Wednesday, January 2, 2013

From Mercantile Exchange to Railroads

We're looking at Double Entry: How the Merchants of Venice Created Modern Financeby Jane Gleeson-White, starting here.

So double-entry book-keeping served as a foundation stone of capitalist rationality and, on an individual level, business success. Luca Pacioli's advice would echo through generations of clerks laboriously maintaining ledgers.

In Pacioli’s view, three things are needed by ‘anyone who wishes to carry on business carefully. The most important of these is cash or any equivalent, according to that saying, Without this, business can hardly be carried on.’ The second thing necessary in business ‘is to be a good bookkeeper and ready mathematician’. The third ‘and last thing is to arrange all the transactions in such a systematic way that one may understand each one of them at a glance, ie, by the debit and credit method’. Not much has changed today.

Production and Decisions

Capitalism developed and changed in the eighteenth and nineteenth centuries, however. Book-keeping evolved into accounting. The medieval core of double entry proved durable for these new, much larger enterprises.

This vast new range of double-entry applications reflects the extraordinary expansion of business from the late eighteenth century to the close of the nineteenth, a period which saw the rise of the joint stock company (a business organisation which was funded by selling shares to investors who became partners in the venture), and marks the formative era of accountancy. During these decades, accountants transformed a mere system of recording exchanges into a method of managing and controlling business. The first signs that double entry would be equal to the task of monitoring and directing this new industrial world of factories, wage labour and large-scale capital investment were found in the north of England, in the pottery works of Her Majesty’s potter, Josiah Wedgwood (1730–95)—a factory called Etruria, named, by chance, after the ancient Italian region home to Pacioli’s Sansepolcro.

Wedgwood ran a large business that often did not make much money, for inscrutable reasons. So he decided to investigate.

During this period of scrutiny, Wedgwood made an important discovery—the distinction between fixed and variable costs—and he immediately understood the implications of their difference for the management of his business.

A new form of production - large factories - led to the beginnings of cost and management accounting. This was part of a much broader evolution from a system centered on mercantile exchange to one also suited for production and accountability.

The shift in outlook required to move Pacioli’s bookkeeping system beyond its mercantile origins in an exchange economy (where it recorded the exchange of goods, owing and being owed, paying and collecting debts) to manufacturing, where the emphasis is on the production of goods (the conversion of materials and labour into products) was huge.

The growth of railroads in the mid-nineteenth century brought a whole new set of issues. They required outside investment, which both meant more audit control to prevent fraud, and clearer distinctions between income and capital, so investors could be paid dividends out of actual income.

Not only did a new form of production—factories—challenge and alter double-entry bookkeeping from the 1770s, but the financing and managing of the vast investments required to build railways during the same period of industrial expansion brought new issues of accounting and accountability.

The key accounting issue in a corporation is the amount of profit available for dividends—which means that a corporation must properly distinguish between capital and income, because profits derive from income, not from capital. This new laser-like focus on profits and dividends brought two new accounting questions to centre stage: How to calculate income or profit? And how to value assets? These questions were rarely asked before 1850 but by the end of the century they had become the major preoccupations of practising accountants.


Tuesday, January 1, 2013

Double Entry and the Modern World

I read Double Entry: How the Merchants of Venice Created Modern Financeby Jane Gleeson-White last week, largely motivated by wanting to know some of the deeper reasons behind the surface apparatus of Quickbooks, which for various reasons I have to figure out soon.

It sounds like a dry subject. But the book is historically colorful, thought-provoking and well-written. Accounting numbers rule much of our lives and way of seeing the world. But they have a history and limits and flaws.

Measurement and capitalism

She tells the story of how Italian monk and mathematician Luca Pacioli in 1494 first wrote down the methods Venetian merchants had used to keep accounts, possibly for several centuries before that. The invention of double-entry clarified notions of cost and profit. According to some historians perhaps it led to capitalism itself.

In six pages Sombart set out his belief that the emergence of capitalism and the appearance of double-entry bookkeeping in the thirteenth century are causally related. He wrote: ‘It is simply impossible to imagine capitalism without double-entry bookkeeping; they are like form and content.’

Weber’s definition of a ‘capitalistic enterprise’ is derived from the concepts of double-entry bookkeeping: ‘a rational capitalistic establishment is one with capital accounting’. Like Sombart, Weber argues that double entry is significant because it makes possible an abstract measure of income and expenses—and therefore enables the calculation of profit, the key component of capitalistic business practice. Weber also believed that the formal rationality of double entry made the world a cold and disenchanted place—and, ominously, predicted that double entry would continue its rule ‘perhaps until the last ton of fossilized coal is burnt’.

The new double-entry methods caused a deeper change in perception:

He calls Pacioli’s treatise on double-entry bookkeeping ‘a major innovation in economic history’. First, because double entry provided the means of discarding all information extraneous to decision-making, leaving behind only numbers. And second, because it translated these numbers into a common measuring tool called ‘profit’, which allowed a relatively precise evaluation of actions. Double entry thus transformed business books from mere memory aids into records which allow the calculation of profit—and which can therefore be used to measure the success of each individual transaction and of a business generally.

But this did not come without a price.

We are now so familiar with this once innovative (and largely arbitrary) cost-benefit way of thinking that we take it for granted and cannot imagine it otherwise. And yet, as we shall see, this profit-driven way of thinking encouraged by double entry is not only driving managers to drink, academics to pull their hair out, politicians to short-term opportunism and most human beings to suffer in some way, but it is also destroying the world beneath our feet.

She argues that accounting is poorly suited to count environmental damage, for example. This is a problem when accounting has become central to the practice of policy and government.

National statistics

One of the main extensions of accounting is modern national income accounting. It is so familiar (at least if you have studied economics) that we forget how relatively recent it is. Keynes and Kuznets largely invented it, and both were skeptical about its use.

As a thinker of great depth and complexity who saw economics above all as a moral practice, Keynes was suspicious of statistics and considered these quantitative measures of the national economy as exceptional, emergency measures demanded by the times. In the budget speech which presented these accounts for the first time, the British Chancellor expressed the same view, stressing that the publication of official estimates of national income and expenditure should not be regarded as setting a precedent.

That did not stop a massive increase in the use of techniques which had proved useful during the war.

In 1952, very few statisticians were familiar with the theory and practice of national accounting. This would soon change irrevocably. The work done by Stone, Kuznets and others became the foundation of international accounting, and their national income statistics used to measure economic growth would soon become the key indicator of national success and government performance.

But even the main originator of much national income accounting was skeptical of its application.

But the accuracy and usefulness of national income measures have been questioned from the beginning, by Keynes and others, including Simon Kuznets himself. For example, Kuznets believed the national accounts should include the value of unpaid housework, despite the fact that including this vast contribution to the national economy would present statisticians with the difficult task of making monetary estimates of this valuable work. The US Commerce Department refused to calculate these estimates—and as a result Kuznets broke his association with the department in the late 1940s. Kuznets was also concerned about the effects on people’s lives of the modern economic growth that these statistics encourage as an end in itself.

GNP continues to be questioned as an adequate measure, most significantly recently in the Stiglitz-Sen-Fitoussi study.

Perpetual scandal

The numbers can often conceal as much as they convey, and we can mistake a false impression of precision for truth. The numbers sometimes are outright lies, for one thing. Accounting is also inseparable from scandals, she says, and always has been. People have not lost confidence in accounting despite failure to detect fraud or indications of problems on a litany of cases from Enron to Worldcom to RBS.

However, not only has no such fall ensued but it turns out that these accounting scandals are a regular feature in the landscape of accounting. They are as old as the profession itself, dating back to the earliest days of the formalised use of collective capital: the corporation. Corporations and accounting scandals go together like Gordon Gekko and greed. The nineteenth and early twentieth centuries are rife with corporate collapses of the magnitude of Enron’s and comparable in their elements. And they all stem from significant accounting misstatements orchestrated by influential senior managers. Equally, the responses of lawmakers and watchdogs have been the same over the past one hundred years: tinker around the edges of the law, found new watchdogs, proclaim a new era of greater scrutiny and let accountants and auditors out to play with the managers of vast sums of other people’s money.

We'll look at more tomorrow.


"Sure, Big Data Is Great. But So Is Intuition"

An NYT article is skeptical of inflated claims for Big Data:

The quest to draw useful insights from business measurements is nothing new. Big Data is a descendant of Frederick Winslow Taylor’s “scientific management” of more than a century ago. Taylor’s instrument of measurement was the stopwatch, timing and monitoring a worker’s every movement. Taylor and his acolytes used these time-and-motion studies to redesign work for maximum efficiency. The excesses of this approach would become satirical grist for Charlie Chaplin’s “Modern Times.” The enthusiasm for quantitative methods has waxed and waned ever since.

Big Data proponents point to the Internet for examples of triumphant data businesses, notably Google. But many of the Big Data techniques of math modeling, predictive algorithms and artificial intelligence software were first widely applied on Wall Street.

At the M.I.T. conference, a panel was asked to cite examples of big failures in Big Data. No one could really think of any. Soon after, though, Roberto Rigobon could barely contain himself as he took to the stage. Mr. Rigobon, a professor at M.I.T.’s Sloan School of Management, said that the financial crisis certainly humbled the data hounds. “Hedge funds failed all over the world,” he said.

The problem is that a math model, like a metaphor, is a simplification. This type of modeling came out of the sciences, where the behavior of particles in a fluid, for example, is predictable according to the laws of physics.

In so many Big Data applications, a math model attaches a crisp number to human behavior, interests and preferences. The peril of that approach, as in finance, was the subject of a recent book by Emanuel Derman, a former quant at Goldman Sachs and now a professor at Columbia University. Its title is “Models. Behaving. Badly.”

It really is a matter of proper scope, and consciousness of limits. Big Data is wonderful for finding the Higgs Boson among billions of particle paths, or tracking potential credit card fraud. It is not so good at many other tasks where the data is absent or incomplete or misleading. In those cases, it is little different from ancient farmers looking at the sky and seeing mythical animal patterns.

The Importance of Stocks and Depreciaton


We're looking at Double Entry: How the Merchants of Venice Created Modern Finance by Jane Gleeson-White, starting here. Book-keeping evolved into accounting as outside investors needed assurance that dividends were paid out of actual income, not capital.

Railways and factories also wore out, however, which led to another important concept: capital stock and depreciation.

The advent of the corporation raised several other key accounting issues; for example, how to calculate the declining values—due to wear and tear—of large investments in machinery, rails, rolling stock (or railway vehicles), and so on. This problem gave rise to the concept of depreciation.

It took a long time for accountants to come to terms with depreciation and properly accounting for assets. And this is still a problem, she says, when it comes to the environment since many assets are free.

This is because until recently economists have assumed that natural resources are so plentiful that any loss of them is insignificant, not worth counting. They assumed that natural resources like water, soil, forests and air were free gifts of nature.

But just as the nineteenth-century railway entrepreneurs had to learn that human-made capital—rails and machinery—wears out and must be depreciated, so some economists are beginning to understand that nature’s capital is also subject to wear and tear and depletion. Cambridge University’s Professor Sir Partha Dasgupta is one economist who is critical of the GNP and its use to judge the progress or otherwise of nations. He argues, ‘as so many economists have already done, that GNP’s main weakness lies in the fact that it is insensitive to the depreciation of capital assets’. And from an environmental point of view, this is critical.

The Modern Economy is about Stocks

This is no doubt true. But she perhaps over-emphasises environmental gaps to the exclusion of other social assets like trust or quality of life.

The larger point is we are often too focused on flows rather than stocks, including the depreciation of assets (stocks meaning an amount, like a stock of wheat, rather than an equity share like the stock exchange.) This is a basic economic distinction we often forget. As Dasgupta says, we need to be sensitive to the depreciation of capital assets.

We are much better at being conscious of flows of income rather than the valuable stock of assets which produces that income. Yet many of the great economic challenges of our era have more to do with stocks than flows of income. Many or our capital assets, such as the knowledge required to build an Intel processor or the song "Hey Jude" do not depreciate in the traditional way. They may have to be re-learned or passed on, but they do not wear out.

So what happens when the stock of our valuable assets, properly defined, gets disproportionately much larger than money income flows? In many ways, our prime objective should be to increase the stock of assets. Income and distribution are secondary factors , especially of many of the benefits flowing from those assets are free. Some of our political thought gripes towards this, especially those who think capitalism should be left unfettered to create wealth which government can then redistribute. But that often confuses income with value.

We will come back to this point another time.

Finally, Gleeson-White emphasizes again how the numbers may often conceal deeper uncertainties.

Even accounting’s most fundamental concepts and practices, such as income measurement and asset valuation, are based on uncertainties. Accountants still cannot agree on how to define income, the measurement of which remains one of the intractable problems in financial accounting theory and practice. The valuation of assets only becomes more complex and more fiercely debated as modern global corporate structures and financial instruments become increasingly labyrinthine, and income measurement, the key to determining profits and therefore dividends, is inextricably linked to this contentious, chimerical practice of asset valuation. Nor is the crucial measurement of costs an objective process: costs are also highly contestable figures and may result as much from the collusion or rivalries of firms as from any other actuality. Accrual (or corporate) accounting—the need to allocate revenues and expenses between accounting periods and to value assets and liabilities at the end of an accounting period—raises problems which have never been solved and are probably incapable of solution. Numbers can be negotiated to make management look good. In effect, ‘accounts are used to justify decisions and to excuse mistakes’.

She concludes

In an era of international capital, when our wealth is more than ever tied up in its fortunes, and at a time when corporations, governments and financial institutions are demonstrating their fallibility on a global scale, it is essential that we are aware of the somewhat arbitrary laws of account that govern them—especially because it is in the labyrinthine workings of our accounting systems that value itself is assigned. It seems that if we want to bring our infinitely voracious consumerism into line with the resources of our finite planet, we must consider giving our planet a value that the market can recognise and account for, assign a monetary value to the oceans, air, forests, rivers, wildernesses. • Delete this highlight

(My bold). In the end, we come back to the problem of economic value. There have been many major shifts in perception of costs and decisions and stocks and accountability and depreciation. Together, they make up the modern economy.

It is time for another major shift, to cope with intangibles and abundance and our reliance on those abundant stocks. Value should not be defined by arbitrary default.


Small Towns and Big Cities

Happy New Year! We are back in New York after traveling to see family over Christmas. It is is great to go away, and it is also great to come back home.

We were in a small mountain town for ten days, and it was very nice. Small towns are so much more livable than they were even twenty years ago. The town is filled with good restaurants of all kinds and cuisines - perhaps not as good as New York, but not bad and much cheaper. Standards have leapt ahead in recent years.

The supermarkets are vast. We love Freshdirect here in the city, but going to those big Safeways etc felt a bit like communist era visitors to the West looking at acres of food with big aisles. You can get pretty much anything even in the sticks now. The cost of living is very low, with Walmart dragging down the price of basics.

And that is before you count instant connection with the Internet and cable and Kindle downloads. We can read the Times updated to the second in a place where you would never have seen a paper copy before. It used to be living far away from a good bookstore was a hardship. Now almost any book you want is instantly downloadable, or can be delivered within days. And the town in question has a magnificent second hand bookstore as well.

We're still happy to come back to our little apartment perched in a tower. But sometimes I feel we pay a lot to live in the big city. Perhaps the relative advantage of cities is changing again.

Of course, relative advantage is always changing. People fled downtowns for the suburbs in the postwar years, escaping apartment blocks for houses with big yards. But many still want to be within commuting distance of major cities. Despite predictions of telecommuting revolutions, jobs still cluster in the major urban centers, with property prices to match.

It has been going on a long time. The fact you can buy enoki mushrooms in a small town is a small change compared to the coming of the railroad in the nineteenth century or radio in the early twentieth. But it still feels as if the relative sophistication of the metropolis is fading.

One theme of this blog is we are approaching material abundance, indeed material saturation as a society. In fact, we tried to hint to relatives that we didn't really have room for more stuff this year as gifts, so memberships, subscriptions etc were great as an alternative. ( We got stuff anyway.) Consumption naturally shifts towards intangibles - culture, relationships, vitality.

But many of these intangibles are spread in different ways.The level of material and cultural services even in remote places is now very high. You may not have the Met Opera, but the local cinema was advertising live HD broadcasts from the Met Opera.

It used to be you would escape stultifying repression in small towns for the anonymity and freedom of the city. But that difference has narrowed too.

Cities if anything have a slight deficit in terms of material standard of living. The main advantage they still have is cultural vitality. But even that can be priced out by soaring real estate prices.

It is now easier to take your life with you anywhere. Digital goods are omnipresent anywhere with a fast connection. I wonder if that will ultimately change property calculations.