It’s hard to account for flaws in the rule-book

IT SHOULD be no surprise that socialist economies give the impression of creating more output than capitalist ones. Under socialism you get rewarded based on what you produce – hence an incentive to overstate production. Under capitalism you get taxed based on what you produce – hence an incentive to understate production. These are two rational responses to the rules of the game, and demonstrate how the way we measure economic activity is dependent on those rules.

But there is no clear distinction between socialism and capitalism in practice. To some extent the Soviet Union was merely a market economy laden with rent-seeking and riddled by bureaucracy. The present banking system suffers from similar sorts of corruption and inefficiency.

When economists talk about the efficiency of the profit and loss system, we tend to take for granted that the profit and loss we observe matches with reality. But government interventions are liable to disrupt these signals – inefficient taxes, arbitrary subsidies, and monetary debasement all separate prices from the underlying conditions of demand and supply. Another source of noise is faulty accounting standards – as Gordon Kerr has pointed out in his fascinating new book The Law of Opposites: Illusory profits and the financial sector.

Published by the Adam Smith Institute and supported by the Cobden Centre, of which I am a senior founding fellow, it is a short, accessible, inside account of how present accounting standards not only permit but actually require wrong accounting. With special emphasis on International Financial Reporting Standards (IFRS) Kerr shows how banks are able to game the system. It warrants serious attention from those keen to understand how the regulatory structure actually contributed to the financial crisis.

According to Kerr, “accounts should be the managers’ and auditors’ honest statement of the bank’s financial position” but he points out that “executives have both the motive and means to overstate profits”. It would be naive to think that independent auditing solves this problem, and we should expect accounting errors as a fact of life. But this is mitigated if companies that make errors – or indeed commit fraud – can be rooted out. The profit and loss mechanism is what penalises financial wrongdoing.

The problem with regulation is that by its nature it standardises accounting techniques. Therefore if those techniques are faulty, they create a systemic crisis. Kerr outlines this “dynamic of intervention”, showing how the failure of one policy (such as the Basel II rules placing higher capital charges on small businesses) leads to even worse ones (such as subsidising credit). When bureaucrats launch new interventions to correct the perverse effects of the old ones we are doomed.

Kerr was an adviser to the Private Members Bill proposed by Steve Baker MP last year, which attempts to oblige banks to file accounts based on UK company law rather than IFRS. The banking industry would be wise to consider its arguments.

Anthony J. Evans is associate professor of economics at London’s ESCP Europe Business School.