In praise of mark to market accounting

There's a useful idea out there: things are worth what they're worth. No, not what you paid for them, not what you think they might be worth in the future, but what someone will pay you for whatever it is. There's a further useful idea: that the accounts of an organisation should reflect this idea. What is owned by a corporation, a bank, should be listed in the books as being worth what someone will pay for them.

Two little stories about how such mark to market accounting could help solve our current financial woes. There are worried that if Greece defaults then Royal Bank of Scotland will be back for another bite at our wallets and we really don't want that again.

Our peripheral sovereign exposures outside of Greece, which we have already written down to 50 percent, are circa 1 billion pounds ($1.5 billion), which are modest relative to core tier one capital of circa 50 billion pounds.

Well, no, apparently not. For RBS has marked to market: Greek bonds are worth only 50% of face value, so RBS has them in the books at 50% of face value. They've already taken the loss in fact.

However, compare that with Felix Salmon talking about adjusting the principal on US mortgages:

Maybe the thing for the US government to do, then, is not to force Frannie to accept principal reductions outright — but rather just to force Frannie to mark their current underwater mortgages to some semblance of sanity, rather than doing their see-no-evil act and insisting on holding them at par. If Frannie has to take writedowns anyway, then maybe they’ll do so in a homeowner-friendly way.

One way of dealing with the housing problems over there is simply to say, well, yup, those houses just ain't worth what we all thought. So, instead of you having a $400,000 mortgage, we'll say it's now a $250,000 mortgage. Which is of course absurd....except that it's not. For the losses have already happened.

These mortgages were all bundled up into MBS and CDOs recall? Sliced and diced and sold off as bonds. And the people who bought those bonds have made huge losses: so the losses have already been recognised. As Felix points out, when people buy these bonds in the secondary market (ie, at market value) then they can see that there's a profit to be made by making exactly these principal reductions on the underlying mortgages. Instead of a $400k mortgage which is going to default, leaving them with a $250,000 house, why not just cut the mortgage to $250,000 and have no default?

The loss is already baked into the price at which they bought the bond so why not? Which leads us to the problem at Fannie Mae and Freddie Mac. They refuse to mark their mortgages and bonds to market. Meaning that they refuse to make these mortgage adjustments. But we all know full well that the losses have already occurred: that's why they're bust, recall? If they had to mark to market then the mortgage adjustments could be done and the problem would be over earlier.

Remember: we all know the losses have occurred, all we're actually suggesting is that everyone should recognise them. Just as with bankruptcy itself, when losses have occurred it is best to own up to and deal with them quickly. Which is what mark to market insists that everyone does with the benefits we see above.

RBS has already taken the losses of a Greek default: so we don't have to worry about a Greek default (at least, not about RBS). But not marking to market at Frannie means that the US mortgage and housing problems are likely to drag on for years. After all, all that is really being suggested is that accounts and accounting standards should reflect reality: which is what they're supposed to be doing, isn't it?

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The decline of British retail

With the on-going eurozone crisis, the UK economy is now enveloped in unremitting gloom. Of course, if you over-spend as conspicuously as has been the case over the last decade, the return to normalcy will be immensely challenging – and time-consuming. After years of excess debt, the UK is now experiencing the first elements of a ‘hard landing’.

Last week, the UK retail sector had a shocker, possibly its worst week for generations. The mighty Tesco announced that its core UK like-for-like sales growth over the last quarter, excluding petrol and VAT, fell by almost 1% - its worst performance for 20 years. Whilst Sainsbury’s underlying figures were less gloomy, recent data from other less defensive retailers is far worse. The retail electronics sector remains in a desperate state. Both Dixons and especially Comet (owned by Kesa) are struggling whilst HMV’s share price continues to plummet. Last Wednesday, Mothercare stunned the market, with a trading statement that sent its shares spiralling down by 42% - an astonishing fall for a reputable high street retailer.

In assessing these figures, remember that annual inflation is c5%, so that these like-for-like sales figures are, in real terms, even more depressing.
Currently, optimism is a rare commodity in the retail sector, which partly explains the widely reported last-minute re-drafting of the Prime Minister’s conference speech. The prospects for Christmas already look very grim. Few retailers expect their post-Christmas trading statements to be favourably received.

However, the benefits of a market-led economy mean that it can adjust readily to changed circumstances. Tesco, for example, has already launched parts of its ‘Big Price Drop’ campaign, which – despite an adverse impact on margins – should boost sales. In time, as debt levels revert closer to equilibrium, shoppers will return in greater numbers and lift the high street gloom. But the stark lesson for governments remains – never lose control of public borrowing.

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Devaluation is not the answer

It is fast becoming accepted as conventional wisdom that Greece should default on its debts, leave the euro, print lots of its own currency so that it can carry on spending and, in the process, achieve a devaluation that would boost its economy. I agree with the first of those points, see the second as unnecessary, and view the third and fourth as misguided. Let me elaborate.

The default point is simple enough – there comes a point where you have so much debt that you can’t afford to service it any more, and bankruptcy is the only sensible option. Putting off the inevitable just drags out the pain. As to leaving the euro, while this may (or may not) be desirable on other grounds, it does not necessarily follow logically from default. Even if Greece defaulted on their existing debts, they could still carry on using the single currency so long as they cut spending sufficiently to balance their budget. This brings to points three and four.

The reason generally given for Greece to leave the euro would be to print money to fund continued high spending, and achieve a currency devaluation in the process. Many people argue this would be a good thing, since (a) sufficiently deep spending cuts are almost impossible in a democracy and (b) devaluation would boost Greece’s competitiveness. There may in some places be some truth in the first of these points, but the second is a fallacy. As Detlev Schlicter put it:

Debasing the currency can never be in the interest of Greek society – or any other society for that matter. Of course, weakening the exchange value of the new drachma would be a temporary shot in the arm to the export industry. As Jamie Whyte explained so lucidly here, and using the UK to illustrate the point, a weak currency is a subsidy to exporters funded by a tax on importers. Debasing the currency never furthers overall prosperity. In terms of access to internationally traded goods and services, the Greek population would get instantly poorer.

To restate the point: devaluation would do nothing to boost real prosperity. Gains to exporters would be offset by the fact that imports have become more expensive. In the short run, you might see a boost to employment, as people substitute domestic goods for imported ones. But that’s only a temporary effect – the inflation that inevitably accompanies money printing will invariably cause all sorts of problems, ranging from increased production costs to systematic capital misallocation, and these will soon wipe out any initial gains brought by devaluation. In the final estimation, all you’ve done is propped up a bloated state sector, eroded your productivity, and unjustly transferred wealth from one part of the economy to another.

Eurozone policymakers sometimes contrast ‘external devaluation’, the process described above, with ‘internal devaluation’, which basically means increasing your international competitiveness by reducing your labour costs. Politically, the latter may be much more difficult – thanks, in large part, to the sticky wages phenomenon. But economically it makes a great deal more sense. Money printing doesn’t boost an economy, other than in the very short term. Becoming more productive does. Indeed, greater productivity is the essence of wealth creation. How have so many people managed to forget that?

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Libertarian independence

I visited Manchester this week, to help with the ASI's events at the Conservative Party Conference. Sadly, apart from our own events, the TFA's Freedom Zone and Forest's excellent Stand Up for Liberty event, I left feeling a little despondent. What struck me about the conference was just how marginalized libertarians are within the Conservative Party today – not just the Rothbard-reading, abolish-the-state libertarians, but also classical liberals who just want to reduce the size and scope of government, if not to (say) privatize the roads. The same applies to UKIP and the Liberal Democrats – both have libertarian members who struggle against parties that are fundamentally unlibertarian. (I have not met a libertarian Labour member but a few may exist for all I know.)

Yes, the Conservatives generally agree that income redistribution is a bad thing, but on a range of other important issues the party is at best divided and at worst totally opposed to the libertarian agenda. On issues like sound money, the NHS (“the most precious institution in our country”, according to the PM), bank bailouts, farm subsidies, personal freedoms, localism, economic regulation, migration, foreign interventionism, drugs, defence, corporate welfare, and others, the leadership and/or membership of all of the UK's mainstream parties are set against even moderate libertarian stances.

It's not just that they're insufficiently radical on the areas where there is agreement; in many cases above it is profoundly opposed to libertarian ideals, and this will never change from the inside.

It seems to me that many politically-active libertarians have overinvested in the party politics – rather than convincing politicians, who ultimately have to appeal to voters for their jobs, libertarians should be focusing both on changing public opinion and asserting themselves as a voting bloc. Libertarians, moderate and radical, should be fiercely independence from any particular party.

Matt Welch and Nick Gillespie, both editors at Reason Magazine, have a new book, The Declaration of Independents, in which they argue that libertarians in America should throw away party tribalism and embrace being floating, independent voters and activists. It's not a directly analogous system, of course, but the principle that libertarians should avoid wasting time on party politics and instead work on specific issues is a good one. Why waste time working for a political party that mostly despises what you believe in?

This is true of Conservative libertarians most of all. It's perfectly possible that the Liberal Democrats, UKIP or even Labour could put forward a manifesto that coincides with more libertarian beliefs than the Conservative party – the latter's corporatist "pragmatism" (bailouts, protection for big business) is widespread but may be less ingrained among other parties' voting bases. And the Tories might become more libertarian if they had an incentive to. There is no incentive unless more libertarians assert themselves independently from parties. They have nothing to lose but their membership cards.

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More QE

So, the Bank of England has announced another £75bn on quantitative easing. Bad news.

More quantitative easing means more kicking the can down the road. It means preventing markets from adjusting, and it means perpetuating the misallocated capital, excessive risk-taking, and over-leveraged balance sheets that got us into this mess in the first place. To put it simply, printing money does nothing to solve our current problems. If anything, it makes them worse.

There will be no return to sustainable economic growth until the authorities realize that we can’t defy economic gravity forever. Recessions are about adjustment and recalculation, and as long as policy is designed to prevent the liquidation of bad investments, the paying down of debt, and the reallocation of scarce economic resources, recovery will remain elusive.

Here are the economic policies we need: an effective bank resolution regime, a stable monetary environment, and a thoroughgoing commitment to removing tax and regulatory barriers to investment and entrepreneurship. Right now, we aren't getting any of them.

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How to not learn from other people's mistakes

I first heard about the government's new "credit easing" plan from David Gauke MP, who spoke at at one of the ASI's tremendously successful events. The idea to give government backing to small business bonds in some form sounded strangely familiar. Allister Heath, who also spoke at the event, had the same feeling of deja vu:

It is hard not to see the parallels between Osborne’s plans, which would involve massive government intervention, and what happened to the US mortgage market. If it decides to start a vehicle to purchase bonds issued by small companies, as hinted yesterday, the UK government would encourage their issuance. But it will also mean that the private sector will no longer have an incentive to check their quality, which means that we could soon see an explosion of dodgy, sub-prime small business debt.

Thousands of businesses could over-extend themselves and go bust, and the taxpayer would risk losing a fortune, especially if sound firms continue to borrow from banks and the bad ones tap into the government’s scheme. Osborne may also want to encourage the securitisation of small firms’ loans. Again, this may be a good idea but not if moral hazard destroys the idea as a result of government guarantees. Osborne’s real plan is probably to create a system that could be extended to guarantee all private bond issuance in case the Eurozone implodes; but this would threaten the UK’s solvency by over-extending the government’s balance sheet.

If there was one lesson from the subprime mortgage crisis, it was that government backing for risky loans creates perverse incentives. But the government seems to be completely preoccupied with debt and credit. Instead of cutting back on the state to encourage economic activity, Osborne focuses solely on doing so to cut the deficit and reducing the government's cost of borrowing. In other words, in doing the least amount necessary to fix the debt burden. That's important, but only one part of the story. 

The same myopia can be seen here, in small business policies – where firms need tax and regulation cuts, he gives them government-backed credit with all the financial danger that will create. We need a passionate free marketeer running the show to get the economy moving again. But in Osborne, we've got a zero-conviction manager.

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Occupy Wall Street – the real culprits

For just over a week now Zuccotti Park in New York has become yet another place to be 'occupied' by those claiming to represent the majority in society: in the case of Occupy Wall Street, they claim to represent the '99%', which I suppose includes me (and most likely you).

And their demands? Unclear. The movement is a hodgepodge of the frustrated and annoyed, not a particular coherent political or economic ideology. However, overarching aims demand an end to corporate influence on the political process combined with a generic anger at the bankers and other 'fat-cats' who have, figuratively speaking, gorged themselves on our milk. All this, of course, is topped off with the expected banners exclaiming 'Stop Capitalism'.

Some of the aims I have sympathy for. Undoubtedly the corridors of power have been captured by interest groups and lobbyists (although here big business is not solely to blame). People have a right to be furious about the economic decisions that have been made, thereby saddling them and their future generations to indebtedness. But who are they to be angry with? Is it really Gordon Gekko who should be vilified?

To a certain extent, yes. However the real culprits of this calamity are our disastrous politicians, who dish out taxpayers' money without second thought, disregarding their electorates' wishes. A billion here, a trillion there: when you're seeking re-election spending other peoples' money must be easy. It is government who repeatedly bails out bankrupt firms (with our money) and thereby takes away risk, a vital function of the market. When government encourages Wall Street to act recklessly by shielding them from losses, little is likely to change. To top it off we have no choice in the matter – the government is the only force able to legally steal your money.

True Capitalism is not the problem. The reason successful firms are successful is because they offer things we want. We can choose whether to give them our money – Ronald McDonald has never coerced you into buying a Big Mac. If the government were a firm on the open market, it would go broke within milliseconds.

But we haven't got true capitalism. It is a bastardised form. We have currencies controlled by central banks who artificially manipulate interest rates and money supply. We have governments who are in bed with a harem of interest groups, all vying for special favour and concessions. Our government steps into markets, naively trying to 'correct' them but only emboldening crises. Firms which should have gone under long ago have made too many friends in office: the system is cancerous.

To those at Occupy Wall Street: you have every right to be furious. But who enabled Wall St. to act with such careless abandon? March down to D.C. or the Fed: it is the politicians who have squandered your money on vain political projects and hide behind the redoubt of 'broken capitalism'. Helicopter Ben is not throwing his own money out the side of his helicopter, after all.

It is not capitalism that needs fixing, it is our meddling, incompetent political class and our bankrupt political system. Our economic and political freedom is stifled and it is time to take it back.

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Same old, same old

A few weeks in the wide expanse of Arizona and Utah quickly cleared the brain of despondency about the state of the world. The horizons were limitless, the empty roads a joy to cruise and the sense of time and space humbling but satisfying. But returning to the fag end of the Lib Dem conference and the start of the more depressing Labour affair soon brought back that old despair. The Tories have been little better.

None of this is to say that America itself offers much hope. For like the ruling classes here and in the eurozone, they still don’t come clean on the fundamental reality that most western countries have been living far beyond their means for too long. To be sure, the Tea Party phenomenon cottoned onto it early but its very success attracted a ragtag collection of agendas that have little to do with fiscal sobriety but instead threaten derailing its original mission.

The crise du jour is now the fate of the euro and politicians are nervously dancing around the only realistic solution to save the currency – a formalized fiscal union that will see the richer nations funding the poorer ones. That’s what happens in a federal state and it’s what the US has been doing for decades through national programs like Social Security, Medicare and Unemployment Insurance. Canada has a more formalized mechanism of negotiated formulae that directly transfer funds from wealthier provinces to poorer ones. It’s done in the UK, too – money flows from England to Wales, Northern Ireland and Scotland.

The problem for the eurozone, of course, is that such formalized fiscal transfers are political dynamite. The rich don’t want to support the feckless and the poor don’t want to be bullied. The matter is compounded by the fact that time is fast running out. America and Canada built up their federal fiscal regimes from the bottom up over many decades, bit by bit. The eurozone has probably only a few weeks to do the same and the scheme will have to be imposed from the top down to make it happen.

But if the euro is to be saved that’s what must be done. Is that what the people want?

So much for the big picture where the problems conveniently drowned out further developments on the ground that will do little to spur economic growth. On Oct. 1, the minimum wage went up for young and old and agency workers were granted equal rights as full time staff. Neither measure will foster employment. While our leaders fret about grand numbers in the billions and trillions, they continue to nickel and dime the real economy into submission.

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Sam Bowman

Sam Bowman is Research Director of the Adam Smith Institute, Britain's leading libertarian think tank, where he has worked since 2010. He is responsible for managing and editing the Institute's publications and research, as well as managing the Institute's team on a daily basis and helping with the ASI's overall policy strategy.

His current research agenda is the political economy of "Bleeding Heart Libertarianism", a school of thought that tries to use free market policies to improve the welfare of the poor. His key policy areas are immigration and planning, which he sees as the two major areas where states hurt the poor globally and in the UK respectively. He is also interested in market monetarism, the epistemic challenges facing social democracy, and the case for wealth redistribution within free markets. He likes food, beer and computer games.

He tweets as @s8mb.

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Dr Eamonn Butler

Eamonn Butler is Director of the Adam Smith Institute, rated one of the world's leading policy think-tanks. He has degrees in economics, philosophy and psychology, gaining a PhD from the University of St Andrews in 1978.

During the 1970s he worked on pensions and welfare issues for the US House of Representatives, and taught philosophy in Hillsdale College, Michigan, before returning to the UK to help found the Adam Smith Institute.

Eamonn is author of books on the pioneering economists Milton Friedman, F A Hayek, Ludwig von Mises and Adam Smith, and co-author of Forty Centuries of Wage and Price Controls and books on intelligence testing.

He contributes to the leading UK print and broadcast media on current issues, and his recent popular publications The Best Book on the Market, The Rotten State of Britain and The Alternative Manifesto have attracted considerable attention.

He has also contributed articles to national magazines and newspapers on subjects ranging from health policy, economic management, taxation and public spending, transport, pensions, and welfare.

He tweets as @EamonnButler.

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