[Pen-l] The Fragility of Economic Data

[michael perelman <michael@xxxxxxxxxxxxxxxxx>]

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?

--
Michael Perelman
Economics Department
California State University
Chico, CA
95929

530 898 5321
fax 530 898 5901
http://michaelperelman.wordpress.com
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