Sunday, June 7, 2009

The Fragility of Economic Data

Measurement of profits always includes a certain degree of subjectivity as long as the operation involves durable physical assets or longer-term financial assets, the value of which will depend upon future economic conditions. The economist who concerns himself most deeply with this issue was J. R. Hicks, a younger contemporary of Keynes. Hicks recognized that accounting is backward looking, while economic values depend upon the unknowable future. I backward looking, Hicks meant that accountants use previous prices and extrapolations based upon historical experience. Economics looks at an investment in terms of how it is expected to perform in the future.

For example, when a business purchases a computer for $10,000, it does not write off the full cost in the year of purchase. Instead, it will follow an accounting convention, which will subtract a fixed amount of depreciation for each year of its expected life. Nobody knows whether the computer will be obsolete in two years instead of the expected five. If it has to be replaced sooner than expected, then the computer will have to be depreciated prematurely.

The degree of uncertainty becomes far greater with financial instruments. For this reason, accounting rules can become a matter of life and death for a corporation. To make matters worse, accounting tricks permit corporations to create an illusion of success. Such practices do not depend upon Enron-like fraud. Instead, skilled accountants can circumvent the law, making financial regulation into an oxymoron. At the same time, investors presumed to be making informed decisions, even though they have no way of penetrating the opacity of accounting that supposed to measure how well a firm is doing.

The FASB is supposed to be there to provide investors with reliable information, but when this information became inconvenient, Congress stepped in. Congress did not have to pass any laws; it merely had to threaten to do so.

So now the banks are healthy. The stock market is improving. When will the other shoe drop?


Shag from Brookline said...

"So now the banks are healthy. The stock market is improving. When will the other shoe drop?"

The banks may turn out to be centipedes. Better to keep them barefoot and pregnant with regulation.

Myrtle Blackwood said...

It just goes to show that scientific knowledge, like all knowledge, is inherently ideological and contingent on the politics of its discipline.

Anonymous said...

like when do you lose tenure? isn't ain't no. yo.