Mark-to-Market Accounting Needlessly Destroys

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There is a widespread tendency among the advocates of capitalism to believe that when the government regulates one’s own house, that is wrong and an intolerable outrage, but when it regulates the neighbor’s house, that is a necessity, for everyone else is clearly in dire need of regulating. What would the rest of the world do without our benevolent omniscience?

The marketplace is composed of a veritable jungle of goods and services, including novel financial products. Some of these products are unique, possessing properties that must be appreciated apart from nominally similar assets. The notion that a centralized authority can successfully issue one-size-fits-all valuation methods is as preposterous in the realm of financial products as it is in the realm of art or real estate. The imposition of fair value accounting rules—or any accounting rules—by the government or its delegates should therefore be regarded as wrong and dangerous.

One might then ask: But what if banks should be using fair value accounting anyway? Isn’t the “fair value” of an asset its real value? If so, then isn’t the government just making banks do what they should be doing anyway, because doing otherwise is fraud?

To answer this, one must consider the implications of adopting fair value as the universal accounting standard. Fair value is supposed to represent the market value of an asset. In reason, this value should be a readily accessible concrete market price. However, fair value supporters state that fair value cannot simply be reduced to a price on an electronic exchange. One marvels at the audacious hypocrisy of a viewpoint that holds as valid the modeling of fair value when objective facts are unavailable, but derides as “myth” the modeling of values from readily available facts like cash flow.

At any rate, in application, fair value accounting requires banks to value assets in accordance with a secondary fact: What market participants say an asset is worth. This say-so is hypothesized to be accurate by the very fact that markets always discover the correct price. There is an obvious problem with the notion of adopting a number whose accuracy you cannot logically verify. Why is a successful bidder’s valuation right, but not yours? How do you know?

One might then argue that whether the price is right or wrong, investors need to know how much they could get in the event of a forced liquidation of assets. This would not be a reasonable argument, because the basic assumption of a business is that it will continue existing. An accounting philosophy that holds corporate death as a metaphysical premise is unfit for the real world.

Another obvious problem of valuation by means of such second-hand information is that the next buyer/seller pair has to set their bid/ask not in accordance with objective facts about the profitability of the asset, but by how they think the next set of buyers and sellers will set their prices. The entire market becomes a case of everyone trying to game everyone else’s decisions in advance, not trying to identify profitable opportunities in accordance with objective facts. Those who think that market prices will be rational and reflect the nature of the assets under mark-to-market rules do not take seriously enough the Darwinian concept of competition for resources.

Should we then take the market on faith? Can the market be wrong? If so, how?

This brings us to the ultimate conceptual flaw of fair value rules. Recall that banks “print money” via extension of credit under a fractional reserve system or other leveraging authorization. If all banks are marking assets to market, then the first time the market retraces significantly, all banks take write-downs, or a loss in equity, which means that there is a general credit contraction. Since there is a credit contraction, there is less money in existence, and prices must drop. When prices drop, there are more write-downs. The price of an asset is pegged to a negative self-reinforcing cycle. Fair value accounting rules are like a Ponzi scheme in a nightmare anti-universe where every new transaction serves not to prolong the scheme, but to bring it one step closer to its destruction.

The destruction has been extensive. By the time the financial crisis came to a head in the fall, there had been an estimated $500 billion in write-downs. This amounts to over $5 trillion in credit, or one-third of the GDP. The supporters of the mark-to-market rules have yet to offer an explanation of how credit contraction of this magnitude can result in anything but economic disaster.

The very size of this money destruction also brings up constitutional questions. Article I Section 8 of the U.S. Constitution grants Congress the power to “coin Money” and “regulate the Value thereof.” If one-third of the money supply is erased by means of accounting rules, this amounts to a de facto regulation of the money supply and its value by the Executive branch (which has delegated this power to a private entity acting under the aegis of the SEC).

It is disturbing to consider that the economies of the world have been so beholden to a fatally flawed notion for several quarters, but bad news does not get better with age. The accounting rules should be rescinded in their entirety, and government should refrain, and be restrained, from setting accounting rules for the private sector in the future.

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