubrication by free competition to keep it fully employed; and(2) regulation of its monetary fuel to prevent inflationary overheating.This toxic fundamentalist theory is responsible for the modern lethal two-pronged economic strategy for price stability and full employment:(1) a laissez-faire microeconomic policy of market liberalisation to con-

trol unemployment; in conjunction with

(2) an interventionist macroeconomic policy of monetary restriction to

control inflation

From Old Orthodoxy to the New Economic

Fundamentalism

Introduced with reluctance by a Labour prime minister in September

1976, the Old Orthodoxy was embraced with enthusiasm by the

Conservative government which took office in May 1979 The Old Orthodoxy had become the New Economic Fundamentalism.

The results were sensational The annual rate of inflation, which had peaked at over 20 per cent during the 1970s, was reduced from 13.4 per cent in 1979 to 2.4 per cent in 1996, the Conservatives’ last full year

of an independent Monetary Policy Committee of the Bank of England

The results became even better A period of extraordinary stability ensued It was the end of the era of boom and bust The declaration of victory over the economic problems of inflation and unemployment ushered in a NICE decade of Non-Inflationary Consistent Expansion The history of the “economic miracle” is shown in Table 2.1

The credit crunch of 2007 might have come as less of a surprise, however, and a manageable financial problem might have been pre-vented from turning into a serious global economic crisis, if there had been a more realistic appreciation of the true nature of the economic miracle

Economic Miracle or Mirage?

The success of the microeconomic policy of liberalisation achieved ing the 1980s was undeniable Even the harshest critics were forced to concede that economic flexibility – particularly in labour markets – had improved beyond recognition

dur-And that was not all: Britain in the 1980s and 1990s enjoyed three significant advantages that were absent in the 1960s:

the microeconomic revolution in market flexibility;

the microelectronic revolution in information technology; and the windfall of North Sea Oil

According to the New Fundamentalism, there could be only one result

of a transformation of this magnitude – a great leap forward in the rate

of economic growth

•

•

•

T

The Economic Miracle – Par

The result? A great leap backwards! During the Economic Miracle and the NICE decade up to 2007, the growth rate actually dropped signifi-cantly below the “miserable” rate achieved in the 1960s.

If all three advantages combined had done no more than add one half

of 1 per cent to the 1960s’ 4 per cent per annum target rate of economic growth, Britain’s Gross Domestic Product (GDP) in 2009 would have been double its actual size.1

The 1980s merit not just one entry in the record books but two:(1) the highest peacetime level of taxation in the whole of British history; and

(2) the highest level of unemployment since the Second World War.The excuse that these were temporary side-effects of “squeezing infla-tion out of the system” stretches the definition of “temporary” so far that it ceases to have any meaning.2

When the NICE decade is compared with the “bad old days” of the 1960s, there are some similarly awkward questions Why has the rate

of economic growth fallen rather than risen? Why is unemployment

1 At constant 2005 prices, UK GDP rose from £674,110 million in 1979 to

£1,264,077 million in 2009 – an annual growth rate of 2.1 per cent [Office for National Statistics, series ABMI] At an annual growth rate of 4.5 per cent, the

2009 figure would have been £2,528,154 million.

Statistics, of course, can be notoriously unreliable; and Table 2.1 has its fair share of the “usual suspects”:

The definition of unemployment has been changed no less than 30 times since 1979 By coincidence, 29 of those adjustments helped to shorten the dole queue

[The Economist, 28th July 1990, p.16]

Whatever their other merits, tax credits netted against tax revenue have the effect of keeping taxation “off the books” Price indices depend on a changing basket of goods and services which cannot be representative for all individuals and for all periods of time As a result of error or changes in methodology, many figures are subject to retrospective adjustment Nevertheless, the broad picture is suffi- ciently clear to raise questions about the exact nature of the economic miracle.

2 This criticism is not entirely new:

Theoretical writers are too apt, in their calculations, to overlook these

inter-vals [of adjustment]; but eight or ten years, recurring not unfrequently [sic],

are serious spaces in human life

[Malthus (1820) p.437]

higher rather than lower? Why is the tax burden heading back towards the record levels reached in the 1980s?

According to the New Fundamentalism, the economy is a single-gear machine which requires no more than the lubrication of competition to operate at its full employment potential Could it be that this is simply a delusion? Could it be that Britain (with vastly improved lubrication since 1979) has somehow done the impossible and shifted into a lower gear?

It may also be worth enquiring into the highly acclaimed success of monetary intervention in controlling inflation

Has Monetary Intervention Really Worked?

During the 1970s, world non-fuel commodity prices more than led Throughout the 1980s and 1990s, they actually fell Conditions on the world commodity markets remained benign until the end of 2005 Only then did the IMF’s commodity price indices (charted in Figure 2.1) start to rise significantly above their level at the beginning of 1980.During a period of unprecedented stability in world commodity prices, the Bank of England’s Monetary Policy Committee was remarkably

Figure 2.1 Twenty-five years of calm seas – prior to the storm of 2008

Source: International Monetary Fund, Data and Statistics, series PNFUELW (non-fuel) and

successful in keeping the annual rate of price inflation in the UK within its target range of 2 per cent based on the Consumer Prices Index (CPI)

As soon as world commodity prices began to increase significantly, however, the rate of UK inflation started to climb, until it peaked at over 5 per cent in mid-2008 Its subsequent fall may have owed less to the actions of the Monetary Policy Committee than to the dramatic fall

in the price of oil in the aftermath of the credit crunch

It may not be too difficult to keep the ship stable when the ocean is calm; but, when the sea gets rough, it is a different matter The monetary umbrella, though highly effective for keeping the economy dry when there is not much rain, has an awkward tendency to blow inside-out in

a storm The verdict may seem harsh; but perhaps it is too kind?During the so-called NICE decade, the price of the largest item of most people’s expenditure – their home – almost trebled Maintaining the illu-sion that the house-price bubble represented a genuine increase in real wealth, however, was a crucial element in encouraging the borrowing and consumption necessary to finance the “consistent expansion” from which the NICE decade got its name It has been advertised as stable economic growth; but, as suggested in Chapter 1, it may turn out to have been the greatest pyramid scheme since the days of the Pharaohs.Was inflation really “squeezed out of the system” or was it simply

“squeezed out of the statistics”?

No such doubts appear to have troubled the high priests of the Old Orthodoxy (aka the New Economic Fundamentalism) The single-gear fallacy remains an unshakeable central principle of orthodox economic policy That, more than anything else, explains why the credit crunch was allowed to turn into a global recession

The Stranglehold of Single-Gear Economics

The major obstacle to a policy of monetary and fiscal expansion to the extent required to restore liquidity and stimulate demand in the sum-mer of 2007 was the fear of losing control over prices Viewed in the single-gear perspective, recession was seen, not as a mortal danger, but almost as an instrument of policy Even as late as the autumn of 2008, the main preoccupation of the governor of the Bank of England was still the spectre of inflation:

A period of muted economic growth is necessary to dampen sures on prices and wages and return inflation to the target in the medium term

pres-[Letter to the Chancellor of the Exchequer, 15th September 2008]

In the meantime, however, common-sense had taken over Whatever the textbooks might say, it was becoming clear that many economies were experiencing a definite downward shift in gear Governments all over the world were forced into panic-stricken emergency rescues to save the banking system from total collapse The most notable was the

$700 billion bailout of the United States financial system provided by the Emergency Economic Stabilization Act passed in October 2008 Britain‘s response was equally impressive Its National Debt increased from just under £500 billion (36 per cent of GDP) in July 2007 to over

£2,000 billion (144 per cent of GDP with bank “bail outs”) by the end

of 2008.3 But these efforts were too late and insufficiently coordinated

to prevent the real economy from being tipped into recession.4

The only way to avert total catastrophe was, in effect, by printing money So terrifying was the association with hyperinflation – from the Weimar Republic of the 1920s to modern Zimbabwe – that the monetary expansion included the coining of a new term: “quantitative easing”

The Failure of the New Economic Fundamentalism

“Rescue now, pay later” was clearly preferable to a 1930s-type slump But it demonstrated the poisonous policy consequences of toxic single-gear economic theory There was no coherent policy for preventing a liquidity crisis from causing serious recession There is still no coherent

policy for coping with the consequences of the ad hoc emergency

meas-ures which have resulted in an apparently uncontrollable rise in debts and deficits Unless the toxic theory is discarded, there is little prospect

of a coherent strategy for full employment without inflation

The New Economic Fundamentalism has conspicuously failed to deal with what should have been a perfectly manageable (though exceedingly difficult) financial crisis As long as it retains a stranglehold on theory and policy, there is little hope of solving the far more difficult real eco-nomic problems which pose a serious threat to the global economy Real

3 Office for National Statistics, series RUTN and RUTO (Throughout this book,

£1 billion represents £1000 million.)

4 G20 summits were held in Washington (15th November 2008) and London (2nd April 2009) At the London meeting, the leaders of the Group of Twenty,

issued a Global Plan for Recovery and Reform in which they pledged “to do

what-ever is necessary to restore confidence, growth, and jobs”:

By acting together … we will bring the world economy out of recession and prevent a crisis like this from recurring in the future

[Communique, para.4]

problems, which require real – not financial – solutions, include ageing populations, climate change, and, in particular, the lack of economic opportunity which is the source of so much conflict between nations.

The Multi-Gear Alternative

The object of this book is to break the stranglehold of the Old Orthodoxy

by identifying the toxic theory responsible for the fundamentalist view

of the economy as a single-gear machine; and to suggest an alternative for enabling a multi-gear economy to operate at its full potential.The key to the efficient operation of a free-market economy is the observance of two basic laws: the Law of Competition and the Law of Circulation The reason for the conspicuous failure of the New Economic Fundamentalism is that its preoccupation with the Law of Competition

is so intense that the Law of Circulation is not even recognised

Plan of the Book

The argument is presented in two volumes The present volume identifies toxic economic theory as the cause of the bankruptcy of modern eco-

nomic policy The next volume, entitled A Multi-Gear Strategy for Economic Recovery, outlines the implications for the reform of economic policy and

develops a recovery strategy for rapid growth without inflation

The present volume exposes two fundamental theoretical errors resulting from what Leijonhufvud [1969, p.25] calls the “schizophrenic” split of economic theory into separate micro and macro compartments The microeconomic “market-value” fallacy is largely responsible for causing the economic crisis of 2007/8 The macroeconomic “single-gear” fallacy is responsible for preventing a solution

Part II – The Microeconomic “Market-Value” Fallacy – explains how faulty microeconomic theory has corroded accounting standards to such an extent that they have become inherently fraudulent By sanc-tioning the misreporting of economic failure as accounting success, they have spread “balance-sheet myopia”, created a powerful incen-tive to “short-termism”, and provided an irresistible opportunity for

“rewards for failure” By fostering the delusion that increases in market value necessarily represent increases in real wealth, the market-value

fallacy is the root cause of the house-price bubble and the lending mid directly responsible for the credit crunch of 2007

pyra-Part III – The Macroeconomic “Single-Gear” Fallacy – identifies faulty

“single-gear” macroeconomic theory as the main cause of the policy

paralysis of 2007 It accounts for the Bank of England’s hesitation to step

in immediately as “lender of last resort” to prevent the financial system from seizing up It also accounts for the Treasury’s hesitation to step in as

“spender of last resort”5 to prevent the real economy from tipping into recession There is, therefore, a need for a “multi-gear” policy alternative

A major obstacle to effective economic reform, however, is the functional nature of the tax system Part IV – The Tax That Got Passed

dys-by Mistake – explores the logical inconsistencies of the present system, which is not so much a “system” as an incoherent collection of histori-cal anomalies It manages to offend against the principles not only of economic efficiency but also of social justice Part V – Reform of the Tax System – contains proposals for reforming the tax system so that it

is responsive to market forces Instead of being an almost able obstacle to the goals of economic policy, it can be converted into

insurmount-a powerful instrument for their insurmount-achievement This is insurmount-an essentiinsurmount-al requisite for the alternative economic strategy, which is the subject of the next volume

pre-Part VI – The Bankruptcy of Modern Economic Policy – concludes that the root cause of the conspicuous failure of modern economic pol-icy to deliver stable economic growth is bad theory The detoxification

of economic theory requires proper appreciation of the microeconomic foundations of macroeconomic theory, so that it is impossible to over-look the multi-gear nature of the economy

The next volume is devoted to the development of an alternative

“multi-gear” strategy which attaches as much importance to freedom

of circulation as it does to freedom of competition The ground is pared by the present volume, which criticises the New Fundamentalism

pre-in economic theory and policy for its obsession with the Law of Competition to the exclusion of the Law of Circulation

The main obstacle to an effective policy to deal with problems ated by the current economic crisis is the dominance of the neo- classical consensus, which has become so firmly entrenched that economics may have more in common with religion than with science

gener-Until economic theory is purged of the fundamentalist extremism of the neo-classical consensus in economic theory, there is little hope of prog-ress in economic policy Parts II and III of this first volume are, therefore, devoted to exposing the two major fallacies of neo-classical economics

5 Either by reductions in taxation, in order to stimulate private spending, or

by increases in public spending, provided that they are justified on their own merits.

Part II

The Microeconomic

“Market-Value” Fallacy

Introduction

Following a spate of financial scandals and growing popular criticism

of the accountancy profession, the United States Financial Accounting

Standards Board (FASB) launched its Conceptual Framework Project in the

1970s The declared intention was to go back to first principles without any preconceptions Not even such hallowed financial statements as the profit and loss account and balance sheet were to be spared from scrutiny

As accounting standards bodies in various countries became embroiled

in the inflation accounting controversy of the 1970s, however, the FASB’s good intentions were forgotten When responsibility for the conceptual framework was taken over by the International Accounting Standards Board (IASB) in the early 1990s, its efforts in defending the status quo attracted some well-aimed criticism from within the profession:

A conceptual framework should be more than an ex post facto

justifi-cation of an already chosen approach

[Ernst & Young (2004) p.99]The IASB relied upon the belief that the existing system of accounting inherited from Mediaeval Venice could be made relevant for reporting modern business performance by the introduction of current market values Under the misleading label of “fair-value accounting”, the sys-tem was dependent on the microeconomic market-value fallacy The IASB seal of approval, supported by the New Economic Fundamentalism, resulted in an officially sanctioned epidemic of balance-sheet myopia – the inability to see beyond a firm’s balance sheet Short-termism became endemic in business practice

The dangers of propagating a market-value delusion were spelled out

by the European Central Bank early in 2004 The deafness of politicians and financial regulators to what they did not want to hear led inexora-bly to the credit crunch of 2007

3

A Mediaeval System of Accounting

The United States Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) do not always see eye-to-eye They are in complete agreement, however, on the two major – and quite distinct – functions of business accounting:

(1) stewardship reporting on “the custody and safekeeping” of resources;

and

(2) performance reporting on “their efficient and profitable use”.1

The system of accounting to perform both functions is the same all over the modern world, and it is solidly based on the latest developments from Mediaeval Venice.2

The Conventional “Hybrid” System of Accounting

The Venetian system is based on records of actual transactions between the firm and other parties These transactions normally result in:(1) a flow of funds (cash or credit) between the firm and other parties

during the lifetime of the firm; and

(2) a stock of funds (cash or credit) at the end of its life.

1 See FASB (1978) para.50 and IASB (2008) p.17.

2 A definitive description is provided in a treatise by Luca Pacioli entitled

Summa de Arithmetica, Geometria, Proportioni et Proportionalita published in 1494

However, double-entry bookkeeping is thought to have been in use over 150 years earlier in Florence [see de Roover ‘The Development of Accounting Prior to Luca Pacioli’ in Littleton and Yamey (1956) pp.114–174].

Resources are recorded at cost price (funds outflow) when they are acquired They are recorded at selling price (funds inflow) when they are sold This constitutes a reliable historical record based on the objectively verifiable evidence of transactions that have actually taken place.

In order to provide up to date information, however, it is normal to divide the life of a going concern into artificial accounting periods of

no longer than one year At the end of each accounting period, those

resources that have been used up or sold during the period are charged

in the profit and loss account as “expenses”; and those resources that

are left over at the end of the period are shown in the balance sheet as

“assets”

Resources still in the process of conversion from input into output, however, present a major end-of-period accounting problem Two ques-tions need to be answered:

The first is a “volume” question:

How much of the resource has been used up or sold during the period, and how much is left over at the end of the period?

The second is a “value” question:

What monetary figures should be attached to these quantities?The first question commonly arises in connection with the consump-tion of stocks and work-in-progress and with the use of benefits from long-lived “fixed” assets (including buildings, plant, equipment, research and development expenditure, and goodwill)

The second question concerns a basis of valuation to enable all items

to be expressed in terms of the common denominator of money The traditional (and still popular) favourite is historical cost Alternatives (canvassed particularly strongly during the inflation accounting con-troversy of the 1970s) include current purchasing power equivalent, current cost, and deprival value.3 Fair value (the current favourite) is the subject of Chapter 4

Irrespective of how the end-of-period adjustments are made, however, their effect is to transform the whole nature of the accounting system from a pure (funds) system into a (funds and value) hybrid:

Once the accounts are “contaminated” by end-of-period asset ations, the figures lose their purity as records of transactions: they

valu-3 See Rayman (2006) ch.5.

become an unidentifiable mixture of records of fact and assessments

of value

[Rayman, Financial Times, 12th December 2002]

The consequences are far-reaching:

Accounting information is a strange conglomeration of figures, some based on funds, some on values, and some on an unidentifiable mixture of both

[Rayman (1969) p.68]This has vital implications for the two major functions of accounting

Stewardship Reporting

For stewardship reporting on the “custody and safekeeping” of a firm’s

resources in the narrow sense of keeping track of them from acquisition

to disposal, the hybrid nature of the Mediaeval resource accounts is

no obstacle The figures themselves have no significance other than as backward-looking symbols of volume:

It does not matter whether the monetary symbol for one unit of finished product is £10 or £100, or whether the symbol for a three-year-old piece of equipment is £200,000 or £400,000

[Rayman, Financial Times, 12th December 2002]

To anyone familiar with the particular “accounting code” in use for choosing the symbols, the conventional accounts are ideal for keep-ing track of a firm’s resources from acquisition to disposal As long as the auditors exercise due diligence, they can examine the accounts in order to give their opinion on the custody and safekeeping of the firm’s resources Although this aspect is sometimes mistakenly dismissed as mere “bean counting”, it normally requires ingenuity, imagination, and highly developed forensic skills Many of the most high-profile finan-cial scandals are the result of failure in this area

When properly implemented, the accounting system is an excellent instrument for reporting on “the custody and safekeeping” of resources and for ascertaining whether or not they have been used honestly on legitimate business This function of accounting may appear to be limited; but it is vitally important for the detection of error and fraud